Inflation Archives - Page 8 of 9

Shrinkflation and Skimpflation Are Eating Our Lunch

Posted on July 20, 2023July 20, 2023 by phoffman@channelchek.com

Why Economic Data Doesn’t Reconcile With Personal Experience

Does grocery shopping and eating out cost the same as it did in 2019? Government statistics on personal consumption and expenditures would seem to indicate they do. Most of us know that we are paying noticeably more to eat than we did a few years ago. Below is an article explaining the flaws in government data and the nuances that hide actual experience from this set of numbers. It is written by Dr. Jonathan Newman, he is a Fellow at the Mises Institute, his research focuses on inflation and business cycles, and the history of economic thought. – Paul Hoffman, Managing Editor, Channelchek.

Economist Jeremy Horpedahl dismissed the silly claim by anticapitalists that capitalism must engineer food scarcity for the sake of profits. He presented a graph of Bureau of Labor Statistics (BLS) data demonstrating a substantial decrease in household food expenditure as a percentage of income—from 44 percent in 1901 to a mere 9 percent in 2021. This is something to celebrate and certainly can be attributed to the abundance of market economies.

But when Jordan Peterson asked, “And what’s happened the last two years?” I went digging. First, I confirmed Horpedahl’s observation: the amount we spend on food as a proportion of our budget has fallen dramatically. Second, I saw what Peterson hinted at: a significant spike in food spending when covid and the associated mess of government interventions hit (figure 1).

Figure 1: Food and personal consumption expenditures, 1959–2023

Source: US Bureau of Economic Analysis, FRED.

Interestingly, the spike looks like a blip. Someone oblivious to the events of the past few years might see this chart and say, “Yeah, something strange happened in 2020, but it looks like everything is back to normal.” I’m certain that this doesn’t align with anyone’s experience, however. Even today, no one would say that restaurant visits and grocery store trips cost the same as they did in 2019.

What changed in 2020? Why does this graph not feel right? Assuming the Bureau of Economic Analysis data isn’t totally off (and it is important to be skeptical of government data), why would a January 2023 report on consumer inflation sentiment conclude that “there is a disconnect between the inflation data reported by the government and what consumers say they now pay for necessities”?

The difference lies in the qualitative aspects of our experience as consumers. Spending proportions may have returned to their trend, but that isn’t the whole story. “Shrinkflation” and “skimpflation” have taken their toll on the quantity and quality of the food we enjoy—or maybe the food we tolerate is more apt.

Businesses know that charging higher prices is unpopular, especially when many consumers are convinced that greed is driving price inflation. So businesses resort to reducing the amount of food in the package, diluting the product but keeping the same amount, or otherwise cutting corners in ways that consumers may not immediately notice.

Thankfully, websites such as mouseprint.org document some of these cases:

Sara Lee blueberry bagels reduced from 1 lb., 4.0 oz. per bag to 1 lb., 0.7 oz.

Bounty “double rolls” reduced from 98 sheets to 90 (how is it still a “double roll”?)

Gain laundry detergent containers reduced from 92 fl. oz. to 88 fl. oz. without any obvious difference in the size of the container

Dawn dish soap bottles reduced from 19.4 fl. oz. to 18.0 fl. oz.

Green Giant frozen broccoli and cheese sauce packages reduced from 10.0 oz. to 8.0 oz. with no change in the advertised number of servings per package

In some instances of skimpflation, the volume or weight of a product remains the same, but the proportions change. For example, Hungry-Man Double Chicken Bowls (a frozen dinner of fried chicken and macaroni and cheese) maintained a net weight of 15.0 oz., but the protein content dropped from 39 grams to 33 grams.

And while firms are reducing the quantity and quality of the food they sell, consumers are also choosing to purchase less food and even lower-quality food. The January 2023 report on consumer inflation sentiment shows that 69.4 percent of respondents “reduced quantity, quality or both in their grocery purchases due to price increases over the last 12 months.”

We have also seen a widespread and long-lasting change in customer service at restaurants. Many restaurants switched to providing only takeout for months or years. Even though the dine-in option has been reintroduced at some restaurants, the service hasn’t quite been the same, with QR-code menus, shorter hours, less staff, and terse demeanors.

It’s not surprising that the massive government interventions, including creating trillions of new dollars, would have countless effects—some that show up in various statistics but many that do not. For example, if we look back at the period of German hyperinflation, we see surprisingly boring data on food spending proportions (figure 2).

Figure 2: Household expenditures in Germany, 1920–22

Source: Data from Carl-Ludwig Holtfrerich, *The German Inflation, 1914–1923: Causes and Effects in International Perspective*, trans. Theo Balderston (New York: Walter de Gruyter, 1986), cited in Gerald D. Feldman, *The Great Disorder: Politics, Economics, and Society in the German Inflation 1914–1924* (New York: Oxford University Press, 1997), p. 549.

Historian Gerald D. Feldman commented on the German household expenditure data in a way that sounds familiar: “As one study after another pointed out, however, the full impact of these changes had to be understood in qualitative terms.” There was “reduced quality and quantity of the food consumed” and “poorer quality clothing,” among other qualitative changes.

Government statistics are unable to capture these subtleties. This should be obvious—your personal experience as a consumer is more than just the price you pay for a certain weight of food. We aren’t merely machines; we don’t describe our lives in miles per gallon or kilowatt hours.

This is why Ludwig von Mises attacked the conceited aggregates and indexes purported to measure various aspects of consumers’ lives: “The pretentious solemnity which statisticians and statistical bureaus display in computing indexes of purchasing power and cost of living is out of place. These index numbers are at best rather crude and inaccurate illustrations of changes which have occurred.”

He concludes: “A judicious housewife knows much more about price changes as far as they affect her own household than the statistical averages can tell.”

Original Source

https://mises.org/wire/shrinkflation-and-skimpflation-are-eating-our-lunch

Is this the Soft Landing They Told Us Could Not Happen?

Posted on July 12, 2023July 12, 2023 by phoffman@channelchek.com

Weighing in on Powell’s Chances of a Hard Landing

Is the U.S. economy headed toward a soft landing? While rare, the numbers are beginning to argue in favor on the side of a soft landing versus a hard one. An economic soft landing is a situation in which the Federal Reserve is able to slow economic growth without causing a recession. A hard landing, on the other hand, is a situation in which the central bank’s efforts to slow down economic growth lead to a recession. Recent inflation reports, employment numbers, and economic growth figures are looking more and more like monetary policy over the past year and a half, may be defying past performance; the U.S. might be able to avoid a situation where the economy shrinks (negative growth).

Background

The Federal Reserve has been facing a difficult challenge for almost two years as inflation spiked well above the Fed’s 2% target. In fact increases in prices were at a 40-year high as inflation began to soar toward double-digits. Fed monetary policy, which effectively controls the money in the economy, that in turn impacts interest rates, has been acting to raise rates to bring inflation under control. Less money increases the cost of that money (rates), which dampens economic activity.

There has been, and continues to be, a risk that the Fed raises interest rates too high or too quickly, this is the hard landing economic path. The hard landing scenario is more common than soft landings.

The Federal Reserve has a miserable record of achieving soft landings. There have been a few occasions when the Fed has been able to slow down economic growth without causing a recession. One example of success is 1994-1995. During this period the Fed raised interest rates by 2.5% from a starting point of 4.25% in order to bring inflation under control. However, the economy continued to grow during this period, and there was no recession.

Today’s Scenario

The current state of the U.S. economy is uncertain. Inflation is at a 40-year high, and the Fed has been raising interest rates in an effort to bring it under control. However, there is a risk that the Fed will raise interest rates too high or too quickly, which could lead to an economic hard landing, with job losses and negative growth. In fact, after an FOMC meeting in November, Fed Chair Powell said it would be easier to revive the economy if they overtighten, than it would be to lower it if they don’t tighten enough. So to the Fed Chair, a hard landing is better than no landing at all.

There has been a high level of concern amongst stakeholders in the U.S. economy. One reason is that the U.S. economy is already slow. GDP growth in the first quarter of 2023 was 2.0%, and it is expected to slow in the second quarter. Maintaining growth while pulling money from the system to reduce stimulus is a difficult maneuver. In fact, it usually ends as a hard, undesirable economic landing.

Another factor that is of concern this time around is the state of the housing market. Home prices rallied with low interest rates during and post pandemic. A fall-off in housing would have a ripple effect throughout the economy, leading to job losses and lower consumer spending. So far, housing has held up as new home sales are strong, and demand for existing homes remains elevated as homeowners with low mortgage rates are deciding to stay put.

Where from Here?

On Monday (July 11), Loretta J. Mester, president and CEO of the Federal Reserve Bank of Cleveland, warned during an address in San Diego that the central bank may need to keep hiking rates as inflation has remained “stubbornly high.” Fed governors go into a blackout period on July 15 as they always do before an FOMC meeting. That meeting will be held on July 25-26. So there is no telling if the voting FOMC members are going to dial back their hawkishness in light of this week’s more favorable CPI report that shows yoy inflation at 3%.

The Fed’s favored inflation gauge is PCE. The next PCE report is not to be released until July 28, after the July FOMC meeting. The previous report showed that in May, inflation was running at 3.8% over 12 months.

The banking system, which showed some cracks back in March, seems to be shored up; although some problems still exist, a full-scale banking crisis does not seem likely. The Fed would obviously like to keep it this way.

Employment gains were the smallest in 2-1/2 years in June, however the unemployment rate is close to historically low levels and wage growth is still strong, so although wages are not fully working their way into the final cost of goods or services, the industries having to pay the higher wages are likely absorbing some of the cost, which could pull from profits.

Part of the Fed’s tightening has been the less talked about quantitative tightening. This reduces the Fed’s balance sheet which swelled as part of the reaction to the pandemic. Reducing this in a meaningful way will take time, but even if the Fed remains paused on rate hikes, there is still $90 billion scheduled to be pulled from the economy each month as maturities will be allowed to mature from the Fed’s holdings without being rolled. This my eventually cause U.S. Treasury rates and mortgage rates to tick up as increased Treasury borrowing, and decreased Fed ownership may put downward pressure on prices.

Take Away

The recent CPI report is causing some that argued a soft landing is achievable to celebrate and those that thought it impossible to consider it a possibility. The chances appear greater, and a soft landing is certainly a desirable outcome for stock prices and U.S. economy stakeholders. From here, there are a number of factors that can increase the risk of a hard landing, they include the pace of additional interest rate hikes, and the behavior of the housing markets. We’re entering a period where we will not hear any commentary from Fed governors, and the next major inflation indicator comes after the FOMC meeting, so markets will be on the edge of their seats until July 26 at 2 PM Eastern.

Paul Hoffman

Channelchek, Managing Editor

Sources

https://www.macrotrends.net/2015/fed-funds-rate-historical-chart

https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20220126.pdf

https://www.bea.gov/data/gdp/gross-domestic-product#:~:text=Real%20gross%20domestic%20product%20(GDP,real%20GDP%20increased%202.6%20percent.

https://www.pionline.com/economy/cooling-inflation-gives-investors-momentary-breather-asset-managers-say

https://www.bea.gov/data/personal-consumption-expenditures-price-index#:~:text=The%20PCE%20price%20index%2C%20released,included%20in%20the%20GDP%20release.

Can You Prepare for Hyperinflation?

Posted on May 8, 2023May 8, 2023 by phoffman@channelchek.com

Hyperinflation, Can Investors Protect Themselves?

Inflation in Argentina so far in 2023 is running at 126.4%. Meanwhile, its GDP has declined by 3.1%. This certainly meets the definition of hyperinflation. Can this situation occur in the U.S. economy? Hyperinflation is when prices of goods and services in the economy run up rapidly; at the same time, it causes the value of the nation’s currency to fall rapidly. It’s a devastating phenomenon that has serious consequences for businesses, investors, and households. Below we explore the causes of hyperinflation, its effects on the economy, and some ways to protect investable assets against it.

Causes of Hyperinflation

Hyperinflation can be caused by a variety of factors, but one ingredient that is most common is excessive money printing by the country’s central bank. When a central bank allows excessive cash in circulation, especially if it is during a period of low or negative growth, natural economic forces that occur when there is an abundance of currency chasing the same or fewer goods, serves to drive up prices and down currency values. This inflation can quickly spiral out of control, leading to hyperinflation. Other causes could include shortages of goods or services driving prices up as demand outstrips available supply.

Effects on the Economy

Excessive inflation is not good for anyone that holds the impacted currency. Businesses can command higher prices, but they will also be paying higher prices to run their business and receiving payment with notes with far less purchasing power. This is because hyperinflation increases costs for labor and raw materials, weighing down profit margins. Less obvious, but certainly adding to the hardship, is that businesses may have trouble securing financing and loans during hyperinflation; this can limit their ability to function or grow.

For households and individuals, hyperinflation also rapidly decreases purchasing power, as prices for goods and services jump up. This lowers living standards in the country as people are forced to pay more for the same goods and services. Additionally, hyperinflation can lead to a loss of confidence in the currency. Behavior including the belief that items should be purchased now because they will be more expensive tomorrow leads to hoarding and other actions that create shortages and drives up prices even further.

How Some Prepare for Hyperinflation

Hyperinflation is rare, yet, once the wheels start turning, such as they did in Venezuela in 2016, or Germany in 1923, it is important for businesses and individuals to take steps to prepare for the possibility. Here are ways that people have prepared for excessive inflation in their native currency.

Diversify Your Investments: While some believe it is always prudent to stay widely diversified, it may offer even more protection when the economy goes through the turmoil of excessive inflation. Preparing in this way means spreading your investments across a variety of asset classes, such as stocks, bonds, real estate, and commodities. This will help by avoiding any one particular asset class that gets hit hard. Keep in mind, stocks are often a good hedge against moderate inflation, and precious metals have historically been looked to for protection in times of extreme inflation. Earnings of companies that export are not expected to suffer as much as importers.

Hold Some Assets Denominated in Other Currencies: This can include established digital currencies, foreign stocks, bonds, that are not denominated in your own home currency. By holding assets denominated in other currencies, you can protect yourself from its devaluation versus others.

Invest in Hard Assets: Hard assets, such as gold and silver, land, and even tools can be a good way to protect yourself or your business from hyperinflation. These assets have intrinsic value and can retain their value even if the currency they are denominated in loses value. Remember that if inflation remains, it is likely to cost more in the coming months for the same piece of office equipment that helps your business run more efficiently.

Cryptocurrencies: Keeping within the guidelines of diversification, more established tokens such as bitcoin and ether are considered by some to help protect from hyperinflation. A word of caution, cryptocurrencies have little history against currency devaluation and inflation. The theory however is these digital currencies are decentralized and not subject to the same inflationary pressures as fiat currencies.

Take Away

In 2018 inflation in Venezuela exceeded 1,000,000%, proving, when the recipe for higher prices is in place, the unimaginable can happen.

While there is no consumer or investor that can proactively impact a rising price freight train, if hyperinflation is expected, there are steps one can take to reduce the negative impacts. These financial steps can be as simple as buying things today that you expect to need later, and more substantially diversifying your portfolio toward hard assets, companies that export to countries not experiencing inflation, and even bonds with either short maturities or an inflation factor as part of the return.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.nasdaq.com/articles/argentina-inflation-seen-at-126.4-in-2023-central-bank-poll-shows

https://www.pbs.org/wgbh/commandingheights/shared/minitext/ess_germanhyperinflation.html#:~:text=In%201923%2C%20at%20the%20most,surprise%20by%20the%20financial%20tornado.

https://www.theatlantic.com/business/archive/2012/03/the-hyperinflation-hype-why-the-us-can-never-be-weimar/254715/

Will the Fed Now Exercise Caution?

Posted on March 14, 2023March 14, 2023 by phoffman@channelchek.com

FOMC Now Contending With Banks and Sticky Inflation

The Federal Reserve is facing a rather sticky problem. Despite its best efforts over the past year, inflation is stubbornly refusing to head south with any urgency to a target of 2%.

Rather, the inflation report released on March 14, 2023, shows consumer prices rose 0.4% in February, meaning the year-over-year increase is now at 6% – which is only a little lower than in January.

So, what do you do if you are a member of the rate-setting Federal Open Market Committee meeting March 21-22 to set the U.S. economy’s interest rates?

The inclination based on the Consumer Price Index data alone may be to go for broke and aggressively raise rates in a bid to tame the inflationary beast. But while the inflation report may be the last major data release before the rate-setting meeting, it is far from being the only information that central bankers will be chewing over.

Don’t let yourself be misled. Understand issues with help from experts

And economic news from elsewhere – along with jitters from a market already rather spooked by two recent bank failures – may steady the Fed’s hand. In short, monetary policymakers may opt to go with what the market has already seemingly factored in: an increase of 0.25-0.5 percentage point.

Here’s why.

While it is true that inflation is proving remarkably stubborn – and a robust March job report may have put further pressure on the Fed – digging into the latest CPI data shows some signs that inflation is beginning to wane.

Energy prices fell 0.6% in February, after increasing 0.2% the month before. This is a good indication that fuel prices are not out of control despite the twin pressures of extreme weather in the U.S. and the ongoing war in Ukraine. Food prices in February continued to climb, by 0.4% – but here, again, there were glimmers of good news in that meat, fish and egg prices had softened.

Although the latest consumer price report isn’t entirely what the Fed would have wanted to read – it does underline just how difficult the battle against inflation is – there doesn’t appear to be enough in it to warrant an aggressive hike in rates. Certainly it might be seen as risky to move to a benchmark higher than what the market has already factored in. So, I think a quarter point increase is the most likely scenario when Fed rate-setters meet later this month – but certainly no more than a half point hike at most.

This is especially true given that there are signs that the U.S. economy is softening. The latest Bureau of Labor Statistics’ Job Openings and Labor Turnover survey indicates that fewer businesses are looking as aggressively for labor as they once were. In addition, there have been some major rounds of layoffs in the tech sector. Housing has also slowed amid rising mortgage rates and falling prices. And then there was the collapse of Silicon Valley Bank and Signature Bank – caused in part by the Fed’s repeated hikes in its base rate.

This all points to “caution” being the watchword when it comes to the next interest rate decision. The market has priced in a moderate increase in the Fed’s benchmark rate; anything too aggressive has the potential to come as a shock and send stock markets tumbling.

This article was republished with permission from The Conversation, a news site dedicated to sharing ideas from academic experts. It represents the research-based findings and thoughts of Christopher Decker, Professor of Economics, University of Nebraska Omaha.

The PCE Inflation Index and Sector Outperformers

Posted on February 24, 2023February 24, 2023 by phoffman@channelchek.com

What Sectors Outperformed the Market after the PCE Inflation Shock?

When an investor inquires, “What stocks do well with high inflation?” they are often asking, “What sectors do well with rising interest rates?,” because inflation expectations often drive rate moves. The text book response usually given are: consumer staples, banks and financials, and commodities. The PCE indexes are considered the Fed’s preferred indicator of inflation trends. The PCE surprised markets on the high side when released on February 24^th. What can investors now expect from higher-than-forecast inflation?

Rather than look at old information on what outperforms the overall market when inflation expectations rise, I thought it would be informative and more useful to see what is outperforming under current 2023 conditions and climate. The chart below and the remainder of this simple study is a snapshot three hours after the news settled in among investors (11:30am ET, February 24^th).

Personal Income and Outlays

Source: U.S. Bureau of Economic Analysis

Sectors Outperforming Overall Market

There were five S&P sectors that outperformed the S&P 500 a few hours after the inflation number showed an almost across-the-board acceleration in price increases. At this point, the S&P 500 had already fallen 1.31%.

Beating the S&P larger index, but the worst of the five outperformers was Health Care (XLV). The Health sector is considered to be a necessity that consumers find a means to pay for regardless of cost. Within the sector there are companies providing goods and services that are more embraced by investors than others. Within the XLV, many stocks were green after the report.

Outperforming the Health Care sector were stocks making up the Industrial Sector (XLI). This includes large industrial manufacturers like John Deere, General Electric, and Caterpillar. Many of these companies have contracts well out into the future that assures business. What is not ordinarily assured is the cost of manufacturing which can go up with inflation. A number of the top holdings in XLI barely budged on the morning – GE was up .08%, Honeywell was down .18%, and UPS was down just .20%.

Almost even with the Industrial Sector was Consumer Staples (XLP). As with Health Care and to a lesser degree Industrials this sector is where money moves to during inflationary periods. Consumers may be postpone a new car purchase, but they’ll keep their buying habits unchanged for products produced by Colgate, Coca-Cola, Proctor and Gamble, or cigarette manufacturers.

Performing second best after the inflation numbers was the Utility sector (XLU). Again this follows the mindset that consumers can only cutback on water, electricity, and natural gas so much. It is more likely that cutbacks would come in other areas like entertainment, or technology. Technology was the worst performing sector.

The top performer, although still modestly negative, was the Financial sector. This includes insurance, banks and credit card companies, as well as investment firms. Banks, particularly those with a higher percentage of traditional banking business, benefit from a steepening yield curve. Banks use cash as their product line. They borrow short from customers, and lend longer term. As the yield curve steepens, their net income can be expected to rise. This may explain why two of the top three holdings were positive after the report, JP Morgan (JPM), and Wells Fargo (WFC). Brokerage firms also may benefit as accounts uninvested balances can be a source of revenue as financial firms earn interest on them. Rising rates means every balance they can earn on creates additional income.

Larger Index Observations

As indicated earlier, technology was the worst-performing sector. This causes the tech heavy Nasdaq to far underperform the other major indexes. The best performing a few hour after the open was the Dow Industrials, which is comprised of just 30 industrial stocks, many paying consistent dividends. The second best performer, beating both the Dow and S&P 500 was the Russell 2000 Small-Cap index. Small-cap stocks tend to be less affected when borrowing costs change, and tend to have more of their end customers located domestically. The U.S.-based customers is an advantage to smaller stocks when rising rates cause rising dollar values. A rising dollar makes goods or services from the U.S. more expensive overseas.

Take Away

The textbook reply to questions related to rising rates, inflation, and sector rotation in stocks held up after the surprise PCE index increase. Banks, and necessities like heat and consumer goods outperformed. Also small-cap stocks did not disappoint, they also held up better than the overall large cap universe.

One difficulty small and even microcap investors face is that information is less available on many of these companies. And there are a lot of them, including in the sectors that outperform with inflation. One easy way to find which smaller companies are rising to the top is Channelchek’s Market Movers tab. This can be viewed throughout the trading day by clicking here for the link.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.bea.gov/news/2023/personal-income-and-outlays-january-2023

https://money.usnews.com/investing/news/articles/2023-02-24/u-s-inflation-accelerates-in-january-consumer-spending-surges

The Record Levels of Cash Held by Investors May Not Indicate a Bear Market

Posted on February 14, 2023February 14, 2023 by phoffman@channelchek.com

Image Credit: Pictures of Money (Flickr)

Investors Receiving a 5% Yield are Losing to Inflation

The CPI inflation report and the Fed’s relentless increases in Fed funds levels have pushed the six-month US Treasury Bill (T-Bill) above 5%. This is the first time since 2007 that this low-risk investment has topped 5%. Last year on this date, the six-month T-Bill was 0.76%. While the stock market is concerned that higher borrowing costs will have the Fed’s intended effect of slowing demand, rates are reaching a point where another concern creeps in. The concern is will traditional stock investors lay back and be satisfied getting paid interest.

More likely, the high cash position represents “dry powder” waiting for an opportunity.

Short Term Rates

Money Market fund assets were $4.81 trillion for the week ended Wednesday, February 8, according to the Investment Company Institute. Just shy of the record MF balances reported in January. Higher than average cash levels have often been thought of as a bullish sign as it represents potential to drive stock prices up when flows toward equities increase.

This may be part of the situation as we come off a dismal 2022 for equities, but there is likely something else incentivizing the retreat to safety. The higher interest rates are in the short end of the curve, investors are getting paid to retreat. High-yielding cash equivalents with six-month T-Bills now at 5% (10-year Treasuries are only 3.75%) may be more than a parking place. It may represent an alternative investment with a much more assured return.

Ten Year Quarterly Returns S&P 500

Is 5% an Acceptable Return?

With inflation at 6.4%, the answer is no. But it is definitely preferable to seven of the periods on the 10-year chart above. And with January’s consumer price index (CPI) report revealing signs of sticky to reaccelerating inflation, the Federal Reserve is more likely to be hiking rates for longer than expected.

For investors looking to invest for longer periods, the stock market handily beats inflation. In other words, for the various time frames below, S&P 500 investors did not see their assets erode due to inflation.

Beating inflation is foundational to investing. Far exceeding it is the goal of many. Investors are not doing this choosing cash, in fact they are choosing to lose buying power rather than risk that the market doesn’t perform as it has historically.

S&P 500 Return for Periods 5-Years to 30-Years

Take Away

Data released on Tuesday February 14 showed the inflation rate (CPI) slowed to 6.4% in January. The cost of goods and services rose 0.5% during the month. The half percentage is the largest one month erosion of purchasing power in three months.

Investors content with 4%-5% returns should consider that they are losing ground to persistent inflation.

Investors with a five-year time horizon or longer should weigh the risks of earning yields below the inflation rate to the ups and downs of stocks. In fact, as more do, the 4-5 trillion in cash can make or quite a bull market.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value=2022

https://www.bls.gov/news.release/archives/cpi_01162008.pdf

https://www.cnbc.com/2023/01/18/investors-are-holding-near-record-levels-of-cash-and-may-be-poised-to-snap-up-stocks.html

https://www.ici.org/research/stats/mmf

https://www.nerdwallet.com/article/investing/average-stock-market-return#:~:text=The%20average%20stock%20market%20return%20is%20about%2010%25%20per%20year,other%20years%20it%20returns%20less.

Wage Inflation, Labor Shortages, and Who Stopped Working

Posted on February 9, 2023February 9, 2023 by phoffman@channelchek.com

Is the Mismatch in Workers and Open Jobs Proving to Be Transitory?

Inflation has been the most bearish word for the stock and bond markets over the past year or more. Shortly after many of the supply chain issues cleared up, and the cargo ships were no longer stacked up outside of major ports, attracting scarce workers with higher pay became a growing cause of inflationary pressure. At the end of November 2022, Federal Reserve Chair Jerome Powell stated that “job openings exceed available workers by about 4 million.” That number has now grown to 4.7 million after the continued strengthening of the market for qualified labor.

This mismatch, depicted in the Fed Data below, between available positions and workers to fill them, developed a more inflationary trend. The graph depicts the mismatch of labor supply and demand and the extent that it has worsened.

When the civilian labor force is greater than employment plus job openings, the economy has an immediate capacity to fill open positions. Currently, the employment level plus job openings are at 170.5 million, while the total labor force is at 165.8 million. Thus the 4.7 million quoted earlier. There are a whopping 4.7 million more jobs available compared to people available to fill them.

The civilian labor force, the amount of people working or looking for a job, is shown below in red; the current employment level plus the number of job openings is shown in blue.

Labor Participation Hesitancy

The pandemic has been emphasized as a cause of this not-very-transitory labor shortage, but the trends in labor demand and labor supply in the graph above indicate that demand was already outpacing supply as the US entered 2018. This was two years before the novel coronavirus hit US shores. Back then the mismatch was about one million workers fewer than jobs available before the economic disruption.

As the US began to move toward business-as-usual, news and market analysts offered many explanations for the labor shortage. These included childcare problems, health concerns, minimum wage pushback, and even a wave of new retirees.

The visual below shows the change experienced in the labor force participation rate (LFPR) for specific age groups: 20 to 24 years old, 25 to 54 years old, and 55+ years old. By subtracting the most recent LFPR from that of January 2020 we get the percentage-point change in labor force participation relative to the month just before the pandemic began impacting businesses.

When the pandemic hit, the sharpest decline in the LFPR was for workers between the ages of 20 and 24. Their LFPR decreased from 73% to 64.4% in 4 months before increasing again. However, at the end of 2022, the LFPR for 20- to 24-year-olds still hadn’t fully recovered and remained 1.7 percentage points below its January 2020 value.

This overall pattern is similar but less extreme for the other age groups. Although no age group fully recovered by the end of 2022, the 25-54 group was closest, at 0.7 percentage points below its January 2002 level. There’s been speculation older workers retired early (and permanently) during the pandemic, and the 55+ group remained 1.4 percentage points below its January 2020 level as of December 2022, with no sign of further recovery.

Take Away

The mechanisms that cause inflation are widely understood. If there is a shortage of goods because of the supply chain, sellers can ask more for the product. If the cost of producing goods or providing services increase, perhaps because of the cost of labor, the seller may try to pass those higher costs along. On the demand-pull side, if there is an abundance of currency, this increases demand for goods and services and is also inflationary.

While the Fed has been waging a fight against rising prices by removing liquidity and ratcheting up the cost of money (interest rates), the number of open jobs compared to the number of workers available to fill them has widened.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.federalreserve.gov/newsevents/speech/powell20221130a.htm

https://www.bls.gov/news.release/empsit.nr0.htm

https://fred.stlouisfed.org/searchresults/?st=unemployment%20rate&isTst=1

PCE Inflation Versus CPI Inflation, What’s the Difference?

Posted on January 26, 2023January 27, 2023 by phoffman@channelchek.com

Image Credit: Brenda Gottsabend (Flickr)

The Increasing Popularity of the PCE Inflation Gauge

US inflation, by a number of official measures, reached its highest level in 40 years last year. For a large percentage of investors and shoppers, this is their first experience of prices quickly rising. For decades, on many tech products, prices declined over time (while adding functionality). There are a number of different measures of inflation reported regularly – they impact us in different ways. Knowing the difference, whether you’re investing, planning a purchase, or expecting a cost of living (COLA) increase, is helpful. Below we go through the different measures so you understand the impact of say “headline CPI” versus “core PCE.”

According to James Bullard, the president and CEO of the Federal Reserve Bank of St. Louis, “measuring inflation is one of the most difficult issues studied by economists.”

By definition, inflation is the percentage change in overall prices in the economy over a specified period, commonly quoted as a year-over-year change. It’s much more than an increase in the prices of a few products. Given the inherent difficulties in following every price in the country, economists have created price indexes to approximate the overall price level.

PCE Inflation

Before the year 2000, the Federal Open Market Committee (FOMC) primarily focused on the Consumer Price Index (CPI) as its inflation gauge. We’ll explain CPI next, but for the Fed, when it now says it has a 2% inflation target, PCE is the data used.

Though the two indexes have a lot of overlap, there are reasons why the PCE is considered a better tool by policymakers.

The PCE price index, which rose 5.5% in November 2022 from a year earlier, is derived from a broader index of prices than the CPI’s more narrow set of goods and services. The argument as to why policymakers gave an edge in the late 1990s to make the change in 2000 is that a more comprehensive index (such as PCE) of prices provides a better way to gauge underlying inflationary pressures. Since the PCE includes more goods and services, the index’s weights for particular items will differ dramatically from those in the CPI. For example, housing has a weight of about 16% in the PCE price index versus 33% in the CPI. The varied items more accurately reflect actual costs to consumers since they may substitute one for another as prices of items change at different rates. This ability to substitute is a primary reason why PCE tends to print lower than headline CPI.

CPI Remains Important

The most widely cited measure of inflation is the headline Consumer Price Index (CPI), which is calculated by the Bureau of Labor Statistics (BLS). This index was created in 1919 as officials devised a way to measure rising consumer prices just after World War I.

The CPI, which rose 6.5% for all of 2022, measures the price changes for a basket of goods and services purchased by the typical urban consumer. The items in this basket are weighted by their relative importance in consumer expenditures. For example, housing—rent and other spending on shelter—accounts for 33% of the index, while medical care accounts for nearly 9%.

This index, like others, takes into account changing consumption. New items come in and old items leave. The example I like to use is that prohibition began in January 1920, just after CPI came into use. Alcohol was not part of the index back then, whereas it is today (5.78% increase in 2022), product adoption changes.

The CPI weights had been adjusted every two years using two years of consumer spending data. Starting in 2023, the BLS will update weights annually using one year of data.

Headline PCE Inflation versus Headline CPI Inflation

The increasing popularity of the PCE is because the index’s weights are updated monthly, versus annually for CPI (prior to 2023 updates were every two years). Thus, the PCE can quickly reflect the impact of new technology or an abrupt change in consumer spending patterns. For example, the onset of the coronavirus pandemic quickly shifted consumption from services like restaurants to services like communication technology. Since the headline PCE uses more timely, actual outlays, it provides the FOMC a more accurate consumer experience in terms of inflation.

The stated target by the FOMC is 2%, a level that policymakers judge to be consistent with achieving price stability and maximum employment. On average, inflation was hovering below this target before the pandemic’s economic ramifications (from 1995 through 2019 PCE average equaled 1.8%).

Other Inflation Measures

While the FOMC targets headline PCE inflation, policymakers also watch other measures to gauge inflationary pressures. The headline PCE measure can be quite volatile due to the effects of extreme price movements for certain products. To get a sense of where underlying inflation really is, economists often look at some summary measure of inflation that doesn’t include these volatile prices.

A so-called “core” index—whether it be PCE or CPI—excludes food and energy components. That has some simplicity around it, but it’s not satisfactory. There are better ways to analyze underlying inflation than to throw out certain goods and services, especially those that hit low- to moderate-income consumers the hardest when prices rise. And even if you exclude food and energy prices, the remaining part of the index is still affected by their volatility; restaurant prices would be a classic example.

More recently, other statistical ideas have been developed. One method looks at price change distribution for the entire range of goods and services.³

One commonly used measure of this type is the Dallas Fed trimmed-mean PCE inflation rate, which removes the upper tail (the largest price changes) and the lower tail (the smallest price changes) and then takes a weighted average of the price changes for the remaining components. This measure has been popular as a tool for examining trends and overall inflation as opposed to special factors that might be driving inflation. Of course, these types of measures⁴ tend to be more persistent and move more slowly than headline inflation measures.

Take Away

While market concerns over inflation for many years were low and most may have been more concerned about deflation, the current tight supply of goods and labor, coupled with the easiness of money, has ushered in a period where markets are likely to feel the impact of each inflation post.

Understanding the most watched inflation gauges will help sort out whether a trend or single post is likely to cause a change in course on interest rates. Or is it more likely a blip that will on average work its way out? The Fed is currently targeting a PCE inflation rate of 2%. The current pace is more than double this, but trending down after the Fed tightened in 2022 at a record pace. The Fed and the markets are now awaiting the impact of those cuts as there is a lag in applying the economic brakes (to lessen inflation) and when the economy has its biggest reaction to the Fed’s heavy pressure on the brake pedal.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm

https://files.stlouisfed.org/files/htdocs/publications/review/11/07/bullard.pdf

https://www.usinflationcalculator.com/

https://ycharts.com/indicators/us_consumer_price_index_alcoholic_beverages_unadjusted

https://www.stlouisfed.org/publications/regional-economist/2022/sep/making-sense-inflation-measures#authorbox

How Inflation Clips Age Groups Differently

Posted on December 27, 2022December 27, 2022 by phoffman@channelchek.com

Inflation for Americans at Each Age

According to the Bureau of Labor Statistics, consumer prices rose 9.1% from June 2021 to June 2022, the highest rate since 1981. That figure is an average of price increases for bananas, electricity, haircuts, and more than 200 other categories of goods and services. But households in different age groups spend money differently, so inflation rates vary by age, too. The diagrams below show average spending for households at different ages, in the categories that make up the inflation index.

Young households spend more of their budgets on gasoline, where prices rose 60% in the last year. Gasoline has been the largest single-category driver of inflation since March 2021, accounting for nearly 25% of inflation by itself. Gas has had an outsized impact considering that the category is 4.8% of Consumer Price Index spending. (Gasoline prices began falling in mid-June.)

Measured in dollars, gasoline spending peaks around age 40, according to government surveys.

But, as a percentage of spending, gasoline spending is highest for the youngest households.

Sources:
US Bureau of Labor Statistics
Consumer Expenditure Survey
Consumer Price Index

Taking an average of all categories, as the inflation index does, shows that inflation is currently highest for younger households. It is about 2 percentage points higher for households headed by 21-year-olds as it is for octogenarians who live at home. That has not been true for most of the last 40 years. Inflation rates calculated in this way were higher for older households as recently as early 2021, when medical care costs were rising faster than gasoline prices.

These estimates are imperfect. The Bureau of Labor Statistics notes in its estimate of inflation for elderly households that different age groups may buy different items within each category or buy them from different types of stores. They may also live in locations with costs of living so dissimilar that national changes in prices are not relevant. Over the past 12 months, inflation was 6.7% in the New York City metropolitan area and 12.3 in the Phoenix metropolitan area, due in part to different housing markets.

The above was adapted from USAFacts and is the intellectual property of USAFacts protected by copyrights and similar rights. USAFacts grants a license to use this Original Content under the Creative Commons Attribution-ShareAlike 4.0 (or higher) International Public License (the “CC BY-SA 4.0 License”).

Why Rate Increases May be Nearing an End

Posted on December 13, 2022December 13, 2022 by phoffman@channelchek.com

Arguments Can be Made for Rates Being Too Low and for Rates Being Too High

The Federal Reserve has raised the Fed Funds rate from an average of 0.08% in January 2022 to its current 4.05%, and a likely adjustment to 4.25% to 4.50% tomorrow. Inflation, as measured by CPI and even the Fed’s favorite, the PCE deflator, has been showing a decreasing rise in prices. So investors within all affected markets are asking, how much more will the Fed raise rates? Ignoring any suggestion that “this time it’s different,” I looked at US interest rates and inflation going back to 1962 and may have found enough consistency and historical norms to help determine what to expect now and why.

Are Increases Nearing an End?

I’ll start with the conclusion. The data suggests that the movement of market rates depends on whether higher current inflation is being caused by temporary or long-lived factors. The 10-year Treasury Note market believes current inflation is mostly temporary. This is shown by its yield, having touched 4.25% in late October, and then falling. The ten-year is now near 3.50%, despite the 0.75% increase in overnight rates implemented on November 2. If the combined wisdom of the Treasury market is reliable, this suggests FOMC rate increases are nearing an end. Perhaps one more smaller hike and then a wait-and-see period. The Fed would then monitor prices while past increases work their way through the economy.

Powell’s Concerns

At his last address on November 30^th, Fed Chair Jay Powell indicated he’d rather go too far (with tightening) and then reignite the economy rather than err on the side of not doing enough and having a bigger problem. The markets and the media largely ignored this, but it’s important to know what the Fed Chair believes is prescient and is sharing publicly. Powell also said, “Given our progress in tightening policy, the timing of that moderation is far less significant than the questions of how much further we will need to raise rates to control inflation, and the length of time it will be necessary to hold policy at a restrictive level.” And then he said something very telling, Powell added, “It is likely that restoring price stability will require holding policy at a restrictive level for some time. History cautions strongly against prematurely loosening policy. We will stay the course until the job is done.”

Market Thinks Inflation is Temporary

But, the markets are overjoyed by the last two months of inflation data. Despite what the nations top central banker is saying. Markets may be right, but if they are wrong (bond and stock markets) spotting it early can help stave off losses. If inflation, which is lower than it had been, but not historically low, proves more permanent, for example, if employers continue to have to bid up the price of workers, and demand for goods causes commodity prices to rise, then the Fed will have paused too early. This will lead to a more difficult challenge for the Fed as compared to tightening too much. The data used in this article are from the Federal Reserve Economic Data (FRED) maintained by the Federal Reserve Bank of St. Louis.

Actual and Expected Inflation

The St. Louis Federal Reserve publishes a market estimate of expected average inflation over the next ten years. It is derived from the 10-year Treasury constant maturity bond and 10-year Treasury inflation-indexed constant maturity bond. It was first published in 2003. Over 2003-2021, 10-year inflation expectation averaged 2.0%, the same as GDP deflator inflation. During the second quarter of 2022, the expected 10-year inflation was 2.7%, or less than 1.0 percentage point above its 2003-2021 average. In contrast, GDP deflator inflation was 7.6%. A significant wedge exists between current and expected inflation.

The breakeven inflation rate represents a measure of expected inflation derived from 10-Year Treasury Constant Maturity Securities (BC_10YEAR) and 10-Year Treasury Inflation-Indexed Constant Maturity Securities (TC_10YEAR). The latest value implies what market participants expect inflation to be in the next 10 years, on average.

Beginning with the end of the last recession on April 1, 2020, the Treasury bond data used in calculating interest rate spreads is obtained directly from the U.S. Treasury Department.

Take Away

The Market’s expectation of 10-year average inflation is dramatically different from current inflation, even at inflation’s new lower pace. This implies the market believes it to be temporary.

If the market’s expectation of inflation is accurate, there is an average difference between Fed Funds and the PCE deflator of 1.6% (since 1962). The last read on PCE was October 2022 at 6%. Reducing this by 1.6 would provide a Fed Funds level of 4.4%. This level is in line with historic averages and likely where we will be after the FOMC meeting wraps up on December 14. This comparatively high rate relative to where we began the year may be considered neutral.

Will the Fed stop at neutral? Are the markets right? Powell said he’d rather err on the side of going beyond what is needed, which suggests the Fed will continue some. As for the markets, being on the side of the markets is how you make money, but getting out before trouble arises is how you keep the money. Markets are not always accurate forecasters and since economic behavior and debt levels tend to adjust slowly, prudent portfolio management suggests it is wise to keep an eye out for today’s interest rates still being too low.

Paul Hoffman

Managing Editor, Channelchek

Source

https://www.federalreserve.gov/newsevents/speech/powell20221130a.htm

https://beta.bls.gov/dataQuery/search

Cathie Wood Expands on Her Expectations of Deflation

Posted on December 7, 2022December 7, 2022 by phoffman@channelchek.com

Image Credit: Singularity University (YouTube)

An Alternative View of Today’s Economy by Cathie Wood

Cathie Wood made the argument that investors comparing the current economic crosscurrents to the 1970s are developing forecasts based on the wrong data-set. Speaking at the Finimize Modern Investor Summit via video, the ARK Invest funds founder instead suggested the current economy and inputs are similar to a different period – she then made a case for her reasoning.

“If you go back to the 19-teens (1912-1922), then the period was very similar to the period we’re in today,” she said at the Investor Summit. That period featured a war, a pandemic (Spanish flu), and supply-chain problems. “It was the most prolific period for innovation in history,” she said, pointing to the disruptive impact of electricity, the telephone, and the car.

Wood explained that inflation went from 24% in June 1920 to -15% in June 2021. She made clear she isn’t forecasting deflation this severe; however, she is expecting year-over-year inflation to swing into negative territory, with prices going down. “What has happened during the last few years is going to flip, and we think that the market will flip back to a preference for growth stocks and our innovation strategy,” she said.

Wood also elaborated on a tweet she issued earlier about how deep the inversion was of the yield curve.

“That’s the bond market saying, ‘hello, Fed, are you watching?'” She said Federal Reserve Chair Jerome Powell is trying to be the reincarnation of Paul Volcker at a time when it’s not appropriate. “I think that’s a mistake because this is not a 15-year problem; it’s a 15-month one,” said Wood. She highlighted that commodity prices are tumbling, supply chains are improving, and companies are

Ark Invest funds have been positioned in a more concentrated waiting pattern while Wood waits for inflation dynamics to be supportive of innovation. She gave an example; the innovation fund, for instance, has been narrowed to 32 companies from 58, Wood said, as she highlighted that the firm has become less convinced China is supportive of innovation.

Take Away

It’s worth reviewing the differing opinions of several investors that have made above-average returns in their careers. While almost no one is always correct, there are many different right ways to make money in any market.

The Ark flagship fund is down 63% this year; in the past, Wood has indicated her funds’ time period to measure return is five years, not one. Perhaps investors with a longer holding period can garner useful ideas from her pounding the deflation drum, while investors with a shorter time horizon are concerned about inflation.

Paul Hoffman

Managing Editor, Channelchek

When Will Monetary Policy Finally Score?

Posted on November 23, 2022November 23, 2022 by phoffman@channelchek.com

Why the Fed Needs to Gain Trust, Gain Momentum, and Gain More Yards

Monetary policy and its implementation is as much sport as science. Economics is actually a social science, so it relies on human behavior to mimic past behaviors as its prediction guide. But as in sports, victory is difficult if there is distrust in the coach that’s calling the shots (in this case Powell), or if there are people on your side that have reason to work against you, (an example would be Yellen). Consistency in blocking and tackling (doing the right thing) and not giving up, over time, wins games. Knowing what to expect from the opposing team (consumers) wins a healthy economy.

One repeated trait in monetary policy is that there is a lag between implementation (easing or tightening) and a change in economic conditions. It isn’t a short lag, and the impact varies. Since it could take more than a year for a policy change to begin to impact the economy, the Fed usually moves at a slow and measured pace in order to not overdo it.

The slow pace allows policymakers to observe the impact of their moves and change tactics (positions on the playing field) mid-game.

Federal-Funds Rate During Tightening Cycles

*Note: From December 2008, midpoint of target range. December 2015 hike excluded from 2016-18 cycle*
*Source: Federal Reserve*

Over the past nine months, we have been in a tightening cycle. During this period, the Fed has raised rates by 3.75%. On average (since 1975), when the Fed has tightened rates, they are notched up by 5.00% over 20 months.

The Fed’s current pace is faster than average. This is because inflation took them by surprise, and rose rapidly. Putting up a strong defense against inflation that has been rampant is necessary to not be shut out and allow the Fed to gain control over the outcome.

Because one has to be able to reflect back more than 40 years to have experienced the Fed raising rates this fast. Many have lost confidence in its ability, and are in their own way working against a winning outcome.

Pace of Fed Hiking Cycles

*Note: From December 2008, the midpoint of target range*
*Source: Federal Reserve*

The stock and bond markets move in group anticipation of expected policy moves by the Fed. This has been more pronounced in recent years as the Fed has basically shared its expectations after each meeting, setting up for the next. Higher rates make bonds and bank deposits more attractive. Higher rates also weaken the economy and corporate profits, and that induces investors to move away from stocks and even real estate.

Bonds now offer the highest yields since 2007. The stock market may have anticipated what was to come as it peaked in early January of this year, more than two months before the Fed began hiking in March.

Fed Hikes and S&P 500 Bear Markets

Sources: Federal Reserve; Dow Jones Market Data

Employment

The Fed is concerned with a wage-price spiral feeding on itself. It likely won’t be satisfied that its tightening has been sufficient until it can be confident that it has avoided a wage-price storm on the economy.

Ideally, this would happen without unemployment rising. Soft landings took place in 1983-84 and 1994-95. But when inflation starts out too high, as it is now, unemployment usually rises notably, and a recession occurs.

Historically, this doesn’t happen until several years after the first increase. This time it is hoped it will be different, since the Fed is playing more aggressively.

Periods of Fed Hiking and Rising Unemployment

*Note: The unemployment rate rose to 3.7% in October, up from the pandemic low of 3.5% a month earlier.*
*Sources: Federal Reserve; Labor Department*

Inflation

Historically, inflation has only fallen to acceptable levels after unemployment has increased, and long after the first rate increase – the exact timing has varied. If the fall in core inflation (which excludes the volatile food and energy components) between September and October continues, and September proves to be the peak, the time between the first Fed increase and the high point of inflation will be one of the shortest of any Fed hiking cycle.

Often, the break in inflation has been accompanied by a recession. The economy receded in each of the first two quarters and then grew in the third. The changes in the inflation component in Gross Domestic Product may have borrowed from one quarter and have been additive to the next. The fourth quarter reading should help level the growth averages out to see if we were indeed in a shallow recession.

Proximity of Peak Inflation and Recessions to Initial Rate Hikes, from Year Hiking Cycle Began

Note: Inflation refers to core CPI.
Sources: Federal Reserve; Labor Department

Take Away

As in many team sports, once one side gets momentum, they are difficult to stop . The Fed needs to gain the trust of the individual players in the economy in order to be successful. Saying one thing, then doing another, would undermine this trust. So far, despite the Fed originally being wrong about inflation, the Fed has done what it has said it would do. Stock and bond markets, which are a considerable part of the economy, have been slow to understand the Fed’s resolve.

It has been implementing the balance sheet run-off plan and raising rates toward a level it believes would equate to a future 2% inflation rate. Like so many other things in the social sciences, widely held expectations of the future become self-fulfilling.

Paul Hoffman

Managing Editor, Channelchek

Sources

https://www.wsj.com/articles/move-over-inflation-here-comes-the-earnings-crunch-11668300124?mod=article_inline

https://www.wsj.com/articles/fed-raises-interest-rates-for-first-time-since-2018-11647453603?mod=article_inline

https://www.wsj.com/articles/feds-aggressive-rate-hikes-are-a-game-changer-11669006579?mod=economy_lead_pos5

www.BLS.gov

Why the Bullish Behavior of the Past May Return

Posted on November 4, 2022November 4, 2022 by phoffman@channelchek.com

Philippe Petit walks Tightrope between buildings one and two of WTC, Manhattan, 1974 – Robert.Dearie (Flickr)

Analyst Team Point Out Asset Classes that Slingshotted in the 1970s

While the traditional fine print usually says, “past performance is no guarantee of future results,’ we all know trading decisions, whether the stocks are to be held for seconds, or decades, are based on probabilities. And market probabilities are rooted in past performance. What does past performance tell us about the chances that the markets can survive high inflation and low growth? Well, if the stagflation of the 70s repeats, there may be a small section of the markets to keep a solid footing.

Michael Hartnett is the chief investment strategist at Bank of America/Merrill Lynch. Hartnett sees in our current economy the ingredients in the macroeconomic picture that lead to the difficult economic combination of high inflation and low growth. His team, in their Flow Show note on Friday, wrote: “Inflation and stagnation was ‘unanticipated in 2022…hence $35 trillion collapse in asset valuations; but relative returns in 2022 have very much mirrored asset returns in 1973/74, and the 70s remain our asset allocation analog for 2020s.”

If the conditions of the 1970s are being mirrored and we are creating a foundation similar to 1973/74, Hartnett and team have a list of assets that could springboard off the stagflation cycle.

The assets with potential include taking long positions in small-caps, value, commodities, resources, volatility, and emerging markets. The group also highlights the short positions that worked well in the 1970s, the note indicates these are larger stocks, bonds, growth, and technology.

Why Small-Caps

As it applies to the smaller companies, the note points out that stagflation persisted through the late 1970s, but the inflation shock had ended by 1973/74, when the small-cap asset class “entered one of the great bull markets of all-time.” The Hartnett team sees small-caps set to keep outperforming in the “coming years of stagflation.”

The current year-to-date status has the Russell 2000 small-cap stock market index (measured by iShares ETF) down 19.8% in 2022. At the same time, the Dow Industrials are down 11%, S&P 500 lost 21%, and the Nasdaq Composite gave back 33%.

The current state of the Fed and Chairman Powell is they continue to be adamant about tightening, Powell said he’d prefer to overdo withdrawing stimulus than do too little. He also knows that until the market believes this, his tightening efforts will have a lower impact.

The BofA team isn’t helping market expectations as they noted, despite Powell’s clear signal that the Fed isn’t ready to declare even a slight victory from its raising rates; the analyst team says, don’t give up on that pivot.

After tightening interest rates through 1973/74 amid inflation and oil shocks, the central bank first cut in July 1975 as growth turned negative, Hartnett points out. A sustained pivot began in December of that year, and importantly, the unemployment rate surged from 5.6% and 6.6% that same month.

The “following 12 months, the S&P 500 rose 31%. The note suggests the lesson learned is that job losses when they occur, will be the catalyst for a 2023 pivot,” said Hartnett and the team.

We’re not there yet. Today’s economic release on jobs showed the U.S. added a stronger-than-expected 261,000 jobs during October. This is a slower pace than the prior month’s 315,000 job gains but still shows the Fed can comfortably notch rates up more and continue reducing its balance sheet.

Take Away

The team of analysts at BofA/Merrill Lynch, reporting to Michael Hartnett, drew conclusions from the stagflation and financial markets’ performance of the 1970s. They shared their thoughts in a research note with investors. Looking at past performance, their expectation is that the Fed will pivot away from aggressively raising rates when it begins to negatively impact job creation. At this point, many markets will have already reacted to inflation expectations and would then react to a more accommodative monetary policy.

The asset sectors to avoid or short are larger stocks, bonds, growth, and technology. The preferred sectors that, in past situations, have done well are small-caps, value, commodities, resources, volatility, and emerging markets.

Be sure to sign-up at no cost for small and microcap company research sent to you each day by Channelchek.

Paul Hoffman

Managing Editor, Channelchek

Source

https://www.morningstar.com/news/marketwatch/20221104397/the-next-big-thing-is-small-get-ready-for-some-bullish-history-to-repeat-with-these-stocks-says-bofa-analysts