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Inflation Slows, Stocks Should Rally

Prof. Peter Morici - 6/30/2007

Yesterday, the Commerce Department reported in March personal income increased $47.3 billion or 0.4 percent, disposable personal income increased $37.6 billion or 0.4 percent, and personal consumption expenditures increased $52.0 billion or 0.5 percent. Consumers continue to lead economic growth, and this should continue. Gasoline prices rose 10 percent in May, and consumers are borrowing more to maintain spending habits. However, spending is moderating a bit as consumers save more. Those savings should find their way into the stock market, and that will be good for stock prices.

The weak 0.7 percent first quarter GDP growth reported yesterday was primarily caused by the slump in new home construction and the trade deficit. The housing sector is likely bottoming, and GDP growth should be in the range of 2.0 in the second quarter and closer to 3 percent in the second half.

Prices for core items, excluding food and energy, continued upward but at a snails pace. Good news on inflation is good news for investors. Worries about rising interest rates should abate, and stock prices should rise.

Inflation and Federal Reserve Policy

The price index for personal consumption expenditures, including food and energy, was up 0.5 percent in May, and was up 2.3 percent from May 2006.

The Federal Reserve closely watches the price index for personal consumption expenditures, less food and energy. This core price index was up 0.1 percent in May, after rising 0.1 in April and not changing in March. In May, the index was up 1.9 percent from May 2006.

As important to the Federal Reserve, the market-based core inflation index, which excludes food, energy and imputed prices like rent on owner occupied homes, was up 0.1 percent, after rising 0.1 percent in April and not changing in March. That index has increased 1.7 percent since May 2006.

The slower pace of economic activity is beginning to cool core inflation but the Fed is not likely to lower interest rates soon.

Oil and gasoline prices are like to surge this summer and the ethanol program is playing havoc with food prices ranging from baked goods to meats and milk. The Federal Reserve remains nervous about a breakdown of pricing restraint elsewhere in the economy.

Savings and the Stock Market

The savings picture worsened. Americans continued to spend more than they earned. In May the savings rate was minus 1.4 percent. That was worse than the minus 1.2 percent April.

After falling through January, prices for existing homes have risen each month since. Liquidity is good, and the housing adjustment has been mild.

In the months ahead, housing prices will continue to improve—rising somewhat in markets with stronger jobs growth, falling in cities with retrenching industries and staying flat in many others.

The losses imposed by the subprime crisis are largely visited on large hedge funds and spread very widely among holders of bonds backed by bundles of low-grade mortgages. As long as the economy continues to grow, most subprime loans will not fail, and that is one reason university endowments are scooping up these bonds from hedge funds requiring liquidity to satisfy their creditors.

Similarly defaults on corporate junk bonds remain low, and will stay low as long as the economy continues to expand.

While wreck and ruin may be visited on irresponsible financiers that manage Bears Sterns and a few other houses whose senior management let their hormones interfere with their judgment, by and large the foundations under the debt secured by most private equity investments remains sound. The bonds that finance private equity deals already paid premiums before the recent scare and large investors will calm once the logic of the fundamentals under the securing corporations overcome herding instincts in debt markets.

Overall, the foundations of the debt market are secure as long as the economy continues expanding, and the stock market should regain its footing and start heading upward again.

Stock prices should continue to outperform the U.S. economy. Most large U.S. companies earn a good deal of their profits abroad. The combination of strong growth in Asia and moderate growth in the United States is good for their bottom line and stock prices.

A weaker dollar against the euro and the pound makes U.S. equities a particular bargain for foreign investors. Large U.S. multinationals earning significant shares of their profits in Asia are a great play for Europeans who sit on strong euros and pounds but have few good investment options at home.

Surging corporate profits, stabilizing interest rates, and robust demand from both domestic individuals and foreign investors should power up stock prices.