Despite widespread expectations of a recession, the macro backdrop in the U.S. has remained favorable to start 2024. In fact, many market participants have been surprised at how resilient the economy has remained in the face of unprecedented rate increases over the last two years. And though growth has shown some signs of slowing in the first quarter, it has not nearly been at the pace many investors had feared.

In recent months, many company management teams reported that they feel their company – along with the economy as a whole – is in a good place. Yet, with this economic strength obstructing continued progress in inflation deceleration, we are anticipating an environment in which company fundamentals, particularly pricing power, will be crucial in identifying the winners and losers in the period ahead.

What’s driving the current economic strength?

At the core of U.S. economic strength today lies a resilient consumer who has proven robust despite escalating interest rates. Household spending power has been maintained throughout much of the Fed’s rate hiking cycle, as many U.S. households were able to take advantage of the 2020 drop in interest rates to lock in record-low mortgage rates. Even as rising policy rates drove 30-year mortgage rates to 8% last year, the effective rate on the outstanding stock of mortgage debt remained at around 3%. As a result, household balance sheets have entered 2024 in a considerably stronger position than in previous hiking cycles.

Higher interest rates on deposit accounts and money market funds have bolstered the household income of primarily higher-income groups, contributing to consumer strength. Moreover, pandemic-related fiscal cash injections have provided lower-income households with the opportunity to invest and save, allowing them to also benefit from the increased interest rates.

Consumer spending power has also been boosted by the significant drop in food, rent and energy prices over the past 18 months. With a reduced portion of take-home pay being spent on daily staples, consumer strength has improved even as prices of other goods and services in the inflation basket have remained elevated.

U.S. 30yr fixed mortgage rate, effective mortgage rate, and effective Fed funds rate

30yr fixed mortgage rate, effective mortgage rate, and effective Fed funds rate
Source: Bloomberg, Principal Asset Management. Data as of February 12, 2024.

Consumer strength is contributing to labor market imbalances

With consumers continuing to spend strongly, companies have been inclined to hire more workers to satiate that strong demand. Yet, with labor in tight supply as the combined impact of the pandemic and population demographics inflict a tremendous headwind on labor participation, wage growth is likely to be high for longer.

According to the St. Louis Fed, between the onset of the pandemic and April 2023, an additional 2.4 million people retired from the labor force over and above normal historical trends, subtracting a significant component of the U.S. labor supply. In addition to this “one-off” pandemic-related dynamic, the baby boomer generation, born between 1946 and 1964, began retiring in 2011, and from now until 2030, 10,000 Americans will reach retirement age every day. From 2022 to 2032, labor force participants between the ages of 16 and 65 are expected to grow less than 2%, while those older than 65 are expected to rise by 34%, suggesting that the supply of traditional working-age laborers will remain highly constrained.

Labor force participation
Percentage of population working or actively seeking work divided by the working-age population

Labor force participation rate since 2000
Source: Bureau of Labor Statistics, Principal Asset Management. Data as of February 29, 2024.

Without sufficient younger workers to replace retiring baby boomers and with continued consumer strength supporting robust labor demand, higher wages will be required to attract sufficient labor to meet demand. Sticky wage inflation may potentially create a feedback loop that keeps inflation, and therefore policy rates, likely high-for-longer.

Companies forced to absorb higher costs

There has been a widespread assumption that inflation will quickly revert to the Federal Reserve’s 2% target. Still, recent data shows that inflation progress has flattened out, and prices are proving stickier than expected. If this trend is maintained through 2024, there will be implications for companies.

For the past three years, many companies have ridden the inflation wave by passing on input cost increases to consumers. Yet now, after implementing significant price increases, companies are becoming wary about attempting to pass on further costs to consumers. Companies without pricing power are more likely to be forced to absorb higher costs, weighing on their margins. And, if inflation and interest rates stay high for longer, no sector will be immune. However, the businesses that can manage through the inflation headwinds are more likely to be those who leverage their advantage and continue to pass on costs to customers. For investors, identifying these types of companies requires bottom-up fundamental analysis rather than broader sector calls.

Select inflation measures
Annualized monthly changes, 2019–present

Core CPI, trimmed mean CPI, and Stick price core CPI since 2019
Source: Bloomberg, Atlanta Federal Reserve, Dallas Federal Reserve, Principal Asset Management. Data as of March 12, 2024.

Pricing power in practice

Truck manufacturer

A truck manufacturer generated record sales and earnings in 2023 in the face of what those in the industry referred to as a “trucking recession.” Having recently refreshed their product lineup to provide operators with real, measurable efficiency benefits, they were not only able to take market share but pricing, as well. Beyond truck sales, the company has a recurring parts business that is substantially more profitable than the overall business and provides a cushion to profitability if truck sales slow.

Home goods retailer

A leading manufacturer and retailer of home goods is in the highly competitive furniture business but sells 95% proprietary products that cannot be bought anywhere else. While they are not immune to industry-wide pressure, their ability to manage pricing and avoid big promotions has shown up in their profitability. They have gradually built out an e-commerce and distribution network, allowing for warehousing and the delivery of bulky items that few companies are set up to do profitably. Though many perceive this industry as highly cyclical, this company is proving to be much more resilient because they are promoting less, pricing more, and selling unique products.

The path forward remains uncertain

The economic environment in 2024 has the potential to be good for some while being very challenging for others. It is an environment where investors should expect to see a wider divergence in company performance as management contends with the tension between growth and interest rates.

With a playbook that is no more certain this year than last, investors should remain focused on company-level fundamentals and investing in advantaged businesses that can do it all: maintain a strong balance sheet, generate ample free cash flow, outmaneuver the competition, invest in long term growth, and consistently return capital to shareholders along the way.

Learn more about Principal Edge: Committed to investing in quality companies that can grow revenues and earnings while returning capital to shareholders.

Macro views

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Risk Considerations
Past performance is no guarantee of future results. Investing involves risk, including possible loss of principal. Inflation and other economic cycles and conditions are difficult to predict and there Is no guarantee that any inflation mitigation strategy will be successful.

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