What a difference a few days make. As we’ve noted over the years, in bull markets corrections are fast and furious. Granted, a 3-day recovery after the first 5% correction in almost a year is faster than normal, but the point remains. So long as global GDP trends are positive, earnings are expanding and massive stimulus measures are implemented, stocks should do quite well.
Since China’s market was closed earlier in the week, uncertainty dominated while Evergrande’s debt payments hung in the balance on Monday. When dealing with a communist regime, it is a true wild card. Once markets opened on Wednesday, the People’s Bank of China pumped $17B into markets. That helped calm investors of contagion effects where commercial paper liquidity was drying up for all participants. Evergrande may not survive the year, but responses like this calm fears of a true Lehman-type event happening.
Some cash was also sitting on the sidelines awaiting Federal Reserve post-meeting comments to be released on Wednesday. There was nothing surprising about the release to raise any fears here either. Chairman Powell and Fed Governors have done a great job in preparing markets for what to expect. Fed funds remain in the range of 0% – 0.25%. A detailed tapering announcement should come in November. Whether an actual taper starts that month or December matters little, it is happening.
Powell noted that it “wouldn’t take a knock-out, great, super-strong employment report” in September, but instead a “reasonably good” report to proceed with tapering in November. In effect, the Fed is no longer data dependent with respect to increasing their balance sheet. Conditions have been met. Since March, QE4 has pushed their assets to $8.4T, more than doubling in just 18 months. Tapering will take eight months, give or take, which equates to $15B per month in fewer purchases. That gradual slowdown will continue to push the Fed’s balance sheet over $9T by June 2022. Although this is technically a form of tightening, Fed Funds are still at zero and will remain so until both unemployment and inflation are at targeted levels. Ending QE4 is nowhere near restrictive.
This does bring into question the next data dependent event, which goes back to jobs and inflation. Jobs should be a layup. There are 1.3 jobs open for every one unemployed person today. If one wants to work, they can find a decent position. Ending extra unemployment checks will help alleviate some of the available labor slack, but Covid concerns remain. Many cities across the country are still in hybrid mode for schools. At least one parent needs to stay home. Other families will continue home schooling due to immunocompromised family members. Other workers are still flush with cash and see no need to rush back. It may not be a straight line, but at this time next year, the Fed’s employment mandate should be met quite easily.
That leaves inflation, the big wild card, for rate liftoff…which then leads to the real tightening phase, balance sheet reduction. Post-Fed, futures markets are now pricing in one rate hike by the end of 2022, in line with new dot plots. Tightening is not expected until at least 2024. Take it all with a giant grain of salt though. Futures markets are pretty good at looking ahead a few months, whereas a year or more is hit or miss.
“Transitory” has been the Fed’s favorite phrase. No one told us transitory is measured in quarters, not months. Their new projection is for low 2% inflation by Q4 2023. That would be ideal, if not a miracle and a rosy economic scenario. However, we have been accustomed to expect Fed models to be inaccurate at best. Wage inflation has been a key determinant for inflation and previous Fed rate hike cycles.
As FedEx#, Nike# and others just reported, it is nearly impossible to fill job openings. So far this year we’ve seen $50 payouts from McDonald’s to applicants who simply show up for interviews. Amazon raised their starting wage for warehouse workers twice in 2021. Tuition reimbursement is coming back across the board for new employees. Numerous states have not raised their minimum wage but corporate America is setting $15/hour as a floor. As noted, there are numerous reasons finding capable workers has proven difficult. Rising consumer incomes, stemming from wage pressure, is one of the better predictors of future inflation rates. Judging by the lack of goods and container ships sitting in the ocean, this problem is not going to be alleviated any time soon.
To play devil’s advocate, let’s delve into why the Fed may be right this time and inflation will not be an issue:
• Historical comparisons are way off base. We’re nowhere near an inflationary scare like the 1970’s, which contained higher energy prices caused by OPEC’s oil embargo, Iranian revolution and an Iran-Iraq war. Or the 1940’s where America was rebuilt after WWII. We’re barely back to 2009 levels and are already trending down. Comps next year are off from today’s higher base, making even a 3% jump difficult to forecast. One can see that the comparisons don’t hold water with those periods:
• Looking further back to the 70’s and 40’s, growth was significantly stronger, demographics were a lot better and debt levels were ideal. By 2023, we will be fortunate to get back to our 2% trendline. Demographics are not improving. Debt is, by all counts, at insane levels.
• Covid-induced pricing pressures are a major factor. Take autos for example. In 2019, global auto sales were 75+ million. In 2021, we’re not even reaching that number, but supplies are non-existent, causing a ramp-up in used car prices. This is not due to lack of workers or too much demand. Chip shortages due to factory closures from the Delta outbreak, paired with ports closed due to too many sick workers, have led to dislocated supply chains. In 2019, we could produce 10 million more cars and not see a bump in prices. None of this inflation has to do with excessive demand or money supply. Apply this same reasoning to numerous industries and inflation is much more muted post-Covid.
• Base effects have to be considered. Recall last April when oil went negative and most commodity prices collapsed as factories were forced to close. Year over year comparisons off a low base is an easy environment to produce 5% inflation. Next year, the CPI will have to go up against a much more normal starting point.
• Delivery and shipping prices skyrocketed recently after being relatively tame for a decade. Freight costs and energy prices have gone up 5-fold over the past year. If/when these two revert back to normal levels, inflation rates would drop to 2.5%. OPEC and U.S. shale production levels are still well below pre-Covid levels. Assuming these areas are allowed to start producing closer to max capacity, energy prices should normalize.
• Direct payments from Governments around the globe are ending. A lot of helicopter money was spent with a fraction going to savings. Those payments are not going to be repeated, causing a decline in demand. Couple this with an end to Quantitative Easing by every Central Bank and you see more restrictive financial conditions. The end of every QE phase led to a drop in inflation statistics.
• Lastly, and most importantly, wage inflation has not correlated with CPI inflation since the early 1990’s due to globalization. For math geeks, the correlation between wage growth and inflation before 1990 was 92%. Since then, it has been only 17%! Globalization has allowed developed nations and large corporations to source less expensive labor around the world. This keeps competition tight and pricing power weak. More importantly, productivity stemming from technological innovation throws on another layer. Case in point is the oft-mentioned kiosk at McDonald’s to take your order. Instead of paying someone $15/hour for 18 hours’ worth of work, along with benefits, companies can simply put in a computer that doesn’t take any breaks.
October 8th will be the next important dataset as we see how many people came back to the workforce during September with the BLS payrolls update. A really strong number will pull forward rate hikes and vice versa. From there it will take time to adjust to this inflation mantra. Job openings will not be filled overnight. Cargo sitting offshore will get unloaded, but shipping lanes will remain congested for months. Wage inflation will remain above the critical 4% level through early next year. Every inflation report will be scrutinized, leading to more transitionary volatility.
For now, it looks like inflation and higher interest rate bulls are in charge. Thursday’s response to Fed comments hoisted 10-year interest rates to their biggest jump since February, and are now up 11bps from the post-meeting announcement, closing at 1.41%. As one might think, banks and Industrials benefitted while yield plays like REIT’s and Utilities suffered. High P/E stocks lagged and FANGMAN participated, but may be passing the leadership baton back to Value peers. Follow-up reactions will be critical in determining if new leadership will continue during the seasonally strong 4th quarter.
Keep your seatbelts fastened, there could be more weeks like this one coming up.
News host Lou Dobbs is 76 today, while 4-time Super Bowl Champion Mean Joe Greene turns 75.
James Vogt, 610-260-2214