Headed in the Right Direction
The latest employment report suggests that the economy is headed in the direction of a soft landing, although it is entirely premature to think such an outcome is locked in. Growth has slowed, hiring has moderated and inflation is slightly lower, so everything is going as the Fed wishes. Even so, growth remains a bit too strong, hiring is still well above sustainable levels, and inflation is far from the Fed’s 2% objective, so the Fed is still far from mission accomplished. And as a result, it is still also premature to think the Fed will not raise policy interest rates further. This is all to be determined.
Is the glass half full or half empty? A case can be made either way, but the correct conclusion, in our judgment, is both or neither, and any such view likely reflects the bias of the person offering an opinion. A review of the latest growth numbers indicates that the pace of expansion has slowed, but it remains above the economy’s longer term sustainable trajectory of 1.5% to 2.0%. Significantly and correctly, as a number of Fed officials have stated publicly, a period of below sustainable growth is needed to loosen the tight labor market. Indeed, hiring has also slowed, but it remains very solid. The estimated underlying growth rate of the labor force is around 0.5%, so somewhere between 50,000 and 75,000 per month. Hiring is still running two to three times that pace. The unemployment rate would have declined recently, if not for an unexpected surge in labor force participation that may soon confront its upper limit (if it hasn’t already). Putting this all together implies that while growth has slowed, it has to moderate considerably further for the Fed to conclude that economic conditions will permit inflation to decline towards its 2% target.
To make this point emphatically, imagine telling a cop you don’t deserve a speeding ticket because you just slowed down to 100 MPH from 120 MPH in a 70 MPH zone. Good luck. The best that can be said is the economy is headed in the right direction, but the Fed has more work to do. One bit of very good news is that there is now no visible reason for concern that inflation might get out of hand, a concern that was very real a year ago. That’s why the Fed can be pleased that growth is moderating, yet it is far from being satisfied that it will necessarily accomplish getting to its inflation target.
Investors have reason to harbor some optimistic thoughts, as long as they avoid undue celebration. Corporate profits should resume a positive trajectory, as long as a modest rate of economic growth is maintained. That isn’t a high hurdle. Equity valuations are actually quite reasonable, especially when excluding the “Magnificent Seven” from such calculations. Multiples for the seven highly valued companies, Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla are extremely high, far beyond the typical S&P stock, but arguably deserved. But even if those seven are debatable, what is less contentious is that the rest of the market is reasonably priced. In fact, one could easily put together an entire portfolio of attractive, healthy companies with solid growth prospects sporting price-to-earnings multiples below 12 or even below 10. Such calculations are obscured when we look at the P/E multiple of the market as a whole, including the seven. A few companies may be expensive, and that is almost always the case. In our judgment, the typical stock is reasonably priced, especially at prevailing interest rates.
Can prevailing interest rates be sustained? If growth needs to slow further, as we believe, it is also premature to conclude that the peak in rates has already occurred or that the Fed is done tightening policy. We need to see more data to reach that conclusion. While some Fed officials think monetary policy is restrictive, including Fed Chair Powell, who has stated that publicly, others think more rate hikes are needed, implying they do not share Powell’s view. We don’t either. In rough terms, it is hard to believe real rates are inhibiting growth when the 10-year Treasury yields about the same as the prevailing inflation rate.
As always, the proof’s in the pudding. As more data becomes available, we will be able to observe whether the Fed is continuing to make progress towards its inflation target or more policy steps are required. In the meantime, we maintain a cautiously positive outlook for equities and remain defensively positioned in fixed income investments.
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