Against the wind
Continuing rally hopes face structural inflation headwinds.
Sitting in Pittsburgh all week, but I did have a hit on Bloomberg TV. Introduced by the host as someone who has been in the business since the ’70s, I said I keep thinking we are experiencing that decade again. Stagflation, and we reached “peak” inflation three times that decade! He remarked afterwards that he hadn’t heard anyone refer to the ’70s in years. Malaise defined the ’70s. A lot of talk about peak inflation, as gasoline, oil and ag commodity prices roll over, manufacturing and services prices, too (more below). Perhaps. But it can take a long time for structural inflation to slow. The stickiest components, wages and rents, aren’t letting up. The Atlanta Fed’s wage-growth tracker has gone almost vertical (the 3-month average yearly pace hit 6.7% in June), wages drove Q2’s Employment Cost Index to a 40-year high, July hourly earnings accelerated and small businesses told the NFIB their biggest problem is finding workers. If it walks like a wage-price spiral …. Even as job openings slowed and jobless claims climbed again this week, the Fed has a long way to go to cool an historically hot labor market where surging boomer retirements have created a big hole. July’s surprise jump in payrolls (more below) still left labor force participation 1.2 percentage points below its pre-pandemic level. Indeed, concerned by the markets’ “Fed pivot” interpretation of Powell’s post-meeting “near neutral” comments, uber-dovish Fed governors this week played down expectations of slower rate hikes this fall and potential cuts as early as next spring. This morning’s jobs report reinforced those comments. Pivot, schmivot.
Rents may pose an even bigger problem. They account for nearly a third of CPI and are climbing even as home prices moderate. Goldman Sachs expects shelter inflation to accelerate to 7% late this year. One big driver: a massive shortage of units that has pushed the housing vacancy rate to 4-decade lows. Supply chain bottlenecks and spiking mortgage rates have made it harder for builders to complete projects, would-be buyers to afford homes and potential sellers to walk away from lower-rate mortgages. “Inflation tends to be inflationary,” is the way strategist Vincent Deluard put it in a recent Gavekal Research seminar. When countries are experiencing +7% annual inflation, as much as the world is, inflation tends to stay high or even accelerate for years. Getting it below 3% usually requires heavy-handed tightening. With both Europe and China struggling (more below) and a squeeze on Russia threatening energy shortages a la the ’73-’74 oil embargo, U.S. growth will be challenged even if it skirts recession (current market odds are 50/50, down from 90% at mid-June’s bottom). Housing, goods consumption and manufacturing are weakening and likely to deteriorate further, and consumers are spending down Covid savings stockpiles (but racking up credit card debt). And this is happening as wage pressures are potentially worsening. So, recession or not, a period of weaker growth and higher structural inflation. Sounds a lot like stagflation—and the ’70s.
Lots of debate over whether the post-Fed rally is a bear market trap. Citing sentiment, credit spreads and volatility, Renaissance Macro believes the evidence supports a bullish case. In it first meaningful change since its late January “cautious” call, Evercore ISI thinks a low has been put it in and would be a “buyer of dips, not a seller of rips.” New York Fed data shows there’s still a lot of cash on the sidelines. Easy to buy dips. But Piper Sander says all this does is prolong an inevitable retest of lows as the Fed keeps tightening and inflation remains elevated. It recommends trimming rather than adding at current levels. “Bear market rallies are violent and kill bulls and bears alike.” With breadth so-so in the latest move, perennially bullish Fundstrat is similarly cautious. “Over our two decades of being on the Street, a hard lesson learned has been to not overly react to sharp unsupported moves in either direction.” My presentation for the road includes a chart I’ve labeled, “Don’t Shoot the Messenger,” showing the historically tight relationship between equity holdings as a % of household financial assets and subsequent 10-year returns on the market. From here, it suggests low single-digit returns. Saying goodbye to me, the Bloomberg anchor reminded his younger colleague how Bob Seger helped us through the “dismal” ’70s and not “Olivia Newton Whatever.” (Dismal? I personally have quite fond memories of that decade—we were young and strong, running against the wind.) Millennials and Gen Zs who’ve never heard of him, you might check out Bob Seger’s music. I think you’ll like it.
- Labor market continues to tighten This morning’s spectacular jobs number, with the 528K jump in payrolls coming in at twice consensus, erases Fed pivot hopes. The U6 underemployment rate, at 6.7%, is the lowest since the series began in 1994. Average hourly earnings surprised and were revised up for June. The 50-year low 3.5% unemployment rate partially reflected a decline in the participation rate, itself driven by a decline in participation among workers ages 16-24. Hmm.
- This doesn’t look like recession July’s ISM services surprised, coming in at a 3-month high on broad-based improvement, including pickups in new orders and business activity and easing supply bottlenecks and input costs. The American Trucking Associations says trucking activity is back to its pre-pandemic record high, June factory orders rose above consensus and July car sales rose.
- The best cure for high gasoline prices is high gasoline prices Prices at the pump have tumbled nearly a dollar since peaking above $5 nationally in mid-June. Slowing economies worldwide and a pullback in driving here in the U.S. contributed to this welcome relief.
- It’s not looking good overseas Tightening restrictions exacerbated a manufacturing slowdown in China, where its PMI fell back into contractionary territory and authorities abandoned a 5.5% growth target. Elsewhere, U.K.’s PMI hit a 2-year low and is likely to fall further as the Bank of England tightened by 50 basis points, the most in a quarter century, and warned of an imminent recession that could last five quarters. In Europe, only the Netherlands and Austrian PMIs remained in expansion, while in Germany, retail sales posted the largest annual drop (in real terms) since records began in 1994.
- It's not as bad here yet July ISM manufacturing also slowed in the U.S. but beat consensus, as new orders and employment contracted and overall activity fell to a 2-year low. Prices softened notably to a 2-year low.
- Housing bites builders Construction spending unexpectedly fell 1.1% in June, the largest monthly decrease since February of 2021. A 1.3% drop in private construction, led by even larger pullbacks in residential and power sectors, drove the decline.
Still running against the wind Gavekal thinks the Fed is so focused on “well-anchored” inflation expectations that it is quite relaxed about “backward-looking” data that show prices rising much faster than most businesses and workers have ever seen. That is creating what’s known in markets as the “there are no new eras” bias, in which most find it difficult to imagine events that have never happened in their lifetimes. The massive millennial and Gen Z generations weren’t around in the ’70s. Today’s interaction of Covid and Russia, with unprecedented monetary and fiscal expansion and all its fallout, guarantee the period ahead almost certainly will be very different from the past 40 years.
Consumption has legs With household savings rates falling below pre-pandemic levels, consumer spending growth will rely on still-hefty savings balances and aggregate incomes. The two key forces behind incomes: wage and payroll growth, with the latter historically the bigger factor.
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