Markets At Inflection Point
There are things in life that change with the times. The markets are one of those things - as data and sentiment changes, market prices adjust. Some things ought not to change - such as, how we interpret data or how we define words. Up is up and down is down. But, that's not been the case of late. Government officials use words that they believe mean one thing, but when their thesis does not play out, they shift the definition of those words instead of just admitting a mistake. Let's see what sort of mistakes we've uncovered this week...
The Great Debate Over Inflation Is Moot. For months now, the Fed and others have continued pushing the idea that the increase in inflation is "transitory." Most recently, Treasury Secretary Janet Yellen (former Chairwoman of the Fed) stated on Tuesday that she believes inflationary pressures are "transitory," yet in the same breath stated, "that doesn't mean they will go away over the next several months." I guess the best course of action at this point is to determine what exactly the word "transitory" means. According to Webster's Dictionary, the work transitory means "existing or lasting only a short time; short-lived or temporary."
Let's see, the Producer Price Index has been steadily rising since April of 2020 (+25.6% over the last 16 months). The Consumer Price Index has been increasing since May of 2020 (+6.7% over the last 15 months). If Inflation is going to be around for the next several months, that means that it will have been rising or high for close to two years! That doesn't sound very temporary to me...but, then again, I'm not in government. In the real world, and on this blog, we deal with data and historical tendencies. We don't change the data or the definitions to fit the narrative.
Other "Transitory" Elements Adding To Inflation. On top of normal inflationary pressures, shipping bottlenecks and labor shortages have helped fuel additional costs of goods. Right now, there are upwards of 70+ container ships anchored off the California coast waiting to be unloaded at either the Los Angeles or Long Beach harbors.
Another dozen or so container ships are anchored off the New York port. The longest delay in unloading the goods on these ships is as high as 4 weeks out. The issue? Lack of manpower, due partly to extended unemployment benefits and COVID restrictions (i.e., mandatory quarantines). This is causing items such as clothing, electronics, toys, and furniture to be delayed.
That, in turn, is causing shipping rates to rise and cancellations of shipping routes to increase. When there are too many consumers chasing too few goods - that's inflationary. Oh, and this is happening right before the consumer build-up known as the "holiday season."
Commodity prices have surged, and if this situation persists, expect commodity prices to continue to march higher. A lot of this was caused by bad policy decisions during and after the pandemic and may require the same government officials who caused the situation to step in and resolve the situation. Unfortunately, government is as adept at fixing disruptions as they are experts at causing disruptions.
What About Stagflation Fears? While the conditions leading to Stagflation could change, we believe the fears concerning Stagflation at this point are unfounded. The term "stagflation" was first used by English politician Ian Macleod in the House of Commons in the 1960s. It became even more popular in the 1970s as inflation doubled, the oil crisis hit, and unemployment reached 9%. Stagflation, as currently defined (pregnant pause - as government can redefine terms on a whim these days) is a period of economic decline marked by high inflation and high unemployment.
As the chart on the right shows, we are not currently in that economic state. Unemployment is at 5.2% (just below the historical average of 5.8%). Inflation is high at 5.3% (historical norm is 3.5%). But, economic growth continues, as the latest revision of 2nd quarter GDP reached 6.7% (historical norm is 3.5%). The U.S. Misery Index, made popular by economist Arthur Okun in the 1960s, helps us measure the distress of Americans by adding unemployment to inflation. Right now, the Misery Index is at 10.5, which is above the historical norm of 9.3, but far removed from the Stagflation period of the late 1970s where it reached a level of 21. Until unemployment shifts higher and GDP shift lower, the threat of Stagflation is on the lower end at the moment.
Where Could Markets Be Headed From Here? This is the key question on investors minds. In our view, the market is not floundering in stagflation fears, rather, it's adjusting to higher yields, the prospect of Tapering, and the end of stimulus. If we examine our Three-legged Stool theory of Economic Growth, we can gain some potential insight into where we could be headed from here.
From the Fiscal Spending standpoint, the market is forward-thinking and sees the stalemate in Congress over a bloated spending package of $3.5 trillion and an Infrastructure bill that is an overshoot, at best. Multiple politicians have recently tweeted, opined, or stated in interviews that the current bills before the Congress are highly popular and only a few senators are holding up the bills from passing. If these bills are so popular, why can't the party that controls the White House, the Senate, and the House of Representatives get these bills through? The reality is that many of the provisions of these bills are not popular among the American people, which is why they can't pass. And, the market generally likes this. Stalemates in Congress mean nothing gets done, and adding $3.5 trillion stimulus to an economy struggling with inflation will add only more gasoline onto the fire. (By the way, $3.5 trillion costs $3.5 trillion; 2 + 2 = 4).
From the Fed Policy standpoint, Tapering is soon to begin (4th quarter) and that means the U.S. economy can stand on its own two feet.
From the Corporate Earnings standpoint, 3rd quarter earnings releases look to be the fifth-straight quarter in which the bottom-up EPS estimate increased during the quarter, which is the longest streak of consecutive quarterly increases since FactSet began tracking this metric in 2002. Yet, 3rd quarter earnings do not look to be quite as strong as 2nd quarter. Regardless, this is still positive. So where is the market headed? In 2013, it took markets a little over a month to adjust to the idea of higher interest rates. We're getting close to that mark now.
In addition, there have been 16 periods in history when the S&P 500 Index pulled back by 5% after one year of no such pullbacks. In those periods, the average return of the market was 2% or higher 1mth, 3mths, 6mths, & 12mths after the pullback. Given that our Wealth Protection Signal is still very low, we would conclude markets are either likely to recover at some point and head higher. In fact, the "fear" component of our Wealth Protection Signal has recently dropped 23% from 9-month highs reached on September 21st. That portion of the Signal is now below the 50-day moving average trendline, which makes a case for smoother sailing ahead in the short-term.
If We're Headed Toward Stagflation, Should The Fed Be Tapering? The economic data looks pretty strong so far this week. COVID data continues to improve, even if the media hysteria persists. Vehicle Sales were down considerably, but that's a function of the jam at ports and chip shortages, not the consumer avoiding large ticket purchases. Factory Orders were higher for August, which is good news considering the situation with shipping delays. Both the Markit & ISM Services indices were higher in September and remained above 50, indicating expansion.
Based upon the latest jobs data, the answer to "should the Fed be tapering" is a resounding "yes!" On Wednesday, the ADP private employment data was much higher than expected and showed solid growth following two months of disappointing numbers.
Approximately 568,000 new jobs were added in the private sector and it was the 1st report since May where every single sector showed job gains. The good news continued on Thursday when both Weekly Jobless Claims and Continued Claims declined more than expected. Initial Jobless Claims dropped to 326,000, which was the first decline in 3 weeks. The level of weekly claims was close to the lows put in on September 9th. Continued Claims, something we are watching closely to determine if people are re-entering the workforce after staying on extended pandemic benefits, also showed further declines. Before we sing hallelujahs just yet, we need to see Continued Claims get back below the 2 million mark.
This morning, the bliss over strong employment numbers earlier in the week was nearly erased due to another bad miss in the government's Jobs Report for September. The market was expecting 500,000 new jobs, yet only 194,000 jobs were added. If we parse the report, we will see that the big decline came from government jobs (a decline of 123,000). If we back out that sector, the total jobs added was 317,000 - a little closer to the market's expectation of 500,000. While the report is not great, the past 5 months jobs reports have all been revised higher. The market could shrug the disappointing number off in hopes that fewer jobs will stave off Tapering. In our view, September's report will not delay Tapering as the unemployment rate dropped from 5.2% in August to 4.8% in September. Based on the economic data, stagflation shouldn't be a primary concern as of yet.