Misplaced Optimism? – August 2022 Macro Commentary
Last week I listened to a few asset managers retract their "recession is imminent/inflation is receding" arguments that they imposed on their investors for the last three months. Most did not. The dovish pivot still articulated by most pundits seems alive and well. The July unemployment rate went down to 3.5%, and July job creation (non-farm payroll) was 528,000 versus the 250,000 consensus. On August 6th, the NYT's Ben Casselman writes: "Jobs aplenty. Sizzling demand. If the United States is headed into a recession, it is taking an unusual route, with many markers of a boom." The last time we saw unemployment at 3.5% was in 1969 when annual GDP growth was 3.1%, YOY inflation clocked in at 6.2%, and the 10-year Treasury averaged 6.67%.
July CPI was unchanged vs. .2% estimate and core CPI was up .3% vs .5% estimate. Core CPI (less food and energy) year over year was up 5.9% vs. 6.1% estimate. Over the last 12 months, the all-items index increased 8.5% before seasonal adjustments. At this point, this is all a bit of noise as the typical consumer is not concerned with these month-to-month changes. Home prices are out of reach, grocery shopping is painful and rents are increasing at a record pace.
The Fed's two-front war of reducing inflation and stopping a recession can't succeed. When you shut off the world economy for two years, then switch it back on again, you'll get rampant inflation for multiple reasons, - and not for only a few months or a year. And yes, bonds and stocks will be volatile.
The Fed implemented various iterations of QE for over a decade, resulting in investors and speculators becoming hooked on never-ending liquidity, and then belatedly started QT in April. But while observed inflation today is indeed still high, expectations for future inflation are not that elevated for reasons that have yet to be clearly articulated. (Soft landing?) For example, five-year inflation expectations derived from US Treasury securities or via surveys range between 2.7-2.9%. One and three-year inflation expectations declined in July to 6.2% and 3.2% from 6.8% and 3.6%. This still implies a current negative real Fed Funds rate of roughly three percentage points. However, media economists insist it's less. That is untenable.
The point is that the real Fed Funds rates calculated using expected inflation have been negative more often than positive over the past 15 years. We will finally be paying the price for this long-term aberration. Whether the inflation rate is 10%, 4%, or 6%, the ten-year Treasury presently at 2.8% is destroying our wealth and eroding our nation's ability to offer working families the ability to save. Yet, we still have high-profile CNBC "star" economists, strategists, and portfolio managers from firms managing trillions of dollars that don't understand that the severity of inflation can and will wreak havoc on our society. And they ostensibly have a captive audience. No wonder so many investors are still complacent about inflation.
The more public NYT's economist/opinion columnist Paul Krugman (bless his heart!) has been talking about lower inflation every month for the last year. My suggestion is to ignore his highly erudite missives if you can. Sadly, his political biases overshadow any clarity in his well-written analyses.
There are more than a few less discussed issues that can't be ignored. For example, Swiss Re-implemented a 12% rise in premiums across its property and casualty lines due to higher costs due to increased natural catastrophes. Ocean shipping rates are four times what importers were paying in 2019, resulting in most retailers betting on congestion not ending any time soon. Nearly 80,000 shipping containers are haphazardly stacked in the port of Savannah - 50% higher than average. Savannah is the third largest port in the country. Labor shortages have perpetuated delays, and unions remain in negotiations with California's ports threatening truck and rail disruptions. Due to strike action, Lufthansa announced the cancellation of nearly all of its flights in Germany several weeks back. As we've said since last year, labor is just beginning to flex its muscle. Labor, simply catching up with lost wages over the previous 40 years, will underpin inflation for the foreseeable future. Hourly earnings, adjusted for inflation, are falling at their fastest pace in decades. While the average salary went up 3.5% in 2021 and 2.8% so far in 2022, grocery bills (buying the same things at the same store) went up 28% over the last two years. That has dire social and political consequences for the working family, who bears the brunt of the decades-long purchasing power demise.
On the spending side, big banks reported record levels of credit-card spending for the second quarter. At JPMorgan Chase & Co., credit-card purchases totaled $271.2 billion, the highest amount dating back to at least 2004 and 33% above the fourth quarter of 2019. Finally, Proctor and Gamble recently announced its biggest annual sales increase in 16 years, as consumers largely absorbed mounting price increases on essentials from toothpaste to toilet paper to dog food.
The peak inflationists have focused on retracing oil and gas prices, but gas prices could very well return to former highs unless we see peace in Ukraine. The EU ban on insurance for ships carrying Russian oil will most likely help push up fuel costs, again. Rents are up nearly 40 percent since January 2021, according to Apartment List - and those numbers tend not to retrace. It makes tackling soaring prices difficult for the US central bank. These rental hikes take time to show up in the official inflationary figures - often nine months to a year.
What are the dovish tilt wealth managers and peak inflationists missing? The interconnectedness of the numerous crises that exist at once. Climate change is causing havoc with floods and fires (previously never seen before), with recurring pandemic mutations increasing pent-up demand and corrupting supply lines, and the ongoing effect of Russia’s invasion of Ukraine moving that conflict westward, causing a historic diaspora. One of these crises is inflationary; all three make it endemic.
Central banks have always been a source of moral hazard in our economies and markets. Don't worry; the central bank will control inflation. Don't worry; the central bank will prevent an economic downturn. Don't worry; the central bank will protect the currency. Don't worry; the central bank will fight unemployment. We are entering our second century of central bank "money management," where we have had periods of runaway inflation, deep recessions, stagflation, market booms and busts, currency devaluations, bank bailouts, and an entrenched "too big to fail" mentality.
No doubt their job is complex, and unfortunately, their policy tools are better suited for more typical downturns, not a historically unique combination of slowing economic growth and soaring prices. In addition, the Fed has no tools to stop the impulsive Mr. Putin, reduce the backlog of container ships clogging ports from the United States to Europe to China, or control the pandemic.
The Fed must increase its QT, produce a normalized yield curve (i.e., positive real rates) and take the overflow of money in circulation under some semblance of control so the secular bear market in bonds can maybe be shortened to three years rather than mimicking the previous fixed income bear market that lasted 15-20 years. (1960-1981). Historically, the 10-year Treasury reached an all-time high of 15.82% in September of 1981, and the inflation rate that same year was 10.32%. The 40-year fixed income bull market started the following year.
Though the Fed is more comfortable cutting rates and throwing money around, I suggest they take a cram course in Volckerism and quickly get comfortable with a more sustained and aggressive QT (>100bp next raise) rather than falsely giving hope to the markets by casually discussing the next opportunity to ease. That would be painful, but it sends the right signal to a very confused market.
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