Recent news leads some investors to believe the economy is already in recession. Couple this with the misinterpreted news that inflation is now under control, and you have the foundation for a rally in both stock and bond prices. We are enjoying the rally but doubt it will last. The economy is not in recession. Unemployment is at all-time low, average hourly earnings are higher and retail sales are resilient. This is hardly the figures of a recession. Inventory adjustments at businesses are historically volatile. This past quarter showed business reluctant to pay higher prices for inventory. This can only last for a certain length of time. Ultimately inventories must be rebuilt or go out of business. Inflation figures no question, showed improvement. A drop from 9.5% to 8% is an improvement. The thoughts of many analysts that inflation is quickly dropping back to the Fed’s 2% target rate is folly. Inflation is stubborn. Housing costs are yet to fully work their way through the figures. Rents are strong and going higher. Mortgage rates are high. Prices of homes, off their highs, are holding up. Housing represents approximately 33% of the inflation calculations. The cost of labor is in the early stages of increasing. With unemployment low and the labor force not increasing, it is unlikely the cost of labor will fall. In fact, it will continue to increase. Don’t be fooled by last month’s report. More workers at lower paying jobs held down the average cost. Energy prices fell last month from the release of millions of barrels of oil from the government strategic petroleum reserve. The fall in price distorted the inflation figures. The release will end by October. Energy prices will then go back to trading upon supply and demand dynamics. In our opinion, the most important ingredient of future inflation is reducing the growth and size of the money supply. The Fed is not addressing this issue. They believe inflation can be reduced to their 2% target by simply raising interest rates. We doubt this. This supports our outlook for inflation to stay stubbornly at the 5% to 6% level for another 24 months until the Fed drains liquidity (printed money) from the banking system.
Financial stocks were battered during the recent market downturn. They have since recovered somewhat. We believe the outlook for bank stocks is bright. They are a beneficiary of higher interest rates. They are also a major benefactor of technology. Their costs of acquiring deposits are much lower. With reasonable loan demand their net interest rate margins will expand nicely. Their charge offs for bad loans are negligible. Consumer debt, credit scores and ability to pay debt is at a high. With our outlook for a strong economy and continued wage growth, this element of banking will remain positive.
The bond market rally is muted. Yields are slightly lower. We urge investors to stay with short (18 months and less) durations. Yields in this area are at yield curve highs. In our opinion the risk of extending maturities outweighs the potential reward.
We remain bullish on commodity prices. Recent price pullbacks are just that, pullbacks. We see gold prices and agriculture prices returning to recent highs.