The latest US consumer sentiment data raised a lot of eyebrows last week, plunging even below the initial COVID panic lows. This chart shows how drops to this level (the horizontal red line) are often associated with recessions.

 

 

The exception to the pattern occurred when Europe’s 2011 sovereign debt crisis roiled world markets. In that case, Americans regained confidence quickly when the problems didn’t spread here. The same may happen this time if Omicron worries and disruptions keep receding. Or maybe not, if the explanation is something deeper.

 

US Economy

 

  • The U. Michigan consumer sentiment report surprised to the downside, driven by sharp declines in the expectations component.

 

 

  • Gasoline prices, which hit the highest level since 2014, have been a drag on household confidence.
  • Despite the labor market’s strength, households are increasingly concerned about their finances.
  • They are also uneasy about business conditions going forward.
  • Will retail sales take a hit as household sentiment sours?
  • Economists continue to downgrade this year’s GDP growth forecasts

 

 

  • as they push inflation projections higher.

 

 

  • The yield curve is expected to invert next year, which typically signals a recession within 6-18 months.

 

 

  • The markets agree. Here is the 10yr – 2yr (OIS) spread one year out.

 

 

  • What will the Fed do in response? The market now sees rate cuts as soon as late next year, as the tightening cycle “overshoots.”
  • Has the headline CPI peaked?

 

 

  • A substantial component of the CPI surge is from “COVID-sensitive” items and base effects.

 

 

  • One area of concern for the Fed is the acceleration in the sticky CPI.
  • High inflation is rapidly eroding wages
  • US nominal wage growth is now the highest in over two decades.
  • Fund managers also see inflation moving lower from here.

 

 

  • Valentine’s Day inflation index

 

 

  • The PPI report topped forecasts, with both the headline and core indices holding near the highs.

 

 

  • Supply chain bottlenecks are off the highs but remain elevated.
  • News services are starting to talk about recession again.
  • Asset managers increasingly think that the economy is in the late phase of the cycle.
  • Housing demand has been strong while inventories are exceptionally tight.
  • But deteriorating affordability will increasingly become a drag on the market.
  • The 30-year mortgage rate is now well above 4%
  • US hog futures continue to climb

 

 

  • The Philly Fed’s manufacturing index declined this month, pointing to softer factory activity at the national level.

 

 

  • Businesses see slower growth ahead, as evidenced by the expected employee workweek index.
  • The economy is getting closer to full employment as both the labor force participation rate and employment/population ratio approach pre-pandemic levels.
  • Housing starts were softer than expected last month (especially single-family) due to workers out sick with omicron as well as some adverse weather conditions. Higher mortgage rates will soon begin to take a toll on residential construction.
  • There are a lot of apartments currently under construction

 

 

The Fed

 

The FOMC minutes (from the Jan 25-26 meeting) were less hawkish than feared.

  • There didn’t seem to be any signal for a 50 bps rate hike in March.
  • The Committee doesn’t appear to be in a rush to begin the balance sheet roll-off.

Participants noted that the removal of policy accommodation in current circumstances depended on the timing and pace of both increases in the target range of the federal funds rate and the reduction in the size of the Federal Reserve’s balance sheet. In this context, a number of participants commented that  conditions would likely warrant beginning to reduce the size of the balance sheet sometime later this year.

However, this was before the ugly January CPI report.

Mark Grant says we are now caught in a bear trap: inflation and the Fed’s choices vs. what Putin may do in Ukraine. Things could go very wrong, very quickly in either situation, and Grant thinks the risk is all to the downside now. He recommends strategies to hold both predators at bay.

Key Points:

  • Grant’s preferred inflation measure is the average of consumption (CPI) and production (PPI). That means 8.6% over the last 12 months.
  • Even with wage growth at the fastest pace in 20+ years, earnings are still far below inflation.
  • The Fed’s use of the word “transitory” for inflation is now a scar etched on the central bank’s wall.
  • Predictions of what the Fed will do are all over the map.
  • Grant thinks stock markets will be slammed if Russia moves into Ukraine, with unknown effects on the rest of Europe.

Grant mentions an overlooked point: When/if the Fed begins reducing its balance sheet, it will matter where on the yield curve they choose to act first. This is another opportunity for error and, given recent mistakes, it is hard to be confident they will get this one right.

 

Inflation

 

We’ll begin with a chart. This is a long-term look at the Consumer Price Index in a format you don’t often see: the actual index . This one is also a log scale so you can see percentage growth consistently (i.e., the vertical distance from 40 to 80 is the same as 80 to 160, and so on). Take a long look and see if you can find a period since World War II when inflation was “transitory.”

 

 

For this 75-year period, the index rose 3.44% on average per year, which adds up to almost 13X. Today you need $1,261 to have the same spending power $100 provided in 1947—though this is a rough comparison because today’s economy is qualitatively different. In 1947 you couldn’t buy an iPhone at any price.

The point I want to stress, though, is that any inflation is a problem. Even 2% inflation—which the Fed now regards as a floor—steals your purchasing power. Slow-motion theft is still theft. Now it’s not even slow motion.

Here’s the same chart as above, zoomed in on the last 10 years and still with a log scale. The two red boxes are the same size vertically, meaning they represent the same amount of inflation.

 

 

From May 2020 through January 2022, CPI rose a total (not annualized) of 10.2%. Going backward from the same point, you have to start at March 2013 to get the same amount of inflation. That means the pace has more than quadrupled.

Here’s another chart showing annual percent change in CPI. Each bar represents a 12-month period, and the red line is that 3.44% average.

 

 

Put all that together and we can say two things:

  • Some inflation is normal but
  • Today’s inflation is not.

Moreover, today’s inflation is abnormal not just because it is abnormally high, but because it is occurring when interest rates are abnormally low, and will likely remain so even if the Fed hikes quite a bit in the next year.

The odd part is that this level of inflation, with wide belief it will remain significant even if somewhat milder, should be driving interest rates a lot higher than they are. What’s going on? I believe the answer is the Fed has broken the markets.

Treasury yields are being held artificially low by the Federal Reserve’s vast quantitative easing purchases. Yields would have been higher without that intervention, with accordingly higher implied inflation expectations.

The market is discounting future economic weakness. Recessions always bring lower inflation if not outright deflation. If growth turns negative for any reason—Fed overshoot, debt collapse, a more serious pandemic, whatever—and stays low for a year, it could easily bring average inflation down to 3% or even lower.

The Fed tries hard not to surprise the markets. They pretty much telegraph their plans in advance. We know that QE will stop within a month (though why it is still underway with 7% inflation is beyond me!) and they plan to raise rates 0.25% per meeting for the next 4–5 meetings with Fed Funds reaching 1.5% sometime in 2023. They will signal well in advance if they decide to do an inter-meeting rate hike, or something changes.

Let’s look at the landscape in which the Fed is proposing to tighten. Look at the chart below which shows the evolution of the Atlanta-based GDPNow versus blue-chip economists. Even the ever-optimistic blue-chip economists see a first-quarter GDP of 2%. The Atlanta Fed is at 1.3%.

 

 

Has the Fed ever embarked on a tightening cycle with consumer sentiment down 20% on a YoY basis? Answer is no. The issue here is 7.5% inflation, a product of the pandemic and principally supply-induced, and so if there is a remedy beyond a robust global harvest, OPEC+ becoming less stingy, shipping capacity spring back to life, or China easing back from its zero-COVID-19 policy, the only way central banks will be able to bring inflation back down with the tools at their disposal will be to crush demand. So think recession. And every recession in history brought with it a bear market in equities—and most of the time, it is more like down 30%–40%, not 20%.

My biggest concern is that the Fed tries to steer a path between fighting inflation and protecting markets. Their number-one job has to be fighting inflation. Most of the people I follow closely believe the Fed will blink.

 

Market Data

 

  • The growth/value underperformance this quarter has been the largest since the dot-com crash.

 

 

  • Companies haven’t been punished this much for missing earnings forecasts in over a decade.

 

 

  • It’s been a rough start of the year for Treasuries.

 

 

  • Higher inflation means lower stock valuations.

 

 

  • Google search activity suggests that retail investors have lost interest in the stock market. Nothing seems to be “going to the moon” these days.
  • The market now expects the yield curve to be inverted in six months.

 

 

  • Europe has been the largest buyer of US Treasuries, agency debt, and corporate bonds over the past decade.
  • Still, foreign purchases of Treasuries are small compared to the Fed’s buying spree.
  • January was the worst start to the year for EM fixed income since 2010.
  • There is an energy crisis about every 30 years.

 

 

  • Small caps have been outperforming in recent days.
  • Corporate earnings guidance has been deteriorating.
  • Fund managers have soured on tech stocks.
  • In addition to concerns around the Fed’s tightening, equity investors remain nervous about the Ukraine/Russia situation.
  • Fund managers have boosted their cash positions.
  • S&P 600 (small-cap) value stocks have been sharply outperforming growth this week.
  • Fund managers haven’t been this concerned about monetary risks in years

 

 

  • Last week, we saw a historic bout of selling pressure in high-yield bonds, on par with the worst declines in 15 years.

 

Thought of the week

 

AT&T fired President John Walter after nine months, saying he lacked intellectual leadership. He received a $26 million severance package. Perhaps it’s not Walter who’s lacking the intelligence.

 

Pictures of the Week

 

 

 

All content is the opinion of Brian J. Decker