Got to talk about inflation again, sorry
It continues to be the issue consensus is worried about.
Inflation is the topic of the day. This week’s elevated read on March CPI (entirely expected, BTW, more below) further stirred debate over whether higher inflation that’s baked into the cake for the next several months (simple math vs. year-ago negative prints) will prove temporary as the Fed insists, or last longer. The recovery is just ramping up and already there are reports of worker shortages (more below), rising wages (surveyed CFOs say they’re soaring) and supply shortages (in computer chips, housing, lumber and certain commodities). Some see these as structural issues that can’t easily be fixed. It takes years to build a semiconductor plant and decades to grow more trees. Layered over all this is eye-popping stimulus (even without the proposed infrastructure package, the cumulative 2020/21 Covid response was, in current dollars, more than 5 times the size of the FDR 1930s New Deal and double the New Deal on a per capita basis) and record government debt poised to grow even more quickly (more below). “Washington has gone bonkers,’’ concludes Yardeni Research. So, rising wages, supply shortages, soaring demand as the economy reopens and a raging flood of red ink. All a perfect recipe for inflation, and yet …
The 10-year yield has rolled over from its recent high, and consensus for the initial Fed rate hike continues to hold at the end of 2022/early 2023. This suggests the market already anticipated the “inflation scare.” At around 2.5%, the 5-year inflation breakeven rate remains in the Fed’s preferred range. It wants to lift average inflation to its 2% target and after a decade of falling short, is fine if inflation runs a little hot. Chair Powell’s focus, as he’s made clear in recent interviews, is aimed more at doing whatever the Fed can to raise employment, particularly for the harder-hit segments of society. In a “60 Minutes” interview, he discussed how his commute home takes him past a “substantial tent city,” and that he thought of the millions of Americans who are still trying to get back to work. Inflation’s impact on corporate profits for now remains supportive of higher equity P/E multiples. And with nominal GDP growth potentially reaching 9% this year and nearly 8% next year, earnings continue to be constructive for the market. Nearer-term issues include declining equity risk premia as rising Treasury yields (until recently, anyway) chip away at equities’ return advantage, tougher seasonality that tends to come when the calendar turns to May and the possibility the economy is nearing peak growth. Deutsche Bank thinks a 6-10% pullback could be in the offing once ISM manufacturing starts to level out. It hit a 38-year high in March. Past pullbacks under such circumstances lasted six weeks on average, followed by a strong rebound if the economic backdrop remained robust. This economy is indeed picking up steam, with the spring and summer months setting up to be the strongest in a year that Wall Street thinks will experience the best GDP growth at least since 1984. Can’t we just enjoy this?
For all the arguments that we’re undergoing a “regime shift” in global inflation, Japan is instructive. It’s been mired in a three-decade-long environment of disinflation, with declining inflation expectations overwhelming everything else. Chair Powell and other Fed policymakers keep sounding similar worries about expectations here—another reason they’re willing to live with inflation above 2% for a while. There are other inflation offsets, too. Increased digitization and e-commerce penetration spurred by this pandemic, the continued retirement of higher-cost baby boomers, the unwillingness of millions of Covid-scarred workers to reenter the workforce, and a work-from-home dynamic that has some giving up raises or even taking a cut to avoid costly commutes and other work-related hassles make a problematic inflation call complicated. Then, of course, there’s capitalism. U.S. shale production just broke out to a new post-lockdown high amid oil’s price spike. Other industries are certain to jump in wherever there are opportunities to make money. When it comes to inflation, my biggest worry is the trashing of the dollar. We’re not there yet. But at some point, Mr. Market is going to react to the trillions upon trillions of debt we’re piling up and push bond rates and inflation significantly higher. MMT’s answer for that, higher taxes, would only make it worse. Persistent inflation requires a wage increase problem. And I’m not so sure. Most wage increases are occurring in the lowest rungs of the economy—socially distant professions where the pay is so low, even significant pay hikes have minimal cost impact. The Fed’s Beige Book noted some firms “are competing more aggressively for lower-wage workers,’’ including bidding wars for housekeepers in a resort location, a restaurant offering $1,000 signing bonuses if workers stayed for at least 90 days and a retailer weighing the possibility of raising its minimum wage to $15 an hour sooner than previously planned. Hmm. Seems temporary to me.
- A house is the biggest purchase most people make Led by single-family homes, housing starts and permits surged in March, and already elevated homebuilder confidence rose again, too. The country needs the new homes as Freddie Mac says it’s running nearly 4 million units short of demand.
- Consumer tailwinds Retail sales jumped almost 10% last month, nearly double consensus, on the powerful combination of new fiscal stimulus, economic reopening and tax refunds. Sectors with the biggest declines through February (restaurants, department stores, apparel, and electronics) had the largest increases in March. April's Michigan consumer sentiment gauge jumped to a 13-month high.
- Manufacturing tailwinds Manufacturing posted a broad-based rise in March, including in auto production despite a semiconductor shortage, and both the Philly and Empire gauges sported strong Aprils, with the Philly read hitting a record high.
- More to come? March headline and core CPI rose a respective 2.6% and 1.6% year-over-year (y/y), consistent with a boost from reopening as hotel lodging, airfares, recreation, car rentals and car insurance all climbed. A jump in energy prices played a leading role in the headline increase, too.
- The MMT experiment The Congressional Budget Office estimates the federal government posted a budget deficit of $660 billion in March, pushing it to a record $4.1 trillion on 12-month basis—almost 20% of GDP, representing 19.6% of GDP. The 12-month total federal outlays surged 66% y/y, as funds from the American Rescue Plan began flowing to households and businesses. Federal receipts dipped 1% y/y, with both individual and corporate income taxes falling from a year ago.
- Contrarian negative One of the hallmarks of the first 11 years of the 2009-present secular bull market was that stocks rallied as investors sold equity mutual funds. That equation has flipped the past two months, as equity fund flows have turned positive and are near their highest levels on record. International investors have upped their buying, too, taking share from institutional investors.
Somebody’s got to pay! As the chorus grows from the United Nations, IMF and World Bank over the rising global debt burden so do calls from the OECD and G-20 for a global minimum corporate tax rate and measures to tax multinationals. Irrespective of the difficulties to enforce and pass local laws, Jefferies thinks many countries will find it impossible to ignore increasing the corporate tax “take.’’
Perhaps we should focus on tax revenue Despite generally higher statutory tax rates, U.S. corporate tax revenue as a share of GDP has steadily run below global and developed markets-ex U.S.-weighted averages since 2000, as well as the emerging-market average. On average, U.S. corporate tax revenues were 2% of GDP from 2000-17 and fell to 1% following the 2017 tax cut. By contrast, tax revenue for the rest of the world has remained stable at about 3% of GDP, despite their steadily declining statutory tax rates.
Should we sell in May and go away? Equities are priced for perfection, BCA Research says, noting its propriety capitulation gauge, its highest since 1976, is at a level that historically has been followed by a 10% correction or worse. Other troubling technicals: the AAII bull/bear ratio is 2 standard deviations above neutral, almost 96% of S&P 500 stocks are above their 200-day moving averages (historically a sell signal this early in a cycle) and volumes have been falling while the S&P makes new highs.