Last Wednesday, the Federal Reserve boosted the fed funds target range by 50 basis points. The new target range is now 0.75% to 1.00%. It was the biggest increase since May 2000. The Fed also confirmed that it would begin to reduce the size of the balance sheet beginning next month. Federal Reserve Chair Jerome Powell quashed the idea of a 75 basis point rate hike, which the market was expecting. The market liked Powell’s cautious approach, with the S&P 500 rallying 2.85% and over 3% for the technology-heavy NASDAQ during last Wednesday’s trading session, but the markets digested perhaps a different story on Friday and into Monday’s trading, reversing Thursday’s price advances and then some.
At his post-FOMC-meeting press conference, Chair Powell was asked by a reporter about his “level of confidence” that the Fed can subdue inflation by “slowing hiring without pushing the economy into recession?” Powell responded as follows:
“There’s a path by which we would be able to have demand moderate in the labor market, and … have vacancies come down without unemployment going up, because vacancies are at such an extraordinarily high level,” Powell observed that with 11.5 million job vacancies and 5.9 million unemployed workers, there are 1.9 job openings for every unemployed person “So in principle, it seems as though by moderating demand, we could see vacancies come down … fairly significantly.” By bringing demand for workers down closer to supply, Powell expects “to get inflation down without having to slow the economy and have a recession and have unemployment rise materially.” He concluded: “I think we have a good chance to have a soft or softish landing …”
Needless to say, some Fed watchers have opined that Powell is delusional because the only way to bring inflation down is to cause a recession. They contend that the Fed is so far behind the inflation curve that runaway inflation will eventually force the Fed into a Volcker-style tightening. They think the Fed’s tightening response to inflation is too soft, and the Fed has lost credibility.
So which scenario will play out? The Fed’s or its naysayers’? We believe the divergent views of the future path of inflation and interest rates are the primary reasons for the correction/bear market in bonds and stocks. Markets do not like uncertainty, and we have much of that now. We believe secondary reasons for the decline are the leveraged unwind in cryptocurrency and low-quality/COVID/disruptive story stocks, which are carrying over to profitable, high-quality investments.
Understanding the path of inflation is essential to understanding possible future Fed action. Taking an evidence-based approach, we believe inflation could be peaking for the following reasons –
(1) Wages. On a year-over-year basis, last Friday’s employment report showed that average hourly earnings for all workers rose 5.5% through April. However, the three-month wage inflation rate has fallen below this rate for the past three months and was down to 3.7% during April. The same can be said for the three-month wage inflation rate in goods-producing and service-providing industries (4.1% three month vs. 5.2% y/y).
(2) Consumer prices. On a year-over-year basis, the Personal Consumption Expenditure Deflator (PCED), which measures inflation based on changes in personal consumption, had mixed results through March, comparing the three-month and 12-month rates: headline inflation (6.6% three month, 7.7% y/y), core inflation (4.2% three month, 5.2% y/y), durable goods inflation (2.5% three month, 10.2% y/y), nondurable goods excluding food and energy inflation (10.9% three month, 6.6% y/y), and services ex-energy inflation (3.7% three month, 4.3% y/y). The standout comparison is the latest three-month durable goods inflation rate (2.5%), which has plummeted below the 12-month rate (10.2%) for each of the past three months through March.
We expect this category of the PCED to be the first and most important contributing factor causing the year-over-year inflation rate to the peak. This decline makes sense to us. If one overspent on durable goods in 2020/21, it would likely cause someone to underspend in 2022/23. We are seeing this in most areas of the major durable goods categories when comparing the last three-month and 12-month inflation rates: new motor vehicles (2.5% three month, 13.1% y/y); used motor vehicles (-27.3% three month, 33.5% y/y); sports & recreation vehicles (4.5% three month, 6.7% y/y); motor vehicle parts (9.5% three month, 11.7% y/y); furniture & home furnishings (16.2% three month, 13.7% y/y); household appliances (22.0% three month, 11.8% y/y); and video, audio & information processing equipment (-4.1% three month, -1.1% y/y). The two areas where increases occurred were housing-related. As homeownership slows and the supply chain disruption lessens, these areas should normalize.
The ISM Services PMI (a measure of services business activity) fell 1.2 points in April to 57.1, contrary to the consensus of a 0.6-point gain to 58.9. The fourth decline in the past five months brought the PMI to its second-lowest level since February 2021. The latest reading is still historically consistent with above-trend growth, but combined with the simultaneous erosion in the ISM Manufacturing PMI, it suggests that private business activity lost momentum at the start of Q2.
(3) Rents. PCED tenant rent inflation in March was 6.2% on a three-month basis, well above the 4.4% rate on a y/y basis, with both trending higher since early 2021. Nationally, new rental leases are up 12%-15%. As more leases are renewed at these higher rates, rental inflation will continue to rise. However, demand has begun to decline as a result of higher rates.
Notwithstanding the signs of peaking inflation, other indicators and developments suggest that inflation is moving higher and might continue to do so.
(1) Unit labor costs. Thursday’s big selloff in the stock market was partly attributable to the release of Q1 data on seasonally adjusted nonfarm business productivity (down 7.5%) and unit labor costs (up 11.6%). Widely ignored was the good news on hourly compensation. It was up just 3.2% during Q1, following three-quarters of gains exceeding 6.0%.
(2) Prices paid. There is no peak yet in the prices-paid indexes in the national surveys of manufacturing (M-PMI) and non-manufacturing purchasing managers (NM-PMI). The NM-PMI’s prices-paid index rose to a new record high during April, likely associated with higher labor costs.
(3) Energy and food prices. Meanwhile, the outlooks for both energy and food prices remain disturbingly inflationary. Global food supplies are falling short of global demand for several reasons. The war in Ukraine has disrupted grain exports from Ukraine. Russia’s exports of fertilizers have also been restricted. In addition, droughts are hitting important grain-producing regions around the world. The war has also destabilized energy markets, especially for crude oil and natural gas.
In light of the above evidence refuting or supporting the path of future inflation, it is important to keep in perspective the current economic environment within the U.S. related to the consumer and business.
Consumers and businesses are in good shape.
At his press conference, Powell observed that “households and businesses are in very strong financial shape.” He noted that households have excess savings “substantially larger than the prior trend.” He also stated that “[b]usinesses are in good financial shape” and that the labor market is “very, very strong.” He concluded: “[T]herefore, the economy is strong, and is well-positioned to handle tighter monetary policy.”
While the personal savings rate fell to 6.2% during March, the lowest since December 2013, consumers saved at a record pace. Over the past 24 months through March, personal savings totaled $2.5 trillion. Interestingly, the M2 money supply (cash, checking deposits, and easily convertible money) is up $5.8 trillion over the same period. The increase suggests that much of personal savings are very liquid. M2 is currently above its pre-pandemic trendline.
Nonfinancial corporations raised $2.3 trillion in the bond market over the 24 months through March, mostly at record-low yields. Companies have refinanced their debts and still have plenty of cash on their balance sheets.
Past recessions usually have been caused by credit crunches resulting from Fed tightening. Given the strength of consumer and business balance sheets and significant M2 liquidity, we doubt that scenario is likely now.
From a Technical Perspective
As the markets decipher the path of inflation and the Fed, one of the indicators we study is the NYSE High Low Index (NYSEHILO), which charts the number of stocks on the New York Stock Exchange, making new highs relative to new lows. The chart has fallen below the 10% line, generally symptomatic of a washed-out equity market.
NYSEHILO is one of the better short-term indicators for the equity market, at least one of the best that we have found. In particular, it has a great track record after reversals from extremely oversold levels. In addition to the current level, the chart also reflects the COVID lows of 2020 and the December 2018 market selloff, which, similar to now, was induced by the fear of rising interest rates and a possible hawkish Fed activity.
In addition to the above indicators, we note the following –
• S&P 500, NASDAQ 100, and Russell 2000 are more than two standard deviations below the 50-day moving average
• Higher lows in the VIX (a volatility measurement) since January, including a lack of a higher high so far on this most recent down move.
• The Semiconductor Index has been outperforming the S&P 500 and NASDAQ 100 over the past few weeks
• “Washed out” breadth with less than 30% of the NYSE and NASDAQ above the 50-day moving average, and the NYSE Hi-Low Index (noted above) is at extremely low levels.
• Extremes in negative sentiment based on several indicators.
A Comment on Portfolio Positioning
Over the past few weeks, market activity has caused us to raise cash in certain portfolio strategies. Individual equity portfolios have a 20% to 32% cash range and certain tactical ETF strategies near the 20% to 22% range. The percentage of companies beating earnings and revenue estimates remains high at 70%.
Additionally, companies continue to increase their dividends at a positive rate. We continue to look for quality companies with a high return on investment, strong earnings per share growth, and maintaining competitive advantages within their industry.
Dated May 10, 2022
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