Thought to ponder…
“But life had other ideas. A plan shifted. A framework disappeared and was replaced by something unforeseen. Man plans, God laughs, indeed. Whatever I may think about God, I believe in randomness. In the noise of the universe that chugs along caring nothing about us, our plans, our desires, our motivations, our actions. The noise that will be there regardless of what we choose or don’t choose to do. Variance. Chance. That thing we can’t control no matter how we may try. But can you really blame us for trying?“
Maria Konnikova
The Biggest Bluff: How I Learned to Pay Attention, Master Myself, and Win
The View from 30,000 feet
It was another week of the bulls getting everything they want – signals of lower inflation, a controlled slowing of the job market and a resilient consumer. Disinflation, balancing of the labor markets mixed with above trend growth: It doesn’t get any better than that for the soft-landing cheer squad. The consensus for 2024 is quickly jelling around calls for a slowdown with no recession and a ratcheting down of rates beginning in the spring. Since 1980, the average time between the last hike and the first cut has been 5.5 months, with a minimum of one month and a maximum of 15 months. If July was the last hike, spring would be squarely in the range. Supporting rate cuts, the Unemployment Rate, is now above the yearend forecast given in the most recent Summary of Economic Projections, indicating that the balance between price stability and full employment is a two-way street. Although this is a sunny picture for the soft-landing crowd, the chances of a hard landing should not be discounted because although consumers and companies have successfully termed out their debt, that begins to change in 2024. More importantly, Unemployment has a history of non-linear moves once it begins to trend higher, creating a feedback loop with consumer spending that typically takes the economy down with it. For the time being, the soft-landing story looks intact, but with volatility in the narrative and each data release having outsized importance.
CPI surprises to the downside with visibility for the continued disinflation, if energy cooperates
Retail sales keeps the resilient consumer story alive but retailer earnings reports and commentary indicating weakness
Oil sends warning sign that demand is fading
The most Frequently Asked Question from clients this week: What surprise unintended consequences come with keeping rates too high?
CPI surprises to the downside with visibility for the continued disinflation, if energy cooperates
The BLS provides a series of categories that allows us to break down inflation around specific groupings. Level 3, has 31 categories. The most recent report showed seven categories that had month over month disinflation. Three of the seven disinflationary categories related to energy, which was the clear driver.
15 of the 31 categories had inflation measuring of over +0.3% for the month, a level that would make the Fed’s target of +2.0% difficult to achieve. Together the 15 categories that had inflation of over +0.3% made up over 65% of the weighting of CPI, with the average among these being +0.7% for the month. Mathematically, it’s a struggle for inflation to move materially there is a larger volume of categories/relative weighting with a lower impulse.
The good news is that two of the major drivers of inflation since the pandemic appear to be turning over.
Shelter
Shelter represents 34.9% of CPI and, slowed from 0.6 to 0.3 in the November report.
After hitting a high of 16.1% year-over-year increase in February of 2022, the Zillow Rent Index, which is expected to lead the housing component of CPI, looks to have levered off at 3.2%, which is about 0.8% below the pre-pandemic trend.
Used Cars
The Used Cars category has fallen the last three months and is now down -7.1% year-over-year.
There are two sides to inflation: Supply and Demand.
There is a strong case that the supply-side of inflation has transitioned to a disinflationary driver, and may serve as structural impulse for disinflation. Supporting this thesis, the monthly contribution to annualized inflation from Core Goods has made a negative contribution to CPI for the last five months.
The biggest drivers of inflation – housing and supply chains – shifting to disinflationary pressures
Retail sales keeps resilience story alive but retailer earnings and commentary indicating weakness
Although Retail Sales fell -0.1%, for the first down month since March, the consensus expectation was for a larger contraction of -0.3%. In addition, the prior month was revised higher from +0.7% to +0.9%. In addition, the Control Group, which feeds into PCE, printed inline with expectations +0.2%. On balance, the report supported the narrative of a resilient consumer.
But then came the retailer reports, which included Home Depot, Target, TJX and Walmart. This is where the picture started to get less rosy. Although the companies generally had good earnings, driven by cost containment, the topline revenue numbers were weak, and guidance was cautious.
Home Depot YoY comparable sales -3.1%
Target YoY comparable sales -4.9%
TJX YoY comparable sales -6.0%
Walmart YoY comparable sales +5.4%
Comments from Doug McMillon, Walmart’s CEO, on Thursday put the markets on ice, as one of the US’s largest retailer uttered the word deflation.
“In the U.S., we may be managing through a period of deflation in the months to come. And while that would put more unit pressure on us, we welcome it, because it’s better for our customers.”
A new word is reentering the American lexicon: Deflation
Oil sends warning sign that demand is fading
Oil reached a high of 93.68 on 9/27, climbing from an interim low of 67.12 on 6/12. The dramatic rise over the summer amounted to a +39.6% increase. The effects were partially muted for the consumer because during this time average gasoline prices only rose +10%.
By mid-week last week oil prices has collapsed -28.5% from the high in September, and average gasoline prices had fallen by a disproportionately large -17.2% from their highs in September.
The asymmetry between rising prices, that were only partially passed on from oil to gasoline in the run up, and falling prices, that were amplified during the selloff, can be explained by supply and demand dynamics and refinery margins.
On September 25, Saudi Arabi announced that they would reduce crude oil production by 1m bpd, extending production cuts already in place since June.
OPEC is reacting to weak global demand and trying to balance oil prices near $90 per barrel. There are of course, probably political motivations in play as well, because higher prices would continue to destabilize the US administration.
According to the American Petroleum Institute gasoline demand in the U.S. has been trending down since June. Although seasonally demand for gasoline usually cools into the winter, 2023’s downturn began earlier than normal, with September 2023 demand measuring lower than either of the last two years.
Additional factors influencing weak demand growth may include, increased supply form US producers, weak demand dynamics due to the impacts of the UAW strike, continued weakness in demand from China.
Weak oil demand coupled with rising production pushing prices lower, S&P fall may coincide
FAQ: What surprise unintended consequences come with keeping rates too high?
When rates are too low or too high the disequilibrium creates aberrations, perverse incentives and paradoxes.
Powell begins each press conference with the following statement:
“We understand the hardship that high inflation is causing, and we remain strongly committed to bringing inflation back down to our 2 percent goal. Price stability is the responsibility of the Federal Reserve. Without price stability, the economy does not work for anyone.”
This statement sets up what I call: The Paradox of the Hawk
The paradox is created because by raising rates to a restrictive level to try and provide relief for the lower income cohorts who are most impacted by inflation, the Fed is actually punishing the same cohort with high rates on mortgages, and cars and generating inflation on goods that are capital intensive to produce, where there is no demand elasticity from lower income level households. Higher rates therefore become a regressive tax on the poor, raising the prices of essential good on those least able to pay, while those who are more able to pay and have cash reserves benefit from higher deposit rates on their idle cash.
Higher rates also discourage investment by companies to grow long-term supply to match with future expected demand growth. Although this is disinflationary in the short-term because with less investment comes less growth and few jobs, it’s inflationary in the longer-term because companies don’t invest in projects to boost production for future demand, leaving them capacity constrained as the economy inevitably grows. This is one of the reasons the inflation becomes sticky, because higher rates may lead to under investment and structural under capacity.
Higher rates having the effect of crushing low-income earners who are out of savings
Putting it all together
Bottom line – we continue to think the operative metaphor for current market conditions is picking up nickels in front a steamroller. Higher equity markets in the short-term represent the last nickels. Although it’s possible to structure a portfolio to tactically participate, we believe there is a steamroller coming that will ruin the party, the pivotal question in our mind is how large will the steamroller be?
High frequency data such as technicals and volatility have shifted in support of risk assets but deterioration in the employment market and consumer demand form a feedback loop that creates non-linearities that maybe hard to restrain.
The good news for the Fed is that with Fed Funds at 5.50 and the neutral rates probably in the range of 2.50 to 3.00. The Fed has ample room to cut rates if/when the data starts showing signs of non-linear adjustments. However, historically risk assets turn lower at the inflection point of non-linearity because the Fed is unlikely to preemptively cut rates and only does so when conditions are unequivocally bad.
This sets up two camps, those who believe in the soft-landing narrative, who see this cycle as different, and don’t think there will be the more typical non-linear outcomes related to restrictive policy on employment and spending, and those who reference historical data to form an opinion that when restrictive policy has its maximum impact, nonlinear outcomes will drive the economy to a hard landing. It’s important to consider, regardless of which camp you’re in, at this point there is no 100% sure thing either way. There are probabilities for both soft and hard-landings, it’s a function of which side you believe the probabilities tip in favor of and what that means for your portfolio construction based on your objectives and risk profile.