Q3 2023
October 3, 2023
In the 1st half of this year, stocks staged a significant rally. Stock prices rose as investors gained confidence that interest rate hikes were nearing an end; that the Fed had successfully tamed inflation.
This past quarter it was confirmed. I first heard it in July, listening to wholesale distributors report their earnings. Universally, managements were saying that raw material and intermediate good prices were no longer rising, they were falling.
The Fed has done a tremendous job taming inflation, which is great for the long-term health of markets. We may see another interest rate hike before year-end, but the bulk of the rate increases appear, for now, to be behind us.
The stock market, however, fell in the 3rd quarter. What is that telling us? It appears the exuberance included believing interest rate cuts were on the horizon. That was unlikely. I believe the market’s softness in the 3rd quarter, in part reflected its acknowledgment rate cuts are not coming any time soon.
The Fed recognizes we still have an issue with tight labor markets, an issue that could seed a long-term inflation problem.
I’ve talked in the past about the wage-price spiral. It’s the inflationary effect of higher wages finding their way into the cost of all goods. The resulting price increases sustain pressure on wage demands and we “spiral” into an inflationary cycle.
Over the past two years, the Fed was fighting inflation caused by the response to COVID, fiat money, and then supply disruptions. Raising interest rates (and the passage of time) seem to have tamed those inflationary pressures. Now we must wait and see if the tight labor market will fuel another round of inflation.
I recognize the wave of labor strikes we’re witnessing are the result of a host of issues but pay is a prominent demand in each. UPS settled with the Teamsters this summer. A 5-year contract including some of the highest wage gains in the union’s history. The current UAW strikes could lead to similar concessions.
The inflation of the past couple years has hurt everyone’s buying power, and people who are working should expect to keep up. Without judgement, I’m observing the forces at play and assessing their risk to the markets.
The Fed sees all this, which is why we will not see interest rate cuts anytime soon.
I can also see the effect of the strong labor markets on company earnings. Across the board, profit margins are under pressure from higher labor costs. The only way to recoup lost margin is to raise prices or increase productivity. Without one or the other, the result is a less profitable (read: “valuable”) company.
Left unchecked, the long-term effect is increased capital substitution of labor. Think of the order kiosks inside McDonalds, you no longer wait in line to put in your order. Higher labor rates make investment in automation more attractive. But this sort of substitution cannot occur over night. For now, companies are bearing the higher labor costs; managements are more concerned about losing good workers in a tight labor market.
Interest rates remain elevated relative to what we’ve seen in the past decade-plus. In the bond market we are focusing our efforts on extending bond maturities where we can lock in these rates. I haven’t been able to say that since 2008 and am pleased that savers are finally getting a decent return on their bonds.
We all wish you all the best, enjoy your Fall
Sincerely,
Mark Hoonsbeen, CFA
Nicollet Investment Management