I Can See Clearly Now

“I can see clearly now…It’s gonna be a bright, bright sun-shiny day.” Johnny Nash. Well not quite, but some major uncertainties have been resolved with the latest jobs report. No doubt, the economy is performing well, indeed, arguably too well and talk of recession is likely to vanish, at least for a while. The Fed is now on hold. Senior Fed officials will confirm that soon enough. Prevailing interest rates were not so high they inhibited growth, so rates should drift higher over time. The stock market’s trajectory will be highly sensitive to incoming President Trump’s fiscal policies, as well as tariffs and border policy. So, many forecasts remain uncertain, as is inevitably always the case.

Looking back with the benefit of a few months of hindsight, growth slowed briefly this past summer, as various unknowns, most critically the outcome of the election, induced some caution on the part of consumers and businesses. So, spending and hiring slowed. But now we know the kind of programs President Trump is likely to promote in his second term, even if the details remain unknown. Still, tax cuts coming, along with some tariffs, a more restrictive border policy, and a more probusiness regulatory regime that will be favorable for fossil fuels, financial companies, and merger activity. Households and businesses can now more readily move forward with their plans.

Solid growth undermines the (weak) case used by the Fed to justify reducing interest rates. Many Fed officials promoted the idea that real interest rates were restrictive, even as they acknowledged they couldn’t determine a “neutral” rate for policy. At the very least, it should now be clear that market rates were not a significant deterrent to growth. They lowered overnight rates by a full percentage point, but the market drove up long-term rates by roughly the same amount. And growth picked up notably, certainly as is very evident from job growth. At this point, there is no longer any justification for rate reductions unless or until inflation moderates much closer to the Fed’s 2% target. But that has also become less likely.

Domestic policies under Trump risk meaningful upward pressure on inflation bolstering the effects of solid economic growth. Solid job growth has been sustainable only because of the influx of legal and illegal immigrants. The domestic labor force rose by about 90,000 monthly over the past year, but the non-native born workforce rose by almost exactly the same number. The augmented growth in labor supply made some moderation in wage rates possible. But President Biden did inhibit illegal immigration several months ago and President Trump is very likely to do even more, even as job openings rose sharply in November. So, we expect a meaningful tightening of the labor market over the coming months, with some spillover into wage pressures. Add in tariffs, which will add to consumer prices, even if we don’t know which product categories or by how much, and the combination is very likely to push inflation upward to some degree. While the Fed lowered rates by 0.25% at its last meeting, even then, many of its senior officials expressed concern with this outlook. This was obvious at the time, so it was mystifying even then that the Fed cut rates in December. But now, it is likely that any voices for further cuts will be met by a stone wall. The Fed is done until a completely new case for policy change emerges.

Globally, there is increased clarity emerging in the Middle East and, perhaps, even with Ukraine. Israel soundly thrashed Iran’s proxies, Assad was chased out of Syria, Hezbollah sued for a truce after its leadership was decimated by exploding pagers and its military forces fled from Israeli forces, while Hamas appears to be close to agreeing to return its Israeli hostages. Attention is now turning to the Houthis, which are still backed by Iran, but also to Iran itself. Iran’s antiaircraft systems have been devastated by Israel, so now its nuclear facilities are vulnerable to attack. And Trump is unlikely to be sympathetic to Iran, unlike Biden, and he surely will not forget that Iran tried to assassinate him. Expect Iran to look for ways to de-escalate. This is the Middle East we’re talking about, so there’s no real prospect of peace breaking out. But a dramatic temporary decline in hostilities looms ahead. And with such a decline, rebuilding and investment opportunities will abound, which will export demand for European and American goods.

The surge in long-term U.S. interest rates is likely behind us for now, although it seems quite likely they will drift higher, as the labor market tightens and inflation holds firm. So, we continue to favor short-term or shorter intermediate securities where the coupons should offset any decline in price. The stock market outlook is more complicated. Solid growth should enable companies to deliver on investor’s strong earnings projections. So, stocks should perform reasonably well, as long as interest rates do not rise sharply from here. But the market’s upside is somewhat capped, since we see no rate declines, so no real potential for P/E multiples to increase. I agree with others that stocks are unlikely to advance as strongly as they have over the past two years. Stock performance should be driven by company earnings, not by expanding multiples. “Look all around, there’s nothin’ but blue skies,” Johnny Nash. Well not quite. The future is always uncertain. But stocks should advance with earnings and continue to outperform bonds.

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