The current episode of inflation we have is unlike anything we’ve seen in modern history. It has three component causes, all equally culpable.

First, there is the Federal Reserve’s easy monetary policy. Quantitative Easing caused asset price inflation in both financial assets and home prices. Low interest rates have spurred increases in home prices, rental property prices, new/used cars, and have clearly contributed to the financialization of the economy.

Low interest rates encouraged investors, both small and large, to reach for yield and take more portfolio risk. Small investors in particular have moved into riskier stocks. If we have a bear market in an inflationary cycle, it will devastate the retirement portfolios of many retirees and those who are close to retirement.

Pretty much no one (except frustrated buyers) is upset when their home or stocks go up in price. Clearly, the Federal Reserve has made that a feature of their policy. They think of it as financial stability.

The problem is that there are many aspects of inflation monetary policy can’t control. We will continue seeing headline CPI and PCE inflation numbers well above their 2% target (which is in and of itself destructive) which means that if the Federal Reserve wants to maintain its inflation-fighting credibility, it will have to go further than anyone thinks now, or lose that credibility. And that risks (gasp!) a recession.

Second, Governments around the world responded to COVID-19 in different ways. Many provided support to workers who lost pay because their employers had to close. The US did so in a particularly haphazard way. It wasn’t exactly helicopter money, but we launched a bunch of different programs that gave some people more than they needed. The government created three peaks which correspond to stimulus payments sent to each American (except certain high-income earners) in April 2020 ($1,200 per person), January 2021 ($600), and March 2021 ($1,400). Those injections had giant effects. This year’s jump in inflation followed the third and largest spike. CRFB suggests several BBB modifications they think would help. Manchin’s pressure already chopped some of the most problematic features. By the time anything passes—which as of now looks unlikely until spring, if then—it may be even smaller. I hope so, because excessive and poorly planned spending is what created much of this inflation. We don’t need more of it.

Third, Basically, the COVID-19 pandemic caused manufacturers around the globe to shut facilities and/or drastically reduce output. At the same time, the additional payments plus assorted other programs distributed enormous amounts of money to people with a high propensity to spend it on consumer goods. That wasn’t a side effect. It was the intent.

That combination alone would have created giant distortions, but it also came in a situation where spending patterns changed. COVID concerns and restrictions pushed the spending away from services and toward goods, many of which were already in short supply and became more so as demand grew.

Many industries are again producing at full capacity. The problem is that demand, while normalizing, is still robust and producers have to catch up. One way they do this is by increasing prices and passing on price increases they receive. It becomes a vicious spiral.

Here’s the problem. Federal Reserve policy doesn’t help supply chain issues. The semiconductor maker producing mid-level chips is not going to spend billions on another plant for old technology if they believe it will sit idle once this short-term demand spike is satisfied. Ditto for many other industries.

Further contributing to inflation and supply chain issues is the very tight labor market. Officially, unemployment is at 4.2%. But there are fewer workers available and they want higher pay. We are clearly in a wage-cost spiral that is only exacerbated by inflation. The average increase in labor costs is still underneath current inflation. If inflation averages 4%+ next year, which it very well could, that is going to mean continuing wage increases which is by definition a major inflation component.

 

US Economy

 

  • Traders were concerned about another upside inflation surprise, but the November CPI report was roughly in line with expectations. That’s why stocks and bonds rallied despite a multi-decade high CPI print last week.

 

 

  • Here are some of the stronger CPI components where prices have gone much higher
  • New vehicles +11%
  • Food away from home (restaurants are rapidly boosting prices to cope with higher wages): +6%
  • Shelter (plenty of room to rise further): +3%
  • Since the market feared an upside inflation surprise, Treasuries rallied when the CPI report came in line with expectations.
  • And inflation expectations ticked lower.
  • One driver of US inflation has been a rapid growth in the money supply. Eliminating QE should slow this trend.
  • The U. Michigan consumer sentiment index ticked higher this month, boosted by a pullback in gasoline prices.
  • Forecasts suggest that the headline CPI is peaking, but the core CPI will keep climbing over the next few months.
  • Rent is expected to keep upward pressure on the core CPI
  • Inflation peaking doesn’t mean that it will return to pre-COVID levels. Economists continue to boost their inflation forecasts for next year, with projections now well above the Fed’s target.
  • Here is a survey from Deutsche Bank showing upside inflation risk

 

 

  • And this chart shows the PCE inflation distribution of outcomes from Numera Analytics

 

 

  • Used vehicles could become a drag on the core CPI later in the year.
  • The Taylor rule implies that the fed funds rate should be 7.6%.
  • State tax receipts have improved markedly this year.
  • November producer price gains surprised to the upside, with the headline PPI approaching 10%.
  • The core PPI ex. trade services (business markups) surged as well.

 

 

  • The spread between upstream and downstream price gains points to profit margin pressures (that’s in addition to rising labor costs).
  • Morgan Stanley expects corporate profit margins to contract meaningfully from current levels.

 

 

  • Logistics bottlenecks continue to drive prices higher.– Warehouse construction prices are up 20% vs. last year.
  • A separate report from Cass Information Systems showed that freight rates have surged 38% over the past year, a new record.
  • By the way, supply-driven inflation has been feeding into consumer prices much more than we’ve seen in recent years.
  • Small businesses continue to struggle with supply shortages as inventories keep tightening.
  • Inflation is increasingly a concern, as companies boost prices and plan to keep doing so in the months ahead.

 

 

  • Businesses also increasingly expect to raise wages.
  • The NFIB survey shows that companies see the economy tanking in the next six months.

 

 

  • The stock market points to robust holiday sales this year
  • November retail sales surprised to the downside
  • The first regional manufacturing report of the month, Empire Manufacturing (NY Fed), topped forecasts.
  • The delivery times index appears to have peaked, suggesting that supply constraints are starting to ease.

 

 

  • However, unfilled orders remain near the highs.
  • Forward-looking activity indicators softened.

 

 

  • And weakness in China’s factory activity adds to downside risks for Empire Manufacturing.
  • Import prices continue to surge despite a stronger dollar. Excluding petroleum, import price inflation is now the highest since 2008.
  • Homebuilder sentiment improved further this month as demand picks up.
  • House purchase loan applications are still going strong, running well above 2019 levels.
  • 2021 has been a good year for home price appreciation.

 

 

  • US deaths (per 100k people) vs. other advanced economies:

 

 

  • Initial jobless claims dipped below the 2019 levels, pointing to further declines in the unemployment rate.
  • Continuing claims are near the lows as well.
  • Capacity utilization continues to climb.
  • Unlike the data we saw from the NY Fed, the December Philly Fed’s manufacturing report was disappointing.
  • CapEx expectations eased.
  • The price index appears to have peaked.

 

 

  • At the national level, the December flash Markit PMI report was also softer than expected.
  • Manufacturing supply strains are starting to ease.
  • US healthcare spending (as % of GDP)

 

 

The Fed

 

The Consumer Price Index hit 6.8% this month, the highest year-over-year number since 1980. Gasoline prices increased approximately 58%. Grocery prices are up 6.4%. Steak is up nearly 25%, bacon 21%, eggs 8%, apples 7.4%, and flour 6%. Shelter costs, which comprise about one-third of the CPI, increased 3.8% on the year, the highest since 2007 as the housing crisis accelerated. And wage pressures are real and not transitory.

In response, the Fed slammed on the brakes this week. The Fed had been buying $80 billion per month of U.S. Treasurys and $40 billion per month of mortgages. Last month, they reduced the total purchases of $120 billion per month to $105 billion. On Wednesday, Powell said the Fed will reduce its bond purchases to zero by the end of March 2022.

After the bond buying goes away, Powell said the Fed will begin to raise interest rates. Three rates hikes are expected next year.

The surprise will be they won’t raise rates at all. Due to the excessive debt in the system, rising rates will prove to be a liquidity constraint on financial assets. The response in the bond market is signaling agreement. Since the Fed’s Wednesday announcement, the 10-year and 30-year Treasury bond yields are lower since the Fed’s announcement.

The Fed raised the Fed Funds rates five times in 2018 from approximately 1% to 1.5%. The stock market declined sharply late in the year, down approximately 20%. Then came the famous Powell Pivot at Christmas time. The Fed admitted they were wrong, changed course, and what followed until now was on the greatest liquidity injection of all time.

The Fed is taking the punch bowl away. If they stay on this new path, we will be in a recession by 2023. I could be wrong, but I don’t believe the Fed can raise rates for too long. Expect the next 20% stock market decline to be met with another pivot. More goodies with similar inflationary consequences. The Fed is in a tough spot.

The FOMC boosted its inflation forecasts.

 

 

By all accounts, the Fed took a hawkish posture (the sharpest policy reversal in years). But the markets’ response was remarkable.

  • Short-term Treasury yields jumped but then rapidly retreated. The market is simply not convinced that the Fed will go through with the dot-plot hikes.

 

 

Inflation expectations jumped, questioning the Fed’s inflation – fighting commitment.

 

 

  • Stocks surged as traders unwound hedges/short positions.
  • Credit spreads tightened.
  • The dollar declined, pushing gold and copper higher.

 

M2 Money supply

 

Here’s another entry in our long-running “What was THAT?” series. The purple line is the US “M2” money supply. This is a broader measure than M1, which includes only cash and checking accounts. M2 adds savings accounts, money market funds, time deposits, and a few other assets that can be quickly converted to spendable cash. As you can see, it took off like a rocket in early 2020.

 

 

Of course, we know what caused this. The Federal Reserve and Congress forced vast amounts of liquidity into the economy when COVID struck. The interesting part is that it hasn’t stopped, or even slowed very much. This idea that the Fed is “tightening” policy is not yet affecting the money supply. Maybe it will, but there’s no sign of it yet.

 

Market Data

 

  • The valuation gap between US stocks and the rest of the world continues to widen.

 

 

  • Insiders have sold quite a bit of stock this year. Note that these are dollar amounts, partly reflecting elevated share prices.

 

 

  • As the Nasdaq 100 marches higher, driven by a few gigantic stocks, fewer of its members are participating. There has been a cluster of negative divergences over the past 30 days, arguing for limited gains in the index.
  • The S&P 500 real dividend yield and real earnings yield hit new lows.

 

 

  • The Nasdaq Composite breadth shows no signs of recovery.

 

 

  • Fund managers have increased their cash holdings.

 

 

  • Share buybacks accelerated this year.
  • The S&P 500 is at the top of its very long-term (since the 1930s) channel. It broke out only twice (late 30s and 90s) and is at levels comparable to the booming 50s and 60s.

 

 

  • Investors have been rotating out of cyclical stocks into defensives.
  • Momentum stocks are underperforming.
  • Speculative growth stocks continue to struggle
  • This week, we saw a continued negative divergence in many tech stocks in the Nasdaq 100. Defensive sectors like Consumer Staples is seeing the opposite scenario, with a recent breadth thrust. Biotech looks oversold. Overseas markets continue to struggle versus the U.S. Sentiment on bonds is trying to recover from a near decade-low.

 

Thought of the Week

 

“I would say, asset valuations… are somewhat elevated.”

 

– Federal Reserve Board Chair Jerome Powell,

Wednesday, December 15, 2021

 

Picture of the Week

 

The ‘Iter Avto’, the 1930’s version of a GPS. Developed by Touring Club Italiano, this device was more like a “map guidance tool” and came with a set of paper maps. It was tethered to the car’s speedometer that kept the scrolling of the map in proportion to the speed of the car.

 

 

A ‘Tasmanian tiger’ in captivity circa 1930. Also known as the thylacine, this carnivorous marsupial was native to the Australian mainland and went extinct in 1936.

 

 

 

All content is the opinion of Brian J. Decker