Orlando's Outlook: Bottoming is a process


Bottom Line Wednesday’s release of the minutes from the Federal Reserve’s January policy-setting meeting—Janet Yellen’s last as Fed chair—unleashed another wave of equity-market volatility, as the S&P 500 plunged 1.7% in the last two hours of the trading day. That sparked a deluge of anguished client questions: Have we seen the bottom? Is a bigger correction coming?

In our view, there are two critical Fed signposts on tap over the next month. Next week new Fed Chairman Jerome Powell will deliver his first Humphrey-Hawkins testimony to Congress—on Tuesday before the House Financial Services Committee and on Thursday to the Senate Banking Committee. Powell also chairs his first 2-day policy-setting meeting on March 20-21 (we expect a quarter-point rate hike), after which he will participate in his first press conference with the media.

So a month from now, investors will have a much better sense of whether the Fed’s leadership transition from Yellen to Powell will usher in more aggressive monetary policy in response to rising inflation expectations. We continue to expect the Fed’s baton pass will go smoothly, at which point investors should enjoy much higher levels of clarity, confidence and comfort.

Be careful what we wish for, we might just get it For those investors who bemoaned the utter lack of volatility in 2017, the VIX spiked from 10 to 50 earlier this month, before settling back to 18 this week. Stocks followed with the S&P plunging 12% in a fortnight off its Jan. 26 peak right to its 200-day moving average of 2,533 on Feb. 9 in a technical correction that erased some $6 trillion in global stock-market value. Stocks have since bounced more than 8%, as they enjoyed their best performance week last week in five years.

Sitting out this bout of volatility has been the benchmark 10-year Treasury yield, which has been grinding higher from 2% last Labor Day to 2.4% at the beginning of 2018 to 2.95% this week, on its way to a successful retest of Ben Bernanke’s 3% taper tantrum peak in 2013. Why has there been no “flight-to-safety” rally in bond yields, as stock prices plummeted? In our view, the bond vigilantes recognize that recent fiscal-policy changes have resulted in a welcomed return to trend-line economic growth of 3%. But that also means that inflation likely will be rising over time at a pace that’s unknown, with a new Fed leadership team whose monetary policy response remains uncertain.

Shoot first, ask questions later Investors’ recent knee-jerk response has been to sell first, and then figure out later if inflation is sufficiently problematic to warrant the trade. As we study several key year-over-year (y/y) inflation metrics, it appears markets have become overly concerned with monthly noise, fearing that a gradual increase will quickly morph into a sharp, unwelcomed spike.

  • Core personal consumption expenditures (PCE) index (the Fed’s preferred measure of inflation) had fallen steadily from 1.9% on an annualized y/y basis in January and February 2017 to a trough of 1.3% in August, approaching its cycle low of 1.25% set in July 2015. But this metric gradually rose to 1.5% in both November and December 2017, so it's finally starting to move in the right direction, although it remains well below the Fed’s oft-stated 2% core inflation target.
  • Core wholesale producer price index (PPI) inflation (which strips out food, energy and trade) rose to a cycle high of a 2.5% y/y gain in January 2018, up from 2.3% in December 2017 and 1.9% in August 2017. This new data series is less than 4-years-old, but the upward trajectory bears watching.
  • Core retail consumer price index (CPI) inflation (which strips out just food and energy prices) in January 2018 was unchanged at a 1.8% y/y gain for the third time in the past four months. In six of the previous seven months, core CPI had been mired at a 1.7% y/y increase, so it’s starting to slowly grind higher. But that’s still down sharply from a 2.3% y/y gain in January 2017, which had matched its highest reading in four years. We would ignore January’s sharp 0.5% month-over-month (m/m) nominal CPI increase, driven by a 1.7% surge in apparel prices (its largest since 1990) due to lean inventory and a lack of post-Christmas markdowns.
  • Average hourly earnings rose for the fourth consecutive month in January 2018 by a stronger-than-expected y/y gain of 2.9%, the strongest increase since June 2009. The tight labor market is beginning to spark an acceleration in wage pressure, which we continue to believe will approach 4% over the next year or so. Eighteen states began 2018 with higher minimum wages, and many companies announced bonuses and salary increases in the wake of President Trump’s December tax cut. But higher wages don’t necessarily translate into higher levels of inflation, as companies can offset wage growth with stronger productivity and tighter profit margins.

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