Weekly Investment Update (03/01/2024)

The percentage of stocks participating in the market’s advance has contracted since the fourth quarter of 2023. For reference, the share of NYSE stocks trading above their 200-day moving average has fallen from 69% at the end of last year to 60% today. Although this is not concerningly narrow, in our view, it is an indication of the persistent dominance of growth, technology, and artificial intelligence driven equities.

A key question going forward is what the catalyst for a sustained broadening of equity market participation will be — including better performance from mid and small cap indexes. In recent years, a key pattern has emerged relative to the relationship between market breadth (as measured by the percentage of stocks above their 200-day moving average) and interest rates. As interest rates rise, market breadth has historically deteriorated and vice versa. The correlation between market breadth and interest rates is as negative as it has been in about 30 years. We think an inflation-driven shift in investor psychology could be behind this relationship — concerns of higher inflation drive rates higher, leading to a concentration of capital in businesses perceived to be less rate sensitive. Given our view that inflation and interest rates are likely to fall as we move through the rest of the year, we expect market breadth to improve.

Increased Labor Supply Has Been Key for Economic Growth and Easing Wage Pressures

What is happening: After falling rapidly during the initial COVID shock, labor demand subsequently outpaced supply during the rapid economic rebound seen in 2021 and 2022. In turn, the excess labor demand resulted in heightened job vacancies and contributed to inflationary wage pressures. As the pandemic receded more fully in 2023, additional labor supply returned to the market, helping to ease wage inflation even as economic growth and labor demand remained robust.

The increase in labor force participation has primarily come from an influx of prime-age workers (aged 25-54), immigrants, and those who left the labor market for pandemic-related reasons, such as a health issue or to care for dependents. While most of the groups that left the labor market during the pandemic have largely returned, one subset remains missing — older workers, many of whom likely retired early. The participation rate for those 55 and older is still roughly two percentage points below the level seen in February 2020.

Why it matters: The increase in labor supply has been critical to both supporting economic growth as well as easing inflationary pressures. Fed Chair Powell highlighted improving labor supply as a key reason the economy held up so well in 2023 despite the Fed’s aggressive interest rate hiking campaign. Furthermore, labor supply is likely growing even faster than the official statistics imply. Illegal immigration does not show up in the labor supply or jobs data, but it is included in the official consumption and spending data as it is difficult to disaggregate the consumption of specific groups. In this way, illegal immigration artificially pushes higher some measures of productivity; the numerator of production is more accurate than the denominator of number of workers, which does not reflect people operating outside of official records.

Supply improvement has been a successful way to ease the inflationary pressures sparked by a tight labor market without requiring demand destruction. While there is still some room for labor force supply to improve (for example, older workers returning to the labor force), the labor supply has likely already recouped most of the “easy gains.” A decrease in labor demand, in addition to incremental labor supply additions, would further help ease wage pressures. In our view, slower economic growth should help to slow the demand for labor and push inflation lower.

Recent Data Show a Resilient Economy, Inflation Continuing to Improve Slowly

What is happening: U.S. economic growth remains resilient, but it is slowing on the margin; meanwhile inflation remains sticky on a month-to-month basis even as it continues its downward trend. Fourth quarter real GDP growth for 2023 was revised slightly lower to 3.2% from 3.3% on an annualized basis, largely due to lower inventory investment. Notably, real consumer spending growth was revised higher to 3.0% from 2.7% annualized, primarily due to a large upward revision in services spending that offset a downward revision in goods spending. First-quarter GDP growth, according to the Atlanta Fed projection, is currently tracking at a 2.1% annualized pace, a still strong above-trend result.

Meanwhile, the longer-term disinflationary trend holds with the year-over-year core PCE rate falling slightly from 2.9% to 2.8%. The monthly statistics are choppier, with the core PCE showing a month-over-month (MoM) gain of 0.4% in January, primarily driven by services. Putting it all together, the strength of services is evident in driving both consumer growth and inflationary pressures while goods spending and prices continue to decline.

Why it matters: The strength in core PCE was largely expected given the stronger-than-expected CPI and PPI reports earlier this month. Sticky inflation alongside continued above-trend economic growth has largely priced out market expectations that the Fed will cut interest rates in March. We expect continued disinflation to occur this year even amid the month-to-month volatility, which will enable the Fed to loosen monetary policy. Rebounding labor supply alongside elevated interest rates that continue to permeate the economy should continue to put downward pressure on inflation.

Moreover, while we expect economic growth to slow from its above-trend pace due to higher interest rates, we view this as a slowdown from high levels of activity and continue to see the odds of a severe recession as very low. Given the projected slower growth environment, Bessemer’s portfolio managers have reduced exposure to cyclically oriented sectors that are sensitive to changes in economic growth.