WHY I'M BULLISH

Once again, conventional economic wisdom on Wall Street and in Washington has proven wrong. Many market and policy professionals started the year certain the U.S. was heading into recession in 2023. Today we find the S&P 500 stock index up 16% year-to-date, the unemployment rate resting comfortably below 4% and the economy having produced another 1.5 million jobs.

I’ve been bullish and remain so.

Early in the year, I thought if the U.S. was going to fall into recession, it would be because companies would respond to profit pressures by cutting costs through mass layoffs. But when I looked at layoffs in March I didn’t see the problem spreading much beyond a few isolated sectors. Through the first quarter, profit margins had proven resilient. This is taking pressure off companies to fire workers. In 2000 and 2007, by contrast, margins were narrowing and companies moved reactively and aggressively to cut costs.

Profit resilience takes pressure off companies to raise prices aggressively, another essential part of the bull market story. I argued last summer that inflation was peaking. It isn’t popular on Wall Street to be overtly optimistic these days; nor is it popular in central banks or newsrooms. But inflation is clearly coming down, a process that I think will continue and is critical to the economic and market outlook.

A few reasons for my optimism about inflation:

• Rental housing price increases were a major driver of inflation after Covid. Private sector measures show rent increases slowed sharply last year, but because rental contracts renew every 12 to 24 months, that slowdown has not yet show up concretely in official statistics. I believe they will soon.
• ?China, the world’s second largest economy, is experiencing something that is starting to look like debt deflation – a condition in which households and businesses have borrowed too much money and cut prices to raise funds to cover their borrowing needs. Contrary to conventional wisdom, China did not experience a post-Covid economic boom. Instead, the private sector is hunkering down. Over more than a decade, Chinese state authorities responded to economic slowdowns by launching state construction projects and encouraging bank lending to support property investment. That game is over. Property is overbuilt. I think China has one obvious lever to pull to get its economy going. It will reduce the value of its currency, the yuan, to reduce the costs of its exports and stimulate its enormous factory sector, the backbone of its economic system. Put another way, I suspect it will export some of its deflation, which might help the U.S. right now. The yuan has already lost 7% of its value against the dollar so far this year, Chinese producer prices are already contracting and U.S. import prices were already down 6% in May from a year earlier; excluding oil U.S. import prices were down 2%.
• ?The Federal Reserve worries that worker shortages are pressuring companies to lift wages and raise prices in sync to keep up with the high cost of labor. I see shortcomings in the analysis. 1) Wage growth is slowing. Annual growth in average earnings of private sector workers slowed to 4.3% in June from a year earlier, compared to 5.9% in March 2022. The rate of wage growth in June wasn’t much higher than it was in late 2018 (3.6%), when few people were worried about a wage-inflation spiral. 2) The theory of a tradeoff between unemployment and inflation (called a “Phillips Curve” in economic shorthand) has a long history of failure. During the 1970s, inflation was high when unemployment was high. In the late 2010s, inflation was low when unemployment was low. Labor markets are complex and so is the inflation process. Simple rules don’t work.
• Here’s a remarkable fact that hasn’t gotten enough attention: Between the fourth quarter of 2019 and the first quarter of 2023, U.S. worker productivity grew 3.7%, which is 1.4% at an annualized rate. We had the worst outside shock to our economy in a century in the form of Covid, which killed millions of people and drove millions of workers away from offices, restaurants and hotels. It also sparked a revolution in remote work. And during this upheaval workers became more productive. In fact, productivity growth during and after Covid so far has been greater than it was during the expansion of the 2010s, when it averaged 1.1% annually. Worker productivity holds down inflation because it supports corporate profits and thus diminishes pressure on companies to raise prices. Productivity has been slowing recently, but only after an earlier surge. If the rise is sustained it will be enormously good news for the nation.
• The bond market doesn’t see inflation as a problem. Yields on 10-year Treasury notes, at 3.8%, are near the same levels as in 2010, when investors worried about deflation. Rates in Treasury Inflation Protected Securities markets (known as TIPS), indicate investors expect inflation of 2.2% in five to ten years, less than they expected through much of the early 2010s. If the bond market is right, Jerome Powell will go down in history as the person who protected the central bank’s inflation-fighting credibility after badly misreading the consequences of Covid-19.

I will get a chance to mark this optimism to market on July 12, when the Labor Department releases its June consumer price index report. That number will almost certainly show that the inflation rate fell into the low 3% range last month. I won’t be surprised if the annual headline inflation rate is in the high 2% range before long.

Federal Reserve officials keep telling investors they expect to raise short-term interest rates two more times this year to ensure they’ve killed inflation. They might not need to, and that’s why stocks are rising.?