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Ignore the Noise

Tuesday's CPI Sparked Selloffs in US Equities and Bonds

These go to eleven

Inflation Noise In "Thinking Fast and Slow", Daniel Kahneman delineates two systems of thought. The first, aptly called "System 1" is fast twitch mental muscle; the second, called--wait for it--"System 2" is deliberate and slow. Social media, and the news media in general, are expert at manipulating our penchant for the first of these systems--indeed, their entire business model is built upon it. But it is the second that we should employ when synthesizing disparate data, as we've received this week.

We've written before that volatility is often highest during the transitions between the stages of the business cycle. Understandably, investors want to be well positioned in the event that growth reaccelerates in renewed expansion, or decelerates in continued contraction. But it takes more than a single indicator, or even a month of different indicators, to identify turning points in the economy. This is because the data we rely on are subject to measurement error, and even when they are accurate, the forces which produce them can fail to sustain.

Didn't fall as much as anticipated

So, on Tuesday, when the US Bureau of Labor Statistic's Consumer Price Index failed to fall as much on a monthly basis as forecast, that lingering fear of resurgent inflation took over the media for the day. The cause of the higher read was higher shelter inflation, as well as higher core inflation.

Housing inflation remains quite high, as it has for some time. Our returning readers are familiar with our view on housing: the US does not have enough of it, its tax subsidies for homeownership and government support for the securitizers of the debt that underpins it distort proper market function, its transaction costs are too high, emotional bias and social mores encourage its purchase over its rental, etc., but its price has been falling and is on a 9-12 month lag. Its effect on CPI makes it look like inflation is higher than it is. Against this backdrop, the increase in shelter cost in January looks like statistical noise.

In addition to the higher shelter price print, core inflation looked elevated as well, suggesting that prices had begun to accelerate upward once again. Annualizing this increase, we arrive at an uncomfortably high rate of inflation.

January data are famously noisy. Fortunately, we have other data that we can use to corroborate the reading it has provided. When we look at inflation for the last half-year, we gain perspective; price gains, when measured from six months ago, versus 1 or 12 months, shows that inflation is well below the Federal Reserve's 2% target.

So, inflation has increased slightly. We will continue to monitor its rate of change over the coming couple of months, but it is just as likely that the economy's recent reacceleration is due to the general price level's earlier vertiginous drop, and the recent increases we're seeing are its short-term consequences.

For purposes of clarity, it is not our opinion that the economy will or should revert to a 2% level of inflation. There's nothing magic about 2%. 2.5% or 3% likely meet the Fed's goal for price stability. The average annual inflation rate in the 90's was 3%, and that of the 00's was 2.5%. In the wake of the GFC, there was no inflation, but deflation rather. Those years spent at or below 2% inflation were probably too low, and the 2% target is likely stagnation-inviting. It is likely better to err to the upside. Nonetheless, the Fed is so focused on improving its legitimacy with the markets in the wake of Post-COVID 19 price increases that it won't say these things out loud. It will stick to its 2% target, and its fixation on this arbitrary level will likely result in recession--but not yet.

Manufacturing Is Looking Up, the Consumer Is Looking Healthy

Both the New York Empire State Manufacturing Index and Philadelphia Federal Reserve

Manufacturing Outlook Survey showed that Manufacturers' outlook is improving. These surveys have recently come in lower, consistent with the manufacturing recession we recently witnessed. For some Manufacturers in New York and Pennsylvania, at least, thngs are on the up and up.

Industrial Production was a touch softer. This would argue against the theory of overproduction and incipient pricing pressures.

If the economy were running hot, we'd see Capacity Utilization approaching 82%. Not only is capacity well below inflationary thresholds, it's not even trending upwards. In fact, it looks to us like the economy is cooling at a very slight pace.

The cost that manufacturers pay for inputs continues to fall, albeit more slowly than in the recent past. Pipeline inflation is likely to plateau.

The monthly change in input prices rose, but remains within normal range.

The worry, of course, is that these price increases get passed along to consumers. Indeed, firms prefer to do this rather than take a hit to their margins. However, they can only pass along these prices if consumers are in a buying mood. The resilience of the American Consumer is a marvel to behold, but it is not a limitless well of durability. The US Consumer is showing some signs of strain in certain segments, though this could be temporary. Retail sales fell in January, as is customary after the spending they do with abandon during the holiday season; nonetheless, sales were down more than forecast.

Additionally, Business Inventories increased. Firms are sitting on inventory that they can't move and will likely have to clear through the use of discounts. This should pressure Retail Sales in the months to come, too.

Naturally, this downturn in consumer spending encourages us to look elsewhere for signs of beleaguerment. When Consumers start to feel the pinch, they pull back on their use of credit. We did see a small retrenchment in consumer credit, but nothing so sharp as to suggest that a change in mood is imminent.

Savings Rates also increase when conditions begin to deteriorate, as Consumers start preparing for a rainy day. But Personal Savings are moving in the wrong direction for that to be the case. Consumers are drawing down on their savings, rather than seeking to replenish them.

Consumers haven't been too reliable over the past couple of years when asked how the economy has been doing, so we're reluctant to give their stated opinion much credence now. Still, the University of Michigan survey shows increasing levels of confidence in the state of the economy.

Taking the Temperature of Labor

Initial Claims for Unemployment Benefits were down in an encouraging sign for the Labor Market.

Although layoffs at large Technology companies of a few hundred employees here and there make big news, the fact is that Layoffs and Discharges are not indicating any change in the Labor Market.

Workers aren't quitting their jobs, either. The change in the Quits Rate has been negative of late, which could reflect that workers are afraid of leaving and not finding another job, or that they are comfortable with their accommodation.

Average Hourly Earnings are much higher and climbing relative to their average of the past decade-and-a-half, though the growth rate has certainly come down. While workers that are getting raises are more likely to stay in their jobs and to spend more, there is a question in our minds as to where this growth rate will land. Sooner or later, these wage gains have to be paid for either by higher prices or lower corporate margins. The former is bad for bonds, the latter bad for equities. Whatever the case, the Labor Share of Income in GDP--coming off historic lows of below 60% even in 2019--looks likely to maintain its current upward trajectory.

Housing and Construction

One area where we do see some weakness looking ahead is in Housing and Construction. Permits fell more than expected in January, although not by a lot. For an economy that needs more houses, and for which the price of shelter is (or should be) a national emergency, these are moving in the wrong direction.

Like Permits, Housing Starts were down. Without new stock in the pipeline to accommodate new demand, we can't expect housing transactions to increase or for prices to fall.

Pulling It All Together

So where does that leave us? We don't have a crystal ball, and we don't pretend to know where the markets will go up from here. We are best at knowing where we are. Contrary to the impression one might get from watching the financial media, nothing much at all has changed in the past week. Growth remains quite strong. Inflation still looks elevated but isn't threatening a breakout. If anything, indicators point to continued deceleration, but not outright contraction--which should be disinflationary. Coupled with China's continued economic malaise, the world may actually import its deflation.

In fact, our leading indicators are revealing more certainty, rather than less, about the state of the economy. For this reason, forecasts of uncertainty continue to come in--which is not to say that volatility will, too.

Our econometric model continues to forecast robust growth for the current quarter of 4.0%. As the markets have repriced the likelihood of the Federal Reserve cutting rates in March, and now May--as we correctly forecasted--on balance it seems that the new tightness of financial conditions will constrain growth and make interest rate cuts in June and September more likely. Still, we would be surprised were we to see more than 1% of interest rate cuts this year. We maintain our bearish position outlook on the S&P 500, and expect earnings growth to disappoint. Our equities positions are defensive in nature, and we maintain a bias toward floating rate debt where we are content to continue to clip coupons. It is our opinion that large cap US equities will continue to struggle to set new highs in pricing, and that therefore the risks are asymmetric to the downside.

Next week, we'll visit our outlook for other developed markets. We continue to see value in European equities and fixed rate debt, as well as Japanese equities. In the meantime, all the best to our clients as we begin the long weekend in America.

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