Not the Beginning of the End
From the recent record high on the S&P 500 Index achieved January 26 through market open this morning, U.S. equity prices have fallen almost 5%. While that’s still less than half of the commonly accepted definition of a “correction”, a 10% retreat, it’s nonetheless the sharpest pullback we’ve seen in almost two years, eclipsing by a hair the drawdown observed heading into the Election in the fall of 2016. So, is this the start of a more pronounced decline? That undoubtedly remains a possibility, but we are skeptical that this is the end of the long bull market. We see an opportunity to add incrementally to equity positions at this level, and we will continue to add risk to our portfolios, should the pullback deepen further.
The Inflation Boogeyman Makes an Appearance
The very phrase “correction” implies that stocks are mispriced and due to be reset. That may well apply here. Market pricing has been on a tear post-Election, with nary a pause along the way, particularly in January of this year. While underlying economic fundamentals have been strong and are getting stronger, and while tax cut legislation presents a further boon to corporate earnings, a growing number of investors were likely uncomfortable with the pace of price gains over the past year. Any sign of distress is sufficient for some to pull a few chips off the table under such conditions, and last week, they were given that sign.
The Bureau of Labor Statistics reported on Friday that wages earned by workers paid hourly climbed 2.9% year over year, the highest such reading since 2009 (although only marginally higher than the 2.8% figure recorded in September that failed to provoke a similar market response). Wage inflation has historically engendered broader price inflation – when workers are getting paid more for doing the same job, prices on all goods tend to rise, as there is more money in circulation without a commensurate increase in the quantity of goods and services available for sale.
So, why is inflation so concerning to equity investors? Several reasons. Firstly, future earnings must be discounted back to present value at a higher rate, implying a lower value in today’s dollars. Also, as bond yields are pushed higher along with inflation, the relative value of stocks versus bonds declines. But most importantly, rising inflation forces central banks to tighten monetary conditions, choking off economic growth and precipitating recession. There seems to be some concern that an overheating economy may be closer at hand than realized. With unemployment already quite low, fiscal stimulus from tax cuts and a potential infrastructure bill may drive wage and price gains to worrisome levels.
Cycle Peak Not Yet in Sight
That may be so, but not at any point on the visible horizon. Inflation is rising, but remains at an entirely benign level today. Likewise, the Fed has been gradually withdrawing monetary accommodation for the past two years, but financial conditions remain exceptionally easy. Companies are indeed paying their workers more, but at the same time, they are investing aggressively in productivity-enhancing software and equipment. As long as productivity is rising (i.e., more goods and services are available for sale per man-hour worked), then companies can pay higher wages without dramatically increasing prices on their products. Runaway inflation is not a clear and present danger by any stretch.
A recession lies in our future – that much is an incontrovertible truth. But, it is a distant future. There is ample reason to believe that economic growth, and corporate profits with it, will be exceptionally strong this year and most likely next year also. Stock prices are a little high, but not exorbitantly so, and investor enthusiasm remains elevated, despite this current hiccup. We are buyers at these levels, and we’ll come in more aggressively, should prices continue to fall, as we have every expectation that the market is going to achieve new highs within a few months.
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