by Hubert Marleau, Market Economist, Palos Management
March 3, 2023
Good news has been bad lately for both stock and bond markets. Good news has added upward pressure on inflation expectations, forcing the Fed to react aggressively, which ricocheted into higher interest rates. Consequently, consumer confidence has trended erratically lower through the piece. The Conference Board’s monthly consumer confidence index, which reflects changes in the labour market and inflation, fell for the consecutive months in February, with the index measuring future economic conditions falling sharply. In the last two months, yield on 10-year Treasuries rose 60 bps to 3.94%, inflation expectation surged from 1.63% one year out to 3.33% and 5-year real rates increased 40 bps to 1.70%. As a result, the futures market has priced in a 33% chance of a half-point hike in the policy rate on March 22, something no one thought possible just a month ago. Several Fed officials tried to quell those worries, but investors did not respond. The S&P 500 touched 3950 last week, close to the 3900 thin red line. The levels surrounding 3900 include the internal trend line that defined the 2022 bear trend. The 50-day, 100-day, and 200-day moving averages also rest in that same area.
Yet bearish sentiment may soon end. The Skew index, a measure of the perceived tail risk of the distribution of S&P 500 returns over a 30-day horizon, has fallen steadily since mid-February. It is true that stock prices immediately suffer from higher interest rates. However, equities have innate inflation-hedging characteristics that can compensate for inflation. They resemble real assets. WisdomTree produced a series of charts, showing that S&P 500 dividend growth consistently outpaced inflation except during the Great Financial Crisis, by an average of 3.68% in the 1957-2002 period. Professor Siegal in the sixth edition of Stocks for the Long Run argued that it is much better to compare forward earnings yields (6.31%) with real bond yields - 10-year inflation-indexed bonds (1.55%). The difference comes up to 4.76%, above the 4.00% long-term average.
Tom Lee, Fundstrat’s head of research, believes that the S&P 500 is ready for a strong 8 weeks and could run up to 4250. His optimism is based on the neglected fundamentals that suggest that valuations are not demanding. First, ex-FAANG, the P/E (2024) is 14.8X and sectors like Energy and Financials are trading at 10x and 11X respectively. Second, the 4.00% yield on 10-year treasury bonds is an implied P/E multiple of 25X. Thus it would not take much to turn the table around if the Fed were to manifest support for baby steps, bond traders were to take a breather and the falling VIX were to let up.
As far as I know, there are only 5 laws in economics: the Marshal's law, which guarantees that prices are determined by supply and demand: Say’s law, which postulates that supply creates its own demand: and Keynes’ law, which states that demand creates supply when capacity is low without inflation. The other two are Smith’s laws of self-interest and of competition.
Incorporating these precepts into macroeconomic terms, a plausible thesis can then be constructed to explain why inflation has gone through the roof. On the supply side, the economy worked at full employment and industrial output was hemmed in by various constraints that limited possibilities to increase productivity. On the demand side, spending was bankrolled by excessive amounts of savings and money. This is exactly what happened: demand outstripped quantitative supply. Consequently, the y/y change in the PCE price index - a comprehensive metric of inflation, rose from a low of 1.5% in January 2021 to a high of 7.0% in June 2022.
The big question now is whether the conditions that prevailed until then, which brought inflation to unacceptable levels, will remain in play in the foreseeable future. I don’t think so. An inflection occurred between April-June of 2022. The variables, which caused brutal inflation, have changed. The January 2023 PCE price index rose 5.4% y/y, 1.6 percentage points lower than it did last June. Moreover, the Atlanta Fed’s NowCasting Model is now projecting an annual rate of increase in Q1 GDP of 2.3%, down from 2.9%. The housing market is frozen and ISM numbers show that the manufacturing sector is still contracting. I believe that the process toward lower inflation and moderate growth will continue for 4 basic reasons.
The Labour Shortage Is Easing
In March of 2021 there were 1,457,698 fewer people of age to work than in December 2019, and 4,679,000 less people willing to push the plough. The reduction in the supply of workers forced business to pay up, swelling wage rates with no apparent increase in productivity. The situation reversed in April of 2021, slowly in the beginning, but it accelerated as 2022 progressed. Since April 2021, 3,212,721 people joined the cohort of potential workers while the labour force rose 5,807,000. Wage rates slowed as the supply rose. In fact, senior executives across a host public companies gave optimistic updates on the labour market, suggesting that hiring conditions have dramatically improved. This is happening because demand for workers is slowing. ZipRecruiter and Recruit Holdings Co, two large online recruiting companies, have data that shows job postings are falling while job seekers are rising. Goldman Sachs economists, analysing private-sector data, estimate the official mismatch between the 11 million job openings and the
5.7 million unemployed people might not be that large. Indeed, there has been a noticeable decline in unfilled jobs. The employment component of the ISM index fell 1.5 points to 49.1, which makes me confident that private payroll growth softened significantly in February. As a matter of fact, preliminary numbers show that the Wage Phillips Curve, the relationship between labour compensation and unemployment is normalising and returning to pre-pandemic observations.
Productivity Is Rising
During the 2 years ended Q2/2022, productivity decreased on average 0.9% per quarter while wage rates were rising, resulting in significantly higher labour input cost. Unit Labour Cost gushed upward to an average rate of 8.7%. Productivity took a turn for the better last June, accelerating to an estimated 1.8%% per quarter, and reducing the change in unit labour cost for the comparable period to an average rate of 1.9%. Labour shortage and input cost that characterise the 2020 and 2021 forced corporations to spend a lot of money on digitalisation methods and robotics to enhance efficiencies. Anecdotal reports abound that huge sectors like professional services, construction and restaurants, which have shun technology, are starting to embrace it. Bank of America noted in a recent study that the adoption rate of new technology like ChatGPT is unprecedented, putting the economy on the verge of another iphone moment and predicting that its economic impact would be $15.7 trillion by 2030. Daily visits to ChatGPT is 40.0 million, same as Microsoft Bing’s web traffic.
Excess Savings are Diminishing
The stock of excess personal savings peaked in the early Fall of 2021 at $2.0 trillion, a lot of that excess has been absorbed into higher levels of nominal GDP. This excess felt 65% to $700 billion in January and will soon be totally exhausted. As a matter of fact, if it had not been for the huge one time $1.1 trillion increase in social security payments, the American people would not have saved any of their disposable income in January. Abstracting from the negative effect of severe winter storms in late December and the positive one of unusual warm weather in January, the trend in ISM services has been broadly flat since the summer and has eased, but is still elevated.
Recent reports are indicating that confidence sentiment has reached a level where consumers usually start to retrench their spending habits to replenish their precautionary reserves. Department stores like Macy’s, Nordstrom and Kohl’s plus big box-retailers like Best Buy, Walmart and Costco are all telling the same story: consumers have turned frugal on discretionary spending. Nordstrom is exiting Canada.
The Money Supply Is Declining
The U.S. money supply just experienced its largest y/y decline on record in January - minus 1.1% - due the Fed’s most aggressive monetary policy campaign in decades. Normally, the money supply runs at the annual rate of 8.0%, suggesting that it ought to be around $19.6 trillion. That is still $1.6 trillion or 8.1% too high. Given that we still have quantitative tightening, an inverted curve, prospective increases in the policy rate, a government that is running out of cash balances and rising bank lending standards, another yearly decrease in the money supply is a likely outcome. Incidentally, the world money supply valued in US dollars is also down 1.1% from a year ago.
The Conclusion
I’m not of the opinion that PCE inflation will end the year at the 2.0% target. However, I do believe that the aforementioned forces are in place to progressively bring inflation to a desirable pace by the end of 2023. Protectionism, de-globalisation, and demographics may force the central banks to accept a new inflation target to prevent recessionary conditions. A 3% inflation target would be a welcome event. In this regard, a Fed funds rate of 5.00% would be adequate, but it would have to stay at that level well into 2024.
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