Stocks finished mixed on Friday as the Dow Jones Industrial Average moved to another record high while the tech-heavy NASDAQ lost 0.5%. It would seem that the rotation toward value away from growth is continuing although the correction in the high flying growth stocks to date hasn’t been severe enough to shake the confidence of long term holders. Markets seem to be looking for leadership. One day it’s the financials when interest rates spike a bit. Another day it might be the energy stocks if oil prices make a big move. Then again it could be the industrials if trade tensions ease a bit. But, so far, none of these counter trends have been sustained. Interest rates or energy prices don’t support big moves. It’s late September, a time when earnings and data reporting are relatively light. The front page is dominated by a bunch of non-economic news with the exception of trade and the tariff story has been played out ad nauseum and almost fully discounted in the market. By fully discounted, I mean that markets are assuming that China and the U.S. still escalate the tariff spat for several more months or quarters before seriously sitting down to try to reach a compromise while, at the same time, NAFTA and trade talks with Europe find an end point that isn’t very disruptive to economic or earnings growth.
With elections now less than seven weeks away and the noise around the Kavanaugh nomination non-helpful to the incumbent Republicans, no one in leadership is interested in souring the high level of confidence that currently exists. Thus, while I don’t see trade talks between China and the U.S. resuming before the elections, I also don’t believe it is likely that Trump will accelerate actions against China before Election Day although he might amp up the rhetoric to play to his base.
The biggest event this week is likely to be the FOMC meeting. Markets are pricing in a 95% change of a quarter point rate increase. In my adult life I have never seen the Fed go against 95% odds. Thus, we can count on that rate increase. The focus, of course, will be on the future. At the moment, the odds are better than 50-50 that another quarter point increase is coming in December. I expect the Fed, via Chairman Powell’s post-meeting press conference and the FOMC statement that will summarize the meeting to make it clear that if the economy stays on its present course of economic strength and slowly rising inflation then another increase in December is likely. At the moment the consensus expectation calls for three subsequent increases next year. While I don’t expect Mr. Powell to directly alter that expectation, it should become clear that the actual number of increases will be closely tied to the pace of wage growth and inflation over the next several quarters. The jump in wages in August is the first real marker that might suggest a directional change upward in inflationary pressures. But the August PPI and CPI numbers were subdued. At an inflection point, every indicator will not change simultaneously. Nor should one take one monthly data point on wages and extract too much from that.
Indeed, if you look deeper into the CPI numbers, several points stand out. First, only two components were particularly worrisome. One was healthcare. But of the factors pushing prices higher, only hospital services, up over 5% year-over-year, seems to be any cause for concern. Drug price increases have been less and less over the past several years and are barely higher today than overall CPI growth. Thus, while healthcare costs are still putting 2
upward pressure on inflation, they should become less of a concern over time. The other big inflationary number within the CPI report was tuition. That number has been higher than the CPI for years and doesn’t seem yet to be slowing down. But, at the same time, marginal quality schools are starting to hurt. Some are closing. This should be a precursor to slowly ebbing inflation in this category. Both healthcare delivery (i.e. hospital care) and education would seem ripe for some significant technological disruption over the next several years. Other than computers in the classroom or library, technological advances in education have been sparse for many years. Walk into a classroom today, whether it be kindergarten or college, and it won’t look very different than it was a generation ago. Judging from test scores, the U.S. is losing ground against the rest of developed world. In healthcare, our outcomes are average while our cost per capita is nearly double the rest of the developed world. In both cases, it will be technology that will close the gap.
One final point relative to inflation. Survey data indicates that home prices for the past several years have been rising by about 5%. But the housing component of the CPI has been increasing at only half that rate. There are two reasons. One is that the CPI’s shelter component, the biggest single component of the index, uses something called imputed rent to calculate the rise in the cost of home ownership. In other words, using actual rent history and the current rate of interest, an equivalent rent is calculated and used as a proxy that converts home ownership into quasi rental. It tends to underestimate the impact of rising prices in a time when rates are relatively low. As a result, inflation may be slightly higher than the numbers indicate. On the other hand, rent or implied rent is only one cost of ownership. Others include utilities, maintenance, taxes, and the cost of improvements. These have all been tame.
The bottom line is that inflation remains relatively tame. The upward pressures from healthcare and education shouldn’t accelerate. Rising wages will exert some pressure but much of that pressure can be offset by higher productivity.
If inflation is tame and earnings continue strong, the path of least resistance still seems up. Certainly, recent gains have been a result of those factors so valuation (i.e. many stocks simply aren’t cheap anymore) would appear to be one force that could limit near term gains. Unlike last quarter when the mood was mixed, we will be walking into the third quarter earnings season with expectations pretty high. As the focus turns to 2019, earnings growth expectations will start to fall from 20%+ to less than 10% as the year-over-year tax rate differential will disappear. Therefore, while earnings will be well received, whether stocks react in a robust manner after they did after Q2 remains an open question. Other factors suggest a more muted response this time around. The impact of escalating tariffs could be highlighted and be an unpleasant surprise for some. Higher interest rates will increase non-operating costs for some. And the recent strength in the dollar (up 3% year-to-date against a bread basket of foreign currencies) will be a headwind to reported earnings for the first time in many quarters. While I don’t expect a big correction, I do think that the response to earnings could be more mixed than some expect. The recent market rise has released some animal spirits among investors who could be jumping in at a less than opportune moment.
This is also the last week of the third quarter. Since it has been a good one for stocks, some portfolio managers who must adhere to strict asset allocation guidelines could be sellers of stocks and buyers of bonds this week to realign portfolios. Once again, that’s a short term trading tweak that long term investors can and should ignore.
Today, Lou Dobbs is 73. Mean Joe Greene is 72.
James M. Meyer, CFA 610-260-2220
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