We last looked at small business owner sentiment in early February, before the Ukraine war spiked energy prices. At that point there was good reason to think inflation might recede. That is no longer the case.

Key Points:

  • The NFIB Optimism Index posted a sixth consecutive monthly drop in June, with all ten index components declining.
  • Owners expecting better business conditions in the next six months is at the lowest level in this survey’s 48-year history.
  • Some 69% of small business owners reported a significant or moderate impact from supply chain disruptions.
  • Price raising activity is at or above early-1980s levels.
  • Labor is a top business problem, both finding workers and the quality of workers available.

Possibly the most disturbing macro point in this survey is that loan-dependent businesses are still paying historically low interest rates. That suggests the Fed may have to tighten considerably more than it already has in order to quell inflation. Meanwhile, small businesses are caught in a vise.

 

The Bullwhip Effect

 

The “Bullwhip Effect” has gotten the media’s attention as of late. However, the causes, effects, and consequences to the market and monetary policy are not well discussed. In order to understand its impact on the financial ecosystem, we need a definition of the “Bullwhip Effect:”

“The bullwhip effect is a distribution channel phenomenon in which demand forecasts yield supply chain inefficiencies. It refers to increasing swings in inventory in response to shifts in consumer demand as one moves further up the supply chain.” – Wikipedia

Historically, businesses have a propensity to overestimate the strength or weakness of the consumer. When consumption is strong, businesses believe it is an indefinite state and vice versa. Therefore, small changes to the demand side of the equation tend to lead to big changes on the supply side.

“Research indicates a fluctuation in demand of 5% will get interpreted by supply chain participants as a 40% change in demand. Much like cracking a whip, a small flick of the wrist, change in demand. can cause a large motion at the end of the whip – manufacturers’ responses.” – Wikipedia

This past year, retailers over-estimated economic demand which led them to broadly over-order from their suppliers and wholesalers. Those suppliers and wholesales, in turn, over-ordered from their own suppliers. Such led to a mismatch between consumer demand and inventories. The bloated inventory levels at Walmart (WMT), Target (TGT), Gaps (GPS), and other retailers are recent examples of this “bullwhip effect,”

The problem gets seen in the massive surge in the inventory to sales ratio of retailers.

 

 

Those inventories must now get heavily discounted, liquidated, or disposed of in the months ahead.

What Caused The “Bullwhip Effect?

The passage of a $1.4 Trillion stimulus package by the Biden Administration, which sent the third round of checks to households,produced the flood of liquidity preceded both the economic resurgence and, not surprisingly, inflation.

 

 

“As the stimulus hits consumers, they spend it rather quickly, which leads to a ‘sugar rush’ of economic activity. Such as:”

  1. Consumers use the funds to make either necessary or discretionary purchases creating demand.
  2. In anticipation of demand, companies boost “inventories.”
  3. The boost in “inventory stocking” boosts manufacturing metrics.

“We are seeing this currently as manufacturing and inventory metrics surge. However, there is a ‘dark side’ to stimulus-fueled activity.

The increase in activity leads to an inflationary rise that companies have difficulty passing on to consumers, ultimately reducing profit margins.

After the stimulus evaporates, consumers struggle with higher costs which further deteriorates their standard of living.” – Sugar Rush

That artificial increase in consumer activity, driven by the massive fiscal stimulus provided directly to households, is showing up in price inflation. Such is the byproduct of too much demand against a backdrop of limited supply due to the pandemic-driven shutdown.

 

 

However, since the Government could not provide continuous stimulus, now that the liquidity “sugar rush” is over, the economy is reverting to its organic state.

That reversion, and the rebalancing of supply and demand, is “deflationary.” Such will pose a significant problem for the Federal Reserve.

The Impact On Monetary Policy

The Federal Reserve is in a race against time. The problem of the “bullwhip effect,” is the reversion of demand leads to supply glut, which as noted above, runs up the supply chain. A recession is often the byproduct of the rebalancing of supply and demand.

While Jerome Powell states he is committed to combatting inflationary pressures, inflation will eventually cure itself. As shown in the inflation chart above, the“cure for high prices, is high prices.”

Mr. Powell understands that inflation is always transitory. However, he also understands rates cannot be at the “zero bound” when a recession begins. As stated, the Fed is in a race to hike interest rates as much as possible before the economy falters. The Fed’s only real tool to combat an economic recession is through cutting interest rates to spark economic activity.

As Deutsche Bank’s Jim Reid illustrates below, the Fed began raising interest rates with inflation significantly higher than seen during prior hiking cycles. Over the past 70 years, the first-rate hike came at the median, when the Consumer Price Index (CPI) reached 2.5%. The first increase this year occurred in March when CPI soared at an 8.5% annual clip.‌ The only rate-hiking cycle that resembles the current environment began in August 1980, when the Fed started raising interest rates with inflation running north of 12%.

 

 

The Fed is way behind the curve in hiking rates, which is why they are aggressively hiking rates now. Their goal is to get to 3.5% to provide the room needed to lower rates when a recession begins.

The Fed Has Little Choice

The problem is that monetary policy is already very restrictive. From inflation, surging short and long-term interest rates, and the “bullwhip effect,” economic growth will slow quickly. Such is already showing up in many of the economic reports. Our real-time composite economic index and the 6-month rate of change in the Leading Economic Index confirm the same.

 

 

“Policymakers know very well the path of inflation, especially the core rate, over the remainder of this year is impervious to interest rate decisions. Monetary policy works with long lags. ‌But the Fed has constituencies other than monetary economists; they have to calm the inflation fears of the public, the markets, and politicians. That means they have no choice but to sound as tough as possible because part of their job is to rein in inflation expectations.” – Ian Shepherdson

That is correct.

However, such is also why the Fed will be back to cutting rates, and restarting QE, by the end of the year as the recession sets in and concerns of “financial instability” arise. As shown, consumer confidence has fallen sharply this year which historically leads to recessionary onsets.

 

 

The reality is that both the Fed and the markets are subject to the “bullwhip effect” of monetary policy.

The only real question is whether the Fed can lift rates enough to have any real effect with the “deflationary” tidal wave crashes ashore.

Unemployment

A top economic concern is whether the Fed’s inflation-fighting moves will push the economy into recession. If so, we should see clues in high-frequency data like weekly unemployment benefit claims. This chart shows that series for the last year. The red line is a four-week moving average to highlight the trend.

 

 

We see initial jobless claims fell steadily as the economy recovered in 2021. They seem to have bottomed around March 2022 and are headed higher. This suggests more people are losing jobs and filing for benefits—a possible recession signal. On the other hand, weekly claims are still quite low, running roughly where they were in early 2020 before COVID hit. This isn’t conclusive recession evidence or even close. It’s nonetheless worth watching, though. That directional change will eventually take claims up to a more concerning level if it continues.

Higher interest rates are one reason for those higher unemployment claims. This chart shows the 6-month Treasury rate. Notice how it started rising in late 2021, well before the Fed actually changed policy. The trend accelerated in June, taking a yield that was practically zero (around 0.06%) as recently as November and boosting it to 2.7%.

 

 

These short-term Treasury yields—out to about two years or so—often serve to benchmark floating-rate commercial loans and some home mortgages. This sharp increase in a relatively short time drastically changed the environment in some sectors. Projects that were feasible at much lower yields may not be now, causing job losses. The inflation impact could be worse. Housing supply is already tight in many places. Cancelled projects are a negative supply factor that could drive apartment rental prices higher, for instance. Fighting inflation can actually cause inflation, at least in the short term.

The COVID period changed the economy in many ways, some of which are probably permanent. Yet it’s also remarkable how some larger trends are resuming. This chart shows survey data from the National Federation for Independent Business, a small business group. The red line is the percentage of owners who say in NFIB’s monthly surveys they have at least one unfilled job opening. It’s one measure of the labor shortage.

 

 

That number bottomed in the 2009 recession period, then rose until COVID struck. More recently it shot sharply higher. Look at the gray arrow we laid over the post-2009 period. If COVID (or something else) hadn’t interrupted that trend, it would now be not far from where it actually is. That’s evidence (though not proof) that the present labor shortage was already brewing before COVID and is now simply resuming its prior growth. COVID no doubt aggravated the problem but wasn’t the initial cause.

 

US Economy

 

  • The June payrolls report surprised to the upside, nearing full recovery
  • While we’ve seen signs of softer economic growth, the payrolls figures are not signaling a recession for now.
  • This jobs report sealed a 75 bps Fed rate hike this month.
  • The gains in private hiring were even stronger, with private payrolls now above the pre-COVID peak.
  • Public sector job gains have been lagging the private sector. A substantial component of this divergence has been public school teachers.
  • Many educators do not wish to return to work.

 

 

  • Credit card balances increased again in May but at a slower rate.

 

 

  • Retailers see slower sales but are still doing quite well.
  • There are more job vacancies than unemployed people in the US, Germany and UK – a sign of tight labor markets.
  • Sales expectations:

 

 

  • The 10-year/1-year portion of the Treasury curve is now heavily inverted as recession concerns rise.

 

 

  • The June CPI report delivered another shocker, with price gains exceeding most forecasts.

 

 

  • On a month-over-month basis, inflation accelerated broadly.

 

 

  • Rent:

 

 

  • The Treasury curve hasn’t been this inverted since 2000.

 

 

  • Real wages are sinking.

 

 

Market Data

 

  • Global stocks and US futures are lower this morning as the US dollar hits a multi-year high.

 

 

  • A stronger US dollar means softer corporate earnings ahead.
  • Is the fourth bear-market rally about to end?

 

 

  • The pullback in earnings estimates has been modest so far.
  • But corporate guidance points to further deterioration.

 

 

  • We’ve had 33 consecutive weeks of more stocks hitting new lows than new highs.

 

 

  • Earnings downgrades are picking up speed.

 

 

  • Capitulation is not yet extreme in the S&P 500.

 

Source: BCA Research

 

  • Typically, market turnarounds occur after 90% of stocks cross above their 50-day moving average. We are not there yet.

 

 

  • This week, we saw Wall Street continue to downgrade S&P 500 companies’ price targets and earnings estimates, but some smart money investors are not following the advice. Fundamentals are deteriorating quickly, and recession is looming.

 

Quote of the Week

 

“We cannot choose how we will die or when, we can only choose how we will live. “ – Joan Baez

 

Picture of the Week

 

 

 

 

All content is the opinion of Brian J. Decker