CPI updates on Wednesday set multi-decade highs on the inflation front, while PPI reports yesterday were quite similar. Headline consumer inflation rose 0.5% (6% annualized) while the more important core metric was +0.6% (7.2% annualized). Price increases were broader based, but with massive increases on a yearly basis for many of the same areas: Gasoline +50%, fuel oil +41%, used cars +37%, new cars +12%, and utility prices +24%. Also ramping up were food +7%, commodities +11%, apparel +6% and shelter +4%. In fact, nearly half of the components in December’s CPI popped more than 5%! Obviously, analyzing prices from a shutdown economy in 2020 vs 2021 has some nuances, but overall, inflation is showing no signs of abating when looking at yearly comparisons.
There are some positives when looking at month to month, as opposed to year over year, comparisons. Gasoline, fuel oil, utility prices and transportation services all declined relative to November. Shelter cost, although elevated, stopped accelerating for now. Even new vehicle price gains are slowing month after month. Health care cost increases continue to be relatively modest. Omicron likely had some impact here, especially for oil costs as crude prices declined. Two weeks into a new year and we’re back at new highs yet again.
Even more impressive was the stock and bond market’s reaction. When critical reports like these come out and show even more inflation than feared, one would expect stocks to decline and interest rates to rise in anticipation of an even more aggressive Federal Reserve tightening plan. We got the opposite, at least for one trading day. Established companies, those with real earnings, saw their stocks continue to bounce off support levels on Wednesday. Defensive and value sectors, which normally excel in a rising interest rate environment, declined fractionally while other growthy industries saw broad based, though muted, gains. However, Thursday reversed some of this positive action with renewed selling in high P/E growth stocks and funds flowing back to value, energy, financial and industrial leaders. Call it a wash over the past few days, in spite of a scorching inflation report. Major indices are down fractionally for the week after a slide into yesterday’s closing bell. We continue to monitor recent support levels and will await confirmation that this high valuation correction is complete.
Over in bond land, interest rates went down across the board the past two days as well, defying inflation bulls despite the hotter numbers. Markets are almost always ahead of the curve. Following an Omicron scare that dragged 10-year Treasury yields down to 1.3%, the subsequent realization that this variant is a lot less deadly and should not impact the labor force or growth too much, yields ratcheted back up and approached 1.8%, their highest levels since before Covid.
Markets have accepted that Fed tightening is coming sooner than expected. Nearly four rate hikes are priced in for 2022. Most economists are on board with this tightening cycle to start in March. One should also expect an outright decline in the Fed’s balance sheet sometime this Summer. With all of that now “known” and mostly priced in, what could change on the inflation front to alter this less-than-ideal monetary tightening phase?
Let’s play devil’s advocate to the consensus view that inflation is rampant, will be long-lasting and interest rates must go higher across the board (these are not predictions, rather items to watch out for in case consensus views are wrong):
• 1970’s comparisons are way off. That period had much higher population growth, more consistent GDP expansion, a new monetary system, and dramatically lower debt levels. The energy crisis was real, but oil has a much smaller impact on consumer balance sheets today and is less impactful to CPI.
• Comparisons will get easier over the coming months. Energy is unlikely to see another 35% increase this year. Ditto for used and new car prices. If another variant doesn’t impact the world again, we’re going to see a much healthier workforce that doesn’t shut down thousands of flights a day. Ditto for factory workers, service jobs, port workers, etc.
• Supplies will get better going forward. Delivery times are at 50-year highs. It is almost impossible to not improve from here. Again, comparing 2021 spikes to 2022 levels could produce much lower growth rates. Judging by the LA ports showing zero real improvement since October, this could be a 2023 event!
• Central banks around the globe, mostly China and emerging markets, were raising rates aggressively last year to impact demand and inflation. China has been the marginal player over the years from an inflation standpoint. Impacting their growth rates takes a lot of steam out of a runaway commodity inflation train.
• The bond market is pricing in muted, long-term inflation premiums across various end markets. Historically, our bond market has been considered “smart money” and leads equity reactions. Betting against them is not usually a good idea.
• Money supply growth was 25% at the onset of the pandemic. That is already declining to single digits. It is not the old number that matters, it is the direction. Government handouts are ending and money supply should keep slowing. Sure, we’re swamped with cash today, but that is already being dwindled down slowly.
• Taking the money supply equation further, what happens during inflationary spirals is that the velocity of money expands. In simple terms, this “velocity of money” measures the number of times at which money is exchanged in an economy. I buy food from a store, that store owner takes those funds and goes out to dinner. That waiter then purchases a TV…and so on and so forth. Even with all this money supply, the velocity of money is at all-time lows. When money is not circulating around at a rapid clip, inflation usually comes down.
• Even further, further…loan demand is well behind normal levels. In effect, the increase in money supply simply took the place of loans. Commercial and Industrial loans are barely above 2009 recession levels. When the Government sent out PPP checks to nearly anyone who applied, it meant no loans were needed or interest payments were necessary. When that occurs, owners of capital are not forced to invest, as opposed to a loan on which they have to generate a return on and pay back.
• Our last 3 quantitative tightening periods all led to slower growth, less inflation and lower interest rates. Is this time different?
• Global rates are still negative or close to it. German 10-year bunds carry a negative 0.06% return. Investors will continue to buy U.S. Treasuries, even at 1.7% when the alternative option is so terrible. That puts a lid on how high long-term rates can go. It should also put a lid on how much the Fed can raise short-term rates before inverting the yield curve again. Our last 7 recessions were preceded by an inverted yield curve.
The likelihood of all the above coming to fruition in 2022 is next to nil. However, one by one, each bullet point has some merit and is worth monitoring. As Covid shifts to an endemic disease and countries can stop shutting down, then we will gradually improve the supply chain, increase worker availability and progress to our new norm. How aggressive our Fed and developed market central banks are in fighting near-term inflation will be critical to the path…volatile or gradual.
For now, investors should continue to focus on quality, free cash flow, valuations that are in line with historic norms, and companies with a leadership product not dependent on easy money. There is a big difference between a business that sells NFT’s and one that sells toothpaste when liquidity is being slowed. Some major banks report earnings today while more updates ramp up next week, giving investors another important look into cost inflation, labor shortages, supply chain delays.
If anyone can remember “Head of the Class”, a fan favorite of my wife, actor Dan Schneider (who played the computer whiz) turns 56 today. Another favorite of ours, singer/drummer Dave Grohl is 53. LL Cool J also turns 54 today. Netflix# hit series “Ozark” will start another season next Friday. Its star, Jason Bateman, is 53.
James Vogt, 610-260-2214