Walking a tightrope
Fed must juggle inflation versus recession risks.
Off to beautiful York, Pa., this week, where I spoke after a moving talk about mental health. Describing the moment of regret that a survivor who had jumped off the San Francisco Bridge shared with him, the speaker’s message was, “It’s OK not to be OK.” The survivor said that “if only one person would have said, ‘Hi’ to me that day,” he would not have attempted to take his own life. My message of volatility but likely a good year in stocks was graciously received. But several attendees wished they “could be as optimistic as me.” One said: “I think the government will look to raid our 401(k)s.” Another: “They’re trashing our future.” Ouch! This week’s CPI report (more below) rattled, putting 50-50 odds on a 50 basis-point Fed liftoff next month and pushing the 10-year Treasury yield above 2%. The “R” word—recession—entered some discussions. But would a half-point hike off zero, or quarter-point hikes every remaining meeting this year (seven) in an economy growing above trend be so bad? Bank of America notes the market rose in 12 of the last 13 Fed hiking cycles, including during inflationary periods, by 16% on average (1972-74’s -12% return was the exception). Companies have adapted so far as margins keep rising with costs—they’ve expanded year-over-year (y/y) in the aggregate among the more than half of the S&P 500 that has reported. Looking back seven decades, Empirical Research found revenues usually rose faster than costs until near the end of a business cycle. Even when revenue growth peaked—and it’s showing no such signs now—stocks on average delivered 20% returns the following 12 months.
A four-decade high in inflation is obliterating good news on jobs and incomes as workers fret over the day to day. Indeed, Michigan consumer sentiment hit an 11-year low this month. Even though wages are rising at 5.1% annualized, their fastest pace in 21 years, real hourly earnings have plunged to 15-year lows. This is far different than Europe, where wage growth is still a pre-pandemic 2% and core inflation is at 1.5%, less than half that of the U.S. A key reason is Europe paid workers to stay on payrolls during Covid shutdowns. In the U.S., it was layoffs first, government assistance later. With U.S. labor force participation pushed lower, companies are having to pay up to try and lure workers back, particularly in lower-skilled entry-level areas where layoffs were the greatest (more below). Participation started to pick up in January, particularly among prime-age workers. This trend is expected to accelerate amid plunging omicron cases (the number of employed people on sick leave jumped to a record 3.6 million January) and the end of Covid checks (the U.S. is on pace for the largest fiscal contraction since the end of the WWII). Piper Sandler thinks pay increases are overshooting fundamentals, which it says are more in line with 3-3.5% wage growth, and says if productivity improves 2% as markets expect, unit labor costs (which drive core inflation) could fall in line with 2% core inflation. Could significantly decelerating inflation be this year’s surprise? The macro does tend to move very, very slowly … and then suddenly. We saw that with inflation’s back-half 2021 spike and, since just December, the 70% (!) plunge in the amount of global bonds with negative yields.
The current environment—Fed tightening, rising crude prices, bond yields and inflation—argues for balance. Information Technology, the bedrock of the past decade’s bull market, is a bigger risk, as is high-rated/longer-duration credit. Sector leadership clearly has turned cyclical, led by Energy and Financials, which have outperformed massively year to date. And the overseas inflation advantage is bolstering the international case—Credit Suisse expects earnings for both the MSCI EAFE and globally oriented S&P companies to outperform domestic U.S. stocks. Double-digit stock gains for the year remain the base case, but with volatility, particularly in the first half as the Fed’s intentions and inflation’s path shakes out. Also, midterm years in a president’s first term tend to be bumpy. But the underlying fundamentals remain promising. Cash-to-liabilities ratios for U.S. households and businesses remain elevated and well placed to ride out higher borrowing costs and increased economic volatility. Forward earnings continue to rise, albeit at a much more modest pace. With low odds of a recession anytime soon, investors can buy good companies on dips, sit back and watch Jerome try to negotiate that tight rope.
- Fun-loving Americans have plenty to spend Bank of America says card spending jumped 12% y/y and 20% over two years in the week ended Feb. 5. Services led as collapsing omicron cases saw outlays soar for travel, lodging, entertainment and restaurants. Consumers have socked away more than $2 trillion of excess savings (that above normal savings). So, if they draw down only a third this year, that’s enough firepower to generate mid-5% growth in personal consumption this year—well above the sub-4% pace of the post-financial crisis era.
- Supply bottlenecks starting to ease The number of shipping vessels queued up to enter the ports of Los Angeles and Long Beach shrank 28% in the past month, and shipping giant Maersk sees disruptions easing toward midyear. Interestingly, new weightings in the government’s CPI basket rose in categories hurt most by bottlenecks, suggesting their disinflationary impact on the way down could be greater than their inflationary impact on the way up. One wild card: a truckers’ strike in Canada that is causing supply issues for automakers is threatening to move to the U.S.
- Peak inflation, please? Despite January’s surprise (more below), TrendMacro noted the median CPI increase was 4.2% y/y, well below the weighted average headline of 7.5% and a sign inflation is not as broad-based as it may seem. Moreover, SIS Research observes it normally takes 12 to 15 months for inflation to slow following a decline in money supply, which has been decelerating since May 2021, implying a midyear slowing.
- Not the surprise markets were hoping for January’s CPI rose more than expected, with the headline up 7.5% y/y and the core up 6% y/y. Energy, food and vehicles led, with the biggest potential hit from housing yet to come (see below).
- Home prices keep climbing They rose 18.4% y/y in December, CoreLogic said, with 2021 representing the biggest annual gain in the index’s history. Pricing strength is expected to continue into this year due to persistently low inventory (1.8 months—the lowest supply since the index began in 1999), though at a moderating pace. Home prices tend to take a year or longer to be fully reflected in CPI data.
- Small businesses worry amid plenty Even though their trailing 12-month sales growth was the highest it’s been since 1994, January NFIB optimism slipped on cost increases, particularly wages. The net percentage raising worker compensation is at an all-time high, creating concern about the ability to keep passing on costs. The good news: the pace of wage increases slowed, and while 61% increased prices, the most since 1986, planned price rises came off their highs.
A structural change in the labor market With near record-low unemployment and near record-high job openings, the Beveridge curve—the relationship between unemployment and job openings—has never been like this. According to Harvard-based Opportunity Insights, average job postings were up 43% for the week ending Feb. 4 versus a baseline period indexed to January 2020, a sign many laid-off workers are moving up the food chain to better jobs. Good for the economy but not Leisure & Hospitality. The lowest-paying sector accounted for 60% of pandemic job losses.
282 days to go The best bull case for Dems would be an end to the pandemic, an historic Supreme Court confirmation, some version of Build Back Better passes into law, a dip in inflation and a GOP that nominates candidates with deep general election flaws. Unfortunately, midterms are mostly a referendum on the president. And Biden’s approval ratings just hit a new low, under 40.
For crypto detractors Many observers have noted that one should short or at least avoid whatever companies are advertising the most during the Super Bowl ads. Remember the dot-com ads in 2000 or later, at the top of housing, all the mortgage commercials? This year’s largest spenders for the 2022 Super Bowl will be crypto companies.