Despite Mixed Signals, U.S. Economy Still Humming Along

By Dr. JoAnne Feeney, Partner & Portfolio Manager

Last week’s two inflation reports raised concerns among equity investors. They finally began to doubt the likelihood of several Federal Reserve rate cuts this year. They should have already known better, but investors can be unrealistically optimistic when it suits them. Specifically, both the Consumer Price Index (CPI) and the Producer Price Index (PPI) came in a little bit higher than was expected, leading many to finally recognize that the Fed does indeed have more work to do to bring inflation back to its 2% target.

While inflation has indeed fallen sharply, it’s looking like it’ll be difficult to wring that last 1 to 2 percentage points of inflation out of the system to reach the Fed’s target. And that means fewer (if any) rate cuts coming this year. So, the 10-year Treasury rate ticked up last week (to 4.28%). Higher interest rates tend to shift stock valuations lower especially for “growth” companies whose earnings are tilted towards future years, since those earnings are discounted more heavily when rates are higher.  And so last week, we saw a bit of a pullback in the S&P 500, which has come to be dominated by growth companies.

While higher rates can undermine equity valuations, the primary driver for a stock’s price over multiple years is the ability of a company to increase sales and profits year after year after year.  For long-term investors, the question shouldn’t be when will the Fed cut rates, but rather, do companies have a healthy sales trajectory and can they generate growing profits? We hear somewhat mixed reports, with some areas of business looking healthier than others, such as the comments below:

These quotes came from industrials, financial, and technology firms; and they are indicative of the variability in business environments facing companies operating in today’s global economy. Recent aggregate data, including GDP growth, ongoing job gains, a low unemployment rate, and rising wages point to a robust economy. Demand for goods and services continues to drive prices higher. And yet, enough companies say the macro environment remains “weak” and conditions “challenging” to make investors wonder. Sometimes, we should take these assessments with a grain of salt, because they can be used as an excuse to deflect investor attention from company-specific execution problems. But when several companies with similar end markets all say roughly the same thing, it may be worth paying attention (as now). 

When we dig deeper, we find that companies are still recovering from the supply chain disruptions of the pandemic. In particular, many companies saw a surge in demand in 2020-2021 that they couldn’t satisfy and are only now seeing operations return to normal. To get back to normal, though, companies had to rebuild inventories and many chose to build them quite a bit higher than before the pandemic. But now those inventories have reached those new higher targets or are seen as excessive, so companies have reduced their parts orders. The companies that supplied those parts are therefore seeing a “weak” or “challenging” demand environment, even though production of the final goods for consumers is still growing.

The auto industry exemplifies this dynamic. If you tried to buy a car a few years ago, you know how few were available. Not only did new car prices surge, but so too did used car prices, because of the spillover of demand. We are finally seeing used car prices fall, as new car production has been growing for the last few years. When the pandemic began, automakers cancelled orders for the semiconductors widely used in autos. These days, hundreds of dollars of chips are needed, and that number is climbing every year. The auto makers erroneously thought that demand for cars would fall, rather than rise, when the pandemic struck (they didn’t anticipate the government’s largess that served to protect household income). Car production fell just as demand surged. And ever since, the car makers have been trying to catch up. They learned a very important lesson and some have even gone on to partner with a chip company to ensure a secure supply of chips in the future. This sector was one that recently concluded a multi-year inventory replenishment. But now they are all set – they have enough chips in inventory, and so orders have fallen back to current production rates. Car production is still growing. So, automakers (and their labor unions) are still seeing solid consumer demand, while the chip suppliers are seeing weaker demand. But that sort of unevenness is nothing new; rarely is it that all segments of any economy are firing on all cylinders at exactly the same times. Amidst this confusion, the Federal Reserve must find the optimal path for interest rates that will both reduce the rate of inflation and preserve a healthy market for labor. Last week’s inflation data showed just how challenging the Fed’s task remains. We may not see rates come down as quickly as some would like (or hope), but the aggregate data still show a resilient US economy, which is a positive for the long-term equity investor, despite pockets of weakness. 

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.