Persistent trumps peak
Inflation that moderates but stays elevated can be a problem.
If I had a nickel, perhaps with inflation maybe a dollar, for every time I heard/read “peak inflation” this week … so what? Where it settles and how long it takes to get there are far more important. Bottlenecks at U.S. ports, trucker shortages and a pandemic that wreaked havoc on supply chains optimized for minimal slack can’t be quickly fixed. My Wall Street sources think it’ll take a year. Now comes the one-two punch of the Ukraine war and new Chinese lockdowns, with Shanghai, the world’s largest port, effectively closed, and Guangdong, the largest manufacturing city in the world, facing lockdown. On the demand side, Gavekal Research sees governments trying to put out the fire with gasoline, fighting the inflationary effects of high energy prices with handouts and subsidies, themselves inflationary. The muted supply response—drilling activity remains below pre-pandemic levels and energy capex has been starved for years—suggests energy prices are likely to grind higher or at best, stay elevated. Despite the Fed’s hawkish rhetoric, annualized money growth is running at a still inflationary 11%. And an extremely tight labor market has underlying annual compensation growing at 6%. Even if productivity expanded by a generous 2%, annualized inflation would still be a brisk 4%, well above what the Fed would be willing to live with. Persistent trumps peak.
At 5.3 million, the jobs-workers gap is the most overheated in postwar history. Goldman Sachs estimates narrowing that gap by half could slow wage growth from its 5-6% pace to 4-4.5%, a range consistent with Fed forecasts in the low-to-mid 2s for 2023 and 2024. And it thinks getting there without a recession may be easier than past tightening cycles as strong labor demand is mostly reflected in an unusually high level of job openings, not an excessive level of employment. It sees post-Covid labor-force normalization adding 1-1.5 million workers above normal population growth, significantly easing worker shortages. From their lips …. (Empirical Research notes that 3 million “early” baby boomer retirees are never coming back.) Wages are sticky and two whole generations have never experienced a wage-price spiral! Meanwhile, conventional wisdom suggests renewed trade wars and tariffs, supply-chain breakdowns and wars are unwinding 30 years of globalization and disinflation. Empirical sees little evidence yet of a reversal and believes the more immediate threat for corporations and their margins is on the interest and tax expense lines. Labor gets attention but interest costs have accounted for a big share of the past decade’s margin gains. The quantitative-easing era let companies extend debt maturities and slash interest expense, dropping debt service costs to their lowest in decades (more below). That punch bowl is empty.
Eight of the past 11 hiking cycles eventually ended in recessions, with a hard landing the rule rather than the exception. (What are our odds?!) But the downturns didn’t come until two years after the cycle began, with equities peaking five months beforehand. That suggests spring 2024 and late 2023, respectively. However, this cycle has some unique characteristics. Fed liftoff began when the economy already was at full employment. Boosted by the pandemic (feeding goods versus services demand) and unprecedented fiscal stimulus, activity for many industries is elevated. Yet investment spending and services are below trend and rising, and household and corporate balance sheets are still strong. This is creating a tug of war between the sticker shock of rising prices and a huge reserve of wealth and liquid assets. Reports this week (more below) reflect some slowing, as does the behavior of the credit markets, which saw yield curves re-steepen and spreads re-widen. Earnings revisions have turned negative, a condition that tends to see equities fall three months later. But Credit Suisse expects healthy 12.2% and 13.9% top-line and bottom-line growth in the Q1 season that just got underway. Tax season may be working against April’s generally favorable seasonality. Huge equity and crypto gains may make for the largest capital gains tax bill in history, feeding selling pressure. Will inflation prove persistent? Time will tell. Equity returns historically have been positive during the first year of Fed hiking. Our portfolio models are still overweight equities but defensive. Sounds reasonable to me.
- Corporate balance sheets strong With profits recovering and companies largely in sound financial shape, ratings agencies are upgrading nearly two times more companies than they are downgrading. In the first quarter, Standard & Poor's published 187 credit upgrades compared to just 97 downgrades, the fifth quarter in a row of more than 150 upgrades.
- Contrarian positives Bullish sentiment fell further in the latest Investors Intelligence bull-bear reading, and ETF flows out of the S&P 500 accelerated toward extreme levels after remaining stubbornly strong throughout the year. Among small caps, the Russell 2000’s 10% year-to-date decline has dropped relative valuations to levels that historically have marked a turning point.
- Michigan sentiment surprises It unexpectedly jumped off March’s 11-year low, with the expectations component surging 18 percentage points. Notably, consumers anticipated a year-ahead increase in gas prices of just 0.4 cents, reversing March's surge of 49.6 cents. The current conditions gauge also increased, while year-ahead and 5-year ahead inflation expectations were unchanged at 5.4% and 3%.
- Peak or persistent? While March’s core CPI was slightly lower than consensus, Cleveland Fed median and trimmed mean numbers, which seek to reflect underlying inflation by eliminating outliers (small and large prices changes), remained in the 6-7% range. Wednesday’s PPI came in hotter than expected, import and export prices surged and the United Nations FAO global food price index rose at a 34% y/y pace. As fertilizer keeps rising, some U.S. farmers are turning to animal manure while in China, President Xi called on the Chinese to produce their own seeds to achieve food security.
- Guess what’s top of mind at small businesses? Nearly a third of business owners surveyed by the NFIB rated inflation as their biggest worry, the highest share since Q1 1981, dropping the monthly optimism gauge to its lowest level since April 2020, the month after Covid shut down the global economy. The percentage expecting better business conditions over the next six months was the lowest on record.
- Americans buying more than gas High inflation sent March real sales falling across the board, but nominal sales rose modestly and the prior two months were revised materially higher. Gas gobbled up outlays but discretionary sales including restaurants and clothing also climbed as the fading pandemic and spring weather lured shoppers.
CPI ex-used cars ain’t so bad Manheim’s gauge of used-car prices decelerated a third straight month in March. This is important because new and used (particularly) cars accounted for nearly a third of CPI’s rise in 2021.
Headwinds for home buyers A 30-year fixed-rate mortgage hit 5.31%, almost double the year-ago level. Realtors report lean inventories, and not a lack of buyers, remains the biggest issue. Credit Suisse believes rapid home price appreciation, rental inflation and wage growth may increase traffic in weeks to come as buyers seek to get ahead of the curve. Still, signs are growing that housing’s GDP contribution will start to fade.
How to think of water scarcity Imagine one bucket holding all the world’s water. Bank of America says one teacup would be drinkable, and just one teaspoon would be accessible to all humanity.