The U.S. stock market is in a “very dangerous” spot as persistently strong jobs numbers and wage growth suggest the Federal Reserve’s interest rate hikes have not had the desired effect, according to Cole Smead, CEO of Smead Capital Management.
Nonfarm payrolls grew by 353,000 in January, fresh data showed last week, vastly outstripping a Dow Jones estimate of 185,000, while average hourly earnings increased 0.6% on a monthly basis, double the consensus forecasts. Unemployment held steady at a historically low 3.7%.
The figures came after Fed Chair Jerome Powell said the central bank would likely not cut rates in March, as some market participants had anticipated.
Smead, who has thus far correctly predicted the resilience of the U.S. consumer in the face of tighter monetary policy, told CNBC’s “Squawk Box Europe” on Monday that “the real risk this whole time has been how strong the economy has been” despite 500 basis points of interest rate hikes.
“We know the Fed has raised rates, we know that caused a banking run last spring and we know that’s damaged the bond market. I think the real question can be ‘do we know that the lowering of CPI has actually been caused by those short-term policy tools they’ve used?'” Smead said.
“Wage gains continue to be very strong. The Fed has not affected wage growth, which continues to outpunch inflation as we speak, and I look at the wage growth as a really good picture of inflationary pressures going forward.”
Inflation has slowed significantly from the June 2022 pandemic-era peak of 9.1%, but the U.S. consumer price index increased by 0.3% month-on-month in December to bring the annual rate to 3.4%, also above consensus estimates and above the Fed’s 2% target.
Smead argued that the fall in CPI should be chalked up to “good luck” due to the contributions of falling energy prices and other factors outside the central bank’s control, rather than the Fed’s aggressive cycle of monetary policy tightening.
Should strength in the jobs market, consumer sentiment and household balance sheets remain resilient, the Fed may have to keep interest rates higher for longer. This would eventually mean more and more listed companies having to refinance at much higher levels than previously and therefore the stock market may not benefit from strength in the economy.
Smead highlighted a period between 1964 and 1981 in which the economy was “generally strong” but the stock market did not proportionately benefit due to the persistence of inflationary pressures and tight monetary conditions, and suggested the markets could be entering a similar period.
The three major Wall Street averages on Friday closed out a 13th winning week out of the last 14 despite Powell’s warning on rate cuts, as bumper earnings from U.S. tech titans such as Meta powered further optimism.
“The better question might be why is the stock market priced like it is with the economic strength and the Fed being pigeonholed into having to keep these rates high? That’s a very dangerous thing for stocks,” Smead cautioned.
“And to follow on that, the economic benefit we’re seeing in the economy has very little tie to the stock market, it doesn’t benefit the stock market. What did the stock market do last year? It had valuations go up. Did it have a lot to do with the earnings growth tied to the economy? Not at all.”
Rate cut need becoming ‘less urgent’
However, some strategists have been keen to point out that the upside from recent data means the Fed’s efforts to engineer a “soft landing” for the economy are coming to fruition, and that a recession is seemingly no longer in the cards, which could limit the downside for the broader market.
Richard Flynn, managing director at Charles Schwab U.K., noted on Friday that up until recently, such a strong jobs report would have “set alarm bells ringing in the market,” but that doesn’t seem to be happening anymore.
“And while lower interest rates would surely be welcomed, it is becoming increasingly clear that markets and the economy are coping well with the high rate environment, so investors are perhaps feeling that the need for monetary policy to ease is less urgent,” he said.
“[Friday’s] figures may be another factor delaying the Fed’s first rate cut closer to summer, but if the economy maintains its comfortable trajectory, that might not be a bad thing.”
This was echoed by Daniel Casali, chief investment strategist at Evelyn Partners, who said the bottom line was that investors are becoming “a little more comfortable that central banks can balance growth and inflation.”
“This benign macro backdrop is relatively constructive for stocks,” he added.