The key risk
It's all about inflation expectations.
This morning’s December retail sales miss (more below) wasn’t all that surprising. Last month’s real-time data on dining, travel and mall traffic suggested omicron was doing a number on shoppers. What hasn’t changed are their pocketbooks. They’re in great shape! Consumers are still sitting on an estimated $2+ trillion of excess savings, their debt service to disposable income is hovering at multi-decade lows and wage gains, particularly among lower-income cohorts, are outpacing even elevated inflation. Wage growth is its highest at least since the 1990s, and base wages are set to rise this year in 27 states and territories, the most since the federal minimum wage hike was last raised in 2009. Record job openings and quit rates suggest the income gains will continue, while the runup in home and stock prices has pushed household net worth to all-time highs. Moreover, access to credit is booming, with consumer credit totaling a record $40 billion in November. All of this should underpin spending as the less virulent omicron variant eventually fades, as South Africa and the U.K. cases suggest will occur. Despite a likely omicron drag on Q1, nominal GDP growth for the year is expected to remain above trend, boding well for the market’s top line and breadth, and for cyclical Value stocks whose margins and valuations tend to hold up in inflationary and rising-rate environments. Notwithstanding the powerful rotation from Growth to Value year-to-date, and short-term oversold levels, the valuation spread between them remains historically wide. And with Fed liftoff coming as early as March, this trade could gain momentum.
While costs are growing rapidly for the S&P 500 in aggregate, revenue growth has been faster, helping margins stabilize around a healthy 17%. The earnings season that kicked off today with several major banks will shed more light on what to expect going forward. Credit Suisse projects revenue and earnings per-share growth to moderate from Q3 but still rise a strong 13% and 20%, respectively. Guidance coming into the reporting season was weak relative to recent quarters, but those prior periods are tough comps. Wolfe Research is expecting solid mid- to high-single-digit beats. Like consumers, U.S. companies are in a good place, sitting on a record $7 trillion in cash. The market historically holds up in the early stages of a Fed rate cycle, but the first hikes can be nasty, as equities fell by at least 10% each time in the four prior instances. Midterm election years also tend to see pullbacks, with stocks typically declining into the election, then rebounding afterward. With this year’s midterms expected to result in divided government and market-friendly gridlock (more below), any post-election rally could be significant, particularly if inflation has moved off the boil.
Real interest rates have been negative since 2009 even though three massive deflationary shocks—the global financial crisis, the euro crisis and the Covid crisis—kept inflation in check. Now, with inflation breaking out and Fed policy rates still at zero, real rates are even more negative. The Fed’s tightening cycle should narrow the gap. But barring another shock or recession, real rates are almost certain to remain negative at least through 2022. Stocks would love that, while bonds may struggle—in times of accelerating inflation, investors have typically lost money in real terms on long-duration Treasuries, the exception being 2008 and 2020, when the economy fell into a deep recession. BCA Research’s base case is to remain constructive on risky assets this year as equities should be able to handle higher bond yields. The key risk is a rise in long-run inflation expectations, which could trigger a wage-price spiral that threatens to push realized inflation higher. So far, such market-based measures of inflation expectations as the 5-year forward TIPS breakeven rate aren’t signaling such a breakout. Inflation in fact appears to be peaking (more below), with the year-over-year (y/y) rates somewhat misleading because they include large paybacks for the collapse in prices in the first year of the pandemic. These base effects should reverse in coming months. Even though bond yields will likely top 2% this year and eventually move much higher, the transition toward “normal” yields is likely to be far slower than in previous cycles. This would be bullish.
- Peak inflation December’s CPI and PPI reports indicate the worst of price increases may be over. Both were better than consensus—monthly headline PPI was half the Street forecast. The New York Fed’s consumer survey also showed expectations for prices three years out holding at 4%, a quarter point below October’s peak, and December import prices surprisingly fell. Still, price pressures broadened beyond used cars and rents, a sign they may be slow to moderate. December CPI apparel prices posted their biggest gain in a year, and two-thirds of CPI components ran above 3.5% y/y. PPI transportation and warehousing costs also jumped, offsetting declines in energy and goods.
- Global manufacturing JP Morgan’s latest tracking points to a 12% annualized gain in global manufacturing on a 3-month basis in December, offsetting Q3’s 5% slump and marking one of the strongest increases in at least two decades. The activity, which puts manufacturing back to its pre-pandemic level, was spurred by a modest re-acceleration in final goods demand and a meaningful jump in inventory replenishment, evident also in Asian and U.S. PMIs.
- Small businesses living with inflation It is their biggest problem, the NFIB said, but companies surveyed by the organization said sales continue to be strong and hiring plans are at a four-month high, putting overall optimism at its best level since early fall. Small businesses account for the majority of hiring in this country and, like big businesses, say finding and keeping workers remain key challenges.
- A December dud Monthly retail sales fell nearly 2%, far worse than forecasts for a small dip, and were down even more if autos are excluded. The results brought an unwelcome end to an otherwise strong 2021 that saw retail sales jump nearly 17% off 2020’s pandemic slump. Online spending represented the biggest drop in December sales, with non-store retailers, furniture & home furnishing, sporting goods, and music & bookstores hit the hardest. Restaurants & bars, which posted the biggest annual gain of 41%, also saw sales slip last month as the virus kept customers and workers away.
- Omicron sickening supply chains … 99% of companies surveyed by Evercore ISI in early January reported supply chain constraints, with virus-related disruptions playing a significant role. And Citi revisited the L.A./Long Beach port complex, finding 500+ of 3,500-4,000 longshoremen were out due to the virus. After noticeable improvement in late November when Citi was last there, queues of ships awaiting unloading were back to late October highs.
- … China could make it worse Its zero-tolerance Covid policy has it locking down entire cities as it also shuts down/sharply reduces production at northern China factories to clear skies of smog prior to early February’s start of the 2022 Winter Olympics. Its uptick in omicron cases comes at an unfortunate time, with the Chinese New Year—when many people travel to their hometowns—on Feb. 1, followed three days later by the opening of the Olympic games. Global goods production doesn’t need any new bottlenecks.
Following the science, not as easy it sounds Two years into the pandemic, Centers for Disease Control recommendations have veered so dramatically from the agency’s initial advice that they quickly have become a viral internet meme. Director Walensky acknowledges the CDC has changed quarantine and isolation guidance based on new research about when Covid-positive people are most infectious and “the real-world circumstances we currently face” with a decimated workforce. That is, guidance now includes social considerations such as the economic impact and what people will realistically tolerate.
A red tsunami President Biden’s approval rating is wallowing at all-time lows in an election year that historically is very poor for the president’s party. Cowen sees similarities to 1994, when Republicans flipped both houses of Congress, and thinks at the least, this year should at least see one chamber of Congress flip for a post-World War II record sixth straight midterm.
Cryptocurrencies demystified The Cleveland Fed discovered that, after the first stimulus check in the spring of 2021, there was a noticeable increase in bitcoin trades in the amount of $1,200, especially by single retail investors. Its analysis also showed that a similar pattern emerged in countries where governments provided stimulus payments to their citizens.