Inflation worries are all the rage
And because it's consensus, it may not be that big a worry.
And perhaps that’s appropriate… Over the past six months, the TIPS 10-year breakeven inflation rate jumped 60 basis points to its highest level since 2014, well above the Fed’s 2% target and just 30 basis points shy of its 10-year high! Housing prices are rising so fast that affordability’s at a 2-year low even with mortgage rates at record lows (more below). Transportation and food & beverage, which together account for almost a third of the CPI gauge, are trending higher. Oil prices are up, the commodity complex appears on the verge of a new super cycle and stimulus continues to flood in. Democrats appear set to go it alone on their $1.9 trillion Covid relief bill, likely to be quickly followed by an infrastructure/stimulus package topping $2 trillion (with up to $500 billion in tax-hike offsets). That’s $3.5 trillion or so on top of a 12-month budget deficit already at a record of nearly $3.5 trillion at the end of January. A spending spree the likes of which this country has never seen in peacetime. As checks and balances break down, unified governments historically spawn higher inflation and bond yields. Possibly the most asked question from investors is at what level does the 10-year Treasury yield stymie this equity rally (more below)? And how much will the Fed act to rein in longer rates? Much like quantitative easing during the global financial crisis dislocated financial markets throughout the last cycle, the Fed’s use of average inflation targeting (allowing inflation to run “hot,’’ i.e., above its 2% target to bring the average over time to 2%) could well do the same for this cycle. This seems to be the consensus.
For all the talk of a bubble, financial conditions are still easing, and market exuberance doesn’t seem to be sounding a danger signal. While some single-stock call/put ratios are at extremes, Credit Suisse notes retail flows are quite muted compared with money market inflows, index call/put ratios are normal, the bull/bear ratio is only just above average and overall tactical indicators are not sending sell signals. There also appears to be limited systemic risk. Fed Chair Powell has highlighted that fiscal, not monetary, policy was driving asset prices. Credit spreads are little changed. Indeed, high-yield bond yields and mortgages rates are making new lows. With 91% of S&P 500 stocks and 92% of Russell 2000 issues still above their 200-day moving averages, the ongoing advance remains remarkably broad. Strategas Research is struck that, for what certainly has the feel of a speculative moment, S&P positioning remains net short. Hardly euphoric. Remarkably, when Powell this week cited maximum employment as “our national goal” that requires the “collective efforts” of all parts of government and the private sector, the 10-year yield fell. In decades past, such language almost certainly would have spawned a bond sell-off and steeper yield curve. But the Phillips curve (the inverse relationship between prices and employment, with lower unemployment prompting higher wages) is viewed as broken. Persistent inflation requires wage pressures. So, what might have once sounded alarms was received by the market with a sigh.
Wages have been rising. Persistent inflation requires wage pressures. At the start of the pandemic, this was because many low-wage workers lost their jobs while most high-wage workers continued working from home. Now, it’s due to a shortage of workers—job openings are rising but fewer people seem willing to take them. This could be due to a job-skills mismatch, the possibility that jobless benefits are better than what’s available or simply to the need for at least one parent to stay at home given child-care shutdowns and closed schools. Women’s participation in the labor force is dramatically down. Renaissance Macro believes that as the pandemic fades, the impact on prices may be a wash, with upward pressures from increased demand offset by normalizing supply chains that should push prices down. The bigger unknown may be whether the four-decade secular downshift in inflation brought on by rising globalization re-emerges or diminishes amid trade tensions and the push for reshoring in the U.S. The Biden administration’s “Build Back Better” initiative centers around much of the work occurring in our country. The massive fiscal and monetary response to the crisis has energized the reflation trade, causing inflation expectations to climb (although, persistent inflation requires wage pressures), the yield curve to steepen, bank/other cyclical sectors and emerging-market (EM) equities and bonds to outperform, commodity prices to soar and EM currencies to rally. If noted market contrarian Humphrey Neill can be taken at his word (“being contrary to facts invites disaster”), Renaissance Macro says this feels like a market presuming inflation is nigh. The bad news is a likely spending spree could lead to problematic inflation. The good news this is already consensus.
- More signs of a V In the U.S., Evercore ISI’s proprietary homebuilding gauge surged to a record high by a wide margin, while worldwide, the OECD’s global leading indicator gauge moved above its pre-pandemic high.
- Inflation still a worry, not a fact Core consumer prices rose 1.4% year-over-year in January, below expectations and well short of Fed targets. A 2021 inflation scare is consensus.
- Consumers itching to spend, eventually … The median prediction for household spending growth a year from now jumped to its highest level since June 2015 in the New York Fed’s survey of consumer expectations.
- … nearer-term caution still an anchor Initial February consumer sentiment unexpectedly fell in the University of Michigan survey, while Bloomberg’s weekly survey of consumer comfort rose slightly but remained far below its pre-pandemic high.
- Small businesses do the majority of hiring The NFIB Small Business Optimism Index fell to an 8-month low last month, with the percentage of firms expecting the economy to improve at its lowest level since 2013.
- Higher home prices weigh on potential buyers The NAHB/Wells Fargo measure of housing affordability remained at its lowest level in two years in 2020’s fourth quarter and below its historical average of 61.8%, which would imply 61.8% of homes sold were affordable to median-income-earning families.
Is 2.50% the breaking point? That was the probability weighted average response Strategas Research received when it asked clients at what level does the 10-year yield start to pressure stocks. It notes that level could take a while to hit as over the 10 years prior to Covid, the average 10-year yield was 2.39%.
Green China Over the past decade, China expenditures to address climate change more than doubled the $600 billion spent by the U.S. Last year alone, 77% of global lithium battery installed capacity occurred in China, versus 10% in the U.S. and an even smaller 4% in Europe.
Trade war a draw? The U.S. deficit with China shrank last year to its smallest annual gap since 2011 but the overall trade deficit widened to the most since 2012, with manufacturing jobs little changed from the start of the trade war that former President Trump launched in 2018.