Inflation Still Hot. Does The Fed React?
Update: Since our original posting, it would appear that the Fed has called an "expedited, closed" meeting for Monday, February 14th at 11:30 am EST. The last time such a meeting was called (November 2015) the Fed raised rates for the first time since 2006.
The market was waiting with baited breath on the CPI print yesterday morning and didn't like what it saw. At this point, I'm reminded of the '80s hit "Some Like It Hot" by the short-lived bank Power Station.
The band formed in 1985 combining two members of Duran, Duran, one member of Chic, and vocalist Robert Palmer. The most popular song, and really only hit, was the aforementioned song, which oddly enough, the bank debuted on Saturday Night Live in February of 1985. Just by examining some of the lyrics, I feel like the Fed and the Biden administration are operating under the construct of the song.
Some like it hot, and some sweat when the heat is on.
Some feel the heat and decide that they can't go on.
Some like it hot, but you can't tell how hot till you try.
Some like it hot, so let's turn up the heat till we fry.
Well, in terms of inflation, frying is what we're doing right now. Let's jump into what we're seeing so far this week...
Worst Inflation In 40 Years. January Consumer Price Index showed an increase of 0.6% last month, which was more than the market was expecting. In fact, January's release makes it 9 of the last 11 releases of CPI that exceeded analysts expectations. I guess my question at this point is, "When is the market going to take inflation seriously?" The year-over-year increase in inflation is now a red hot 7.5%. The last time inflation was that high the Fed Funds rate was at 11.50%!
Though we had a nice increase in employee wages reflected in last week's jobs report, the average person's earnings are still trailing inflation by 180 basis points. In fact, for 10 straight months, inflation has out-paced wage increases. Yesterday, the market did not like the inflation news as most broad indices were down more than 1% for the day. The prevailing concern is that the Fed will not only have to raise rates by 50 basis points next month, but that more than 3 rate hikes will be needed. The current market odds of the Fed raising rates by 50 bps in March has risen to a 57% probability. We are not so sure we can get in the camp that sees more than 3 rate hikes, but 50 bps next month is now likely. First, if we alleviate some of the congestion at the ports and get goods into consumers hands quicker, inflation will decline to some degree. Second, the tide seems to be turning on severe COVID measures, especially in states with port congestion, and that could help increase labor and efficiency at the ports.
Third, some of the rate hike hysteria seems to be driven by those who want to see interest rates normalize quickly. Kim Forrest, Chief Investment Officer at Bokeh Capital Partners, expects inflation to ease as government handout programs are removed. According to her, five to seven rate hikes "is just so crazy - it's a lot driven by bond people here who really just want to get that 10-year to the 3% rate and I don't know that's possible." On the last point, I would slightly disagree, as the 10-year treasury yield yesterday crossed the 2.0% mark for the first time since July of 2019.
If the Fed were to raise 50 bps next month and simply 25 bps two other times this year, then would it be that "crazy" to see the 10-year yield get to 3%? However, regardless of what prevailing opinion might be, the market is clearly pricing in more than 3 rate hikes. Right now, the market odds favor at least 5 rate hikes or more by the end of this year (see graph). If that is indeed what happens, one could expect to see losses in intermediate-term bonds perhaps in the double-digits. There are even whispers of a surprise Fed meeting , so be on the lookout for that. We fall in the camp that some of the shipping delays are corrected before year-end and the Fed has some room to at least pause in hiking rates. Time will tell.
Shipping To Save The Day. There is some consensus that the shipping crisis has peaked and better capacity at the ports could be on the way. First, global shipping rates appear to have peaked. Depending upon which route is viewed, on average, shipping rates are down as much as 10% over the past few months.
The most dramatic decline being the route from Shanghai to New York (-16%). Second, key shipping companies are seeing some relief, although, they admit there's still much up in the air as to how "normalcy" is accomplished. According to AP Moller-Maersk CEO, Soren Skou, the shippers don't have much experience with an emergence from a pandemic. According to Skou, "We are guiding in an environment where we are coming out of a pandemic, and we don't have much experience with that to be honest."
Yet, Skou also noted, "So we are saying we expect quite a strong first half of 2022, and then we expect what we call a normalization early in the second half." Third, some of the items that have been heavily influencing inflation of late (see our previous post on the contributors to inflation) appear to be peaking. The Manheim US Used Car Index is beginning to roll over. If this becomes a pattern, that could also ease inflationary concerns.
Increased Volatility Likely Here To Stay. Last year, markets were on a fairly stable path until about October. Overall, we saw 55 trading days where the S&P 500 Index advanced or declined by 1% or more in a single day. That is actually below average, as most years see about 62 trading days with at least a 1% move. Due to rising interest rates, rising inflation, mid-term elections, and uncertain Fed policy, volatility will likely affect markets throughout 2022. In January of 2021, there were only 5 trading days with a 1% move. This year, there were 7 trading days with a 1% move in January.
Now, that's a small sample size, but that's a 40% increase in 1% moves, or another way of saying volatility. If we break down the VIX (volatility index) for the month of January, we saw a 49.5% increase last month in that measure of volatility. Last year, the index did rise in January, but only 22.7%, by comparison. If we try to extrapolate that out for the rest of this year, we could see 1% moves anywhere from 77 to 82 trading days in 2022.
How we get to that number is by taking either the increase in January of 1% trading days (40%) or by the rise in the VIX in January of this year (+49.5%). Either way, we're looking at above normal volatility this year. That doesn't mean we're set up for a negative year. There have been many times in history where markets experienced outsized volatility, but ended the year in the positive column. In 1987, markets were rocked in October by Black Monday. Most investors forget that we actually ended up positive for that year by just over 2%. In 1999, the market experienced 1% moves in 92 trading days - far above the average of 62. Yet, the S&P 500 Index ended up by more than 19% that year. After the crash of the Tech Bubble in 2000, markets were rocky for multiple years. In 2003, there were 82 trading days with at least a 1% move, and yet the S&P ended up the year in the plus column by more than 26%. In 2010, we were recovering from the Financial Crisis and there were 76 trading days with at least a 1% move. The market finished that year up more than 12%. No one knows where equities will finish in 2022. However, if inflation does ebb lower due to a recovery in shipping and we can earn high single-digit returns in equities, that would be a significant win in a year marked by the headwinds previously mentioned.