It is a busy week on the economic front, which will require some extra-strong fresh brew to get through. All eyes will be on the Federal Reserve, again, as the FOMC will announce their latest monetary policy update. Outside of the FOMC announcement, we have had Housing Sentiment reported this morning (dismal), Housing Starts on Tuesday, Mortgage Applications and Home Sales on Wednesday, Kansas City Manufacturing Index Thursday, and S&P US Purchasing Manufacturers Index (PMIs) on Friday. It is weeks such as these that prompt me to switch from a traditional ice coffee to what my local coffee shop, LDU Coffee, calls a Space Cowboy; cold brew coffee with shots of espresso… basically rocket fuel! Over Coffee with Andrew today, I want to spend some time with you this morning to discuss last week's volatile financial market that stemmed from Tuesday’s "hotter than expected" inflation report, which proved to be Sticky that promptly caused an Icky market response with the S&P 500 closing down 4.77% for the week. Below we discuss how different measures of inflation have continued to drive the DCA narrative of a tighter for longer monetary policy stance. Enjoy! As readers have known, we have been highly critical of the notion that the reflationary environment post-COVID lockdowns would morph into a full-fledged inflationary regime as monetary and fiscal policy initiatives packed a punch much larger than the economy ultimately needed. The unintended outcome has led a structural shift in labor supply (the great retirement) which has been a harbinger for sticky inflation. It is quite remarkable how far market participants have come as we began 2022 with a zero-interest-rate-policy mindset and now forecast a 4% Federal Funds terminal rate by the end of the year. This 180-degree pivot has clearly ushered in uncomfortable drawdowns across ALL assets except cash. So far, year-to-date as of last Friday, the S&P 500 has had a loss of 19.8%, Nasdaq loss of 28.6%, and long-term Treasury bond loss of 28.3%. Now, over two years later since the COVID market lows and upward inflection in inflation growth rates, we have begun to see many financial practitioners and financial media pundits acquiesce that their "transitory narrative" was misguided. The new vogue mantra now is to pontificate the narrative of "peak inflation." In a recent 60-minute interview, President Biden even discussed how inflation had not moved higher month over month. While the President, and financial practitioners and pundits are accurate that the month-over-month growth rate has stagnated, we believe this to not reflect the true inflationary underbelly. There are many different inflation metrics widely used, with each having unique uses. The most often cited inflation metric is Headline Inflation measured by the Consumer Price Index, a measure of price changes for a commonly used basket of goods. This report helps us identify the costs of goods and services price changes throughout the economy across a multitude of variables. And while there is nothing wrong with using this metric, as it is cited quite often, it can be highly misleading as several of the components/variables have outsized effects on the overall report. For instance, the surge in used auto prices in 2021 helped contribute to the upward move in inflation rates as well as the European energy crisis stemming from the Ukraine conflict earlier this year. The recent Inflation Reduction Act, alongside the release of gasoline stockpiles, did help quell the move higher in headline inflation, as we have seen reported at ad nauseam. But when removing the outliers, we begin to see a glaringly different story. As always in this business (or any other), the devil is in the details, and nothing should be taken at face value. As mentioned above, headline report for Consumer Price Index (the main measure of inflation) has stalled its move higher, which has shepherded a victory lap amongst many. Or so it seemed…. The chart below contextualizes the relentless move toward higher inflation by way of alternate measures:
Trimmed Mean- Excluding the biggest outliers in both directions and averaging the rest. Median- Excluding the biggest outliers in both directions and taking the median of the rest. Strick Prices - The rate of "sticky" price inflation, a measure tracked by the Atlanta Fed covering prices that are hard to change Core- Excluding food and fuel, which the central bank has little to no control over Services ex Energy-
Median- Excluding the biggest outliers in both directions and taking the median of the rest.
Strick Prices - The rate of "sticky" price inflation, a measure tracked by the Atlanta Fed covering prices that are hard to change
Core- Excluding food and fuel, which the central bank has little to no control over
Services ex Energy- Where consumers spend most of their aggregate labor income
So, while last Tuesday's inflation report showed no month-over-month inflation growth, alternative measures have shown that inflation has not only risen but broadened in the items that we use in our daily lives. This makes it hard to argue that inflation has peaked and obliterates the transitory narrative. This caused financial assets to quickly reprice for a Federal Reserve that will need to continue a tighter for longer path in an effort to get price stability to their stated mandate of 2% average, something DCA has argued as a base case for some time.
Financial markets have experienced multiple bear market rallies, with the latest hinging on the hopes that the Fed will bring about an easier stance on monetary policy. We find this thesis premature based on the fact that labor markets are currently still too hot for inflation to moderate to the appropriate policy level. The latest report shows that private sector aggregate labor income for the last 3 months, annualized, sits at 7.6%, which is well above the pre-covid average from 2015-2019 of 4.4%. Aggregate income at this level is a key ingredient in keeping core inflation metrics (measures above) elevated. The chart below contextualizes the relationship between core inflation and labor costs.
With labor markets still resilient (DCA expects deterioration in the coming months) and inflation still showing no signs of peak behavior, the Federal Reserve will continue its path of tightening monetary policy until unemployment moves high enough to force "sticky" inflation lower. The graphic below shows the probability of the Fed raising by 75-bps on Wednesday at 82%, which is up from 47% at the same time last month. There is also now an 18% probability of a 100-bps hike on Wednesday, up from a 0% probability one week ago. While DCA does not believe the Fed will hike 100-bps on Wednesday, we would not fully discount the possibility given the recent inflation report.
We continue to maintain elevated cash weights, and defensive growth tilts to reduce relative drawdowns. Our assessment has been that the next phase will be profit deterioration in form of aggregate corporate profits and earnings outlooks, which has begun to manifest with the latest announcement from FedEx. As companies reconfigure margin structures in the event of lower profits from higher borrowing costs and labor costs. Once the unemployment data rises, we will then begin to see a durable pivot in monetary policy which will catalyze upward inflection in the business cycle.
Please do not hesitate to contact me with any questions or comments.
Best,
Andrew H. Smith
Chief Investment Strategist
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