Invest for inflation, not recession
Unrelenting demand presents challenges as Fed seeks to unwind price pressures.
Everyone keeps talking about how supply issues are driving up prices. New Covid lockdowns in China. Russia-Ukraine war disruptions to oil, natural gas and agricultural commodities. A critical lack of workers. All factors, true. But Credit Suisse believes this narrative overlooks the arguably bigger role that demand is playing. Americans are flush with cash—household savings are $2.4 trillion above trend, representing roughly 3-4 years of spending growth—and they’re spending it (more below). Goods purchases, in volume terms, are near or above pre-pandemic trends. Consumer goods imports hit another record high in March, even adjusted for inflation, and are now 45% above their pre-Covid level (more below). Inflation in fact has broadened across goods and services, suggesting the tide of demand is lifting all prices, more so than supply-induced pressures. Sticky CPI—due to rising wages (more below), record-high home prices and rents, and soaring commodity prices—is problematic. It gets embedded and can take years to cool down. The Fed, and global central banks, have a lot of work to do. They’re just getting started.
Earnings keep grinding higher—three-quarters of S&P 500 companies that have reported bested estimates, though the beats were small (under 4% versus 16.5% on average the prior four quarters). And forward earnings estimates are at a record high. This makes the year-to-date decline in stocks all about multiple compression. The bull case relies on P/E expansion, which could come from “better” inflation data and lower interest rates. Perhaps some sniffs of progress on the former (more below). But as suggested above, it’ll take a steep growth slowdown to wring out ingrained price pressures and push bond yields lower. And/or a Fed flinch. What are the odds? A negative Q1 GDP report (more below) belied an economy that’s chugging along. A very tight labor market—with the jobless rate nearly half the job vacancy rate, there is no slack—is feeding robust wage and income growth (more below). A record 70% of firms surveyed by the National Association of Business Economics raised wages in Q1. Americans have used fatter paychecks and hefty savings to deleverage and, now that the pandemic's over (Fauci said so), are ready to party. Corporate balance sheets are solid too (more below), as is business investment. March capital goods orders surged and regional Fed, NFIB and Business Roundtable capex plans firmed. As Redburn puts it, the absence of recession “red flags” is conspicuous.
Market internals aren’t reflecting much anxiety about inflation. Despite faster expected earnings-per-share growth between the two groups (13.1% versus 8%, respectively, by Credit Suisse estimates), companies that tend to benefit from rising inflation (industrial, retail, financial, energy and materials names) are trading at a steep discount versus peers that typically profit when prices are falling. An opportunity, in my view. Bearish sentiment has yet to hit extremes that suggest investor capitulation and the VIX keeps struggling to hold above resistance at 30. This has Fundstrat thinking the market may test the February lows and recommending investors sell into bounces. Market depth and investor positioning are low across equities and bonds. The defensive mindset is strong. Consumer Discretionary versus Staples and high beta versus low beta stocks traded to fresh lows this week. Only one Utilities name is trading under its Feb. 24 level (the last important S&P low), compared to over 40% for the broader Russell 1000. Cash is where investors are overweight. Could prove useful for likely future volatility. As ugly as midterm election years tend to be—and this year’s to-date S&P return is the worst for a midterm election year since 1930—they tend to have happy endings. Historically, the larger and earlier the drawdowns, the larger the recoveries. So, invest for inflation, not recession. Patience is a virtue.
- Negative GDP print misleading The 1.4% headline decline in the initial Q1 estimate centered on trade (more below), a slower inventory rebuild and the Covid fiscal relief cliff. All that overwhelmed a healthy 3.7% annualized jump in final private domestic sales, up from Q4’s 2.6% pace. Importantly, drivers of corporate profits—consumption and investments—rose a respective 2.7% and 2.3%.
- Pay no mind to what consumers say Both Conference Board and Michigan sentiment gauges slipped, but that didn’t slow down consumers. All-important consumer spending accelerated in March off February’s upwardly revised gain, and for all Q1 rose the most in three quarters.
- Peak inflation? Maybe. (May not change anything) Core PCE held at a 0.3% increase for the second straight month in March, lowering the year-over-year (y/y) pace to 5.2%, its first decline in a year. Overseas, Spain’s April CPI surprisingly fell and Germany’s rose just 0.3%, the smallest increase in six months.
- Trade gap clobbers GDP Surging imports accounted for all the decline in the initial Q1 GDP estimate. March’s goods deficit alone swelled to $125.5 billion, blowing past consensus at $105 billion, topping January’s prior record by almost $18 billion and swamping export growth. Some of this is due to progress on the big container ships’ backlog. West Coast ports are reporting double-digit increases in inbound container traffic so far this year.
- Housing rings alarm bells Pending and new home sales kept falling in March as tight supplies, record high prices and mortgage rates that have nearly doubled since last fall are discouraging traffic and pricing out some potential buyers. Not since the 2007 housing bubble has there been such a big gap between the cost of a new home and the amount a 2-income household can borrow to buy it, Axios reports. Millennials, who have been flooding into the market, face the highest mortgage rates in their lifetimes.
- Wage-price spiral March personal income rose more than expected, and February was revised sharply up, too, lifted by wages and benefits that accelerated in Q1 at their fastest pace since 1990.
Fears Fed tightening might break something are unwarranted So says Yardeni, which notes there is still plenty of “helicopter money” left over from the past two years. M2—a broad gauge of money supply—remains $3 trillion above its pre-pandemic trend line. And over the past 24 months, nonfinancial corporations raised a near-record $2.4 trillion in the bond market at near record-low yields.
Layoffs? Goldman Sachs says falling business confidence confirms the sharply deteriorating corporate profit outlook, suggesting more layoffs to come. It still expects solid job growth in the current quarter (roughly 400K/month) but sees the labor outlook turning cloudy in the second half. (This is the first time this year I’ve heard of layoffs).
Déjà vu all over again on Capitol Hill As lawmakers returned from break, we learned that Ukraine aid may get delayed over Covid aid, the best ideas for combating high gasoline prices are FTC investigations of oil collusion and a windfall profits tax, and the cure for inflation is higher corporate and capital gains taxes. A similar “cure” for high inflation in 1968 brought on a recession and no real impact on inflation. Talk of new tax hikes comes as federal tax revenues are higher than before the 2017 tax cut, and state tax revenues as a percentage of GDP are on track to set a second straight all-time high this year.