The Fed Giveth, And The Fed Taketh Away
The primary concern among investors at this point is a Fed policy mistake. In our view, that ship may have already sailed. One of my favorite TV shows of the late '70s was "The Six Million Dollar Man."
Astronaut Steve Austin goes down in an accident and in the show's opening title the doctor assigned to saving Austin's life and making him into the "bionic" man states, "Gentlemen, we can rebuild him. We have the technology. Better than he was before." Obviously a fiction TV show isn't the same as real life economics. But the hubris displayed by the doctor in "The Six Million Dollar Man" is similar to the hubris displayed by the Fed, namely, Chairman Powell. Maybe we should rename Chairman Powell the "Six Trillion Dollar Man."
A common theme running through the markets and its effect on multiple other headwinds facing investors is Inflation. Here's what we're seeing so far this week...
Inflation and Fed Policy Error. The December numbers on inflation came in this week and the news wasn't good. The Consumer Price Index (CPI) increased 0.5% in December, slightly ahead of market projections. In fact, in 7 of the last 9 CPI releases, the actual number was higher than analysts' expectations.
The Producer Price Index (PPI) came out the following day and it was actually lower than expectations, but the year-over-year number reached a four-decade high. When inflation began rising in 2020, PPI was out-pacing CPI as producers were willing to eat the higher costs of goods in order to keep consumers purchasing their products/services. However, now CPI is catching up as producers are passing those higher costs along to the end consumer. This is were the rubber meets the road.
At what point to consumers decide to shift purchases from discretionary to non-discretionary? Wages are not keeping up with the pace of inflation. Last month, wages increased, but have only risen 66% as much as inflation on a year-over-year basis. We need to keep in mind that the U.S. consumer comprises two-thirds of U.S. GDP. If we take a deeper dive into inflation, we can see that food and energy - two key non-discretionary items - make up a larger portion of CPI than just 11 months ago.
In February of 2021, CPI stood at 1.67% (year-over-year). At that time food accounted for about a third of inflation, while energy was actually in the negative column (deflationary). Fast forward to December's report, and food accounts for only about 15% of inflation, while energy accounts for about 25% of inflation. Conversely, the more discretionary items - services & goods - now make up a substantial amount of inflation and those are items that consumers could possibly do without should their priorities change. I wonder if inflation would be rising by as much had the Fed begun to pump the breaks in mid-2020?
Interest Rates and Fed Policy Error. In addition to inflation potentially changing consumer behavior, rising interest rates may also have the same effect. Rising interest rates do not merely influence the sales and purchases of bonds in the market place. As interest rates rise, so do prime lending rates and mortgage rates. Chairman Powell stated this week that the Fed could raise rates 4 times this year. This could affect the amount of consumer loans and mortgages taken out by consumers in 2022.
Millennials are the fastest growing demographic of home buyers. The older group of millennials (aged 24 to 34), make up 13.6% of the U.S. population, but comprise more than 30% of current home buyers. That demographic is expected to grow in terms of home purchases as they age, get married, and start families.
In addition, a recent survey showed that 70% of millennials were encouraged to purchase a home with the onset of the pandemic. And, that demographic is willing to pay up and take a risk on a "fixer-upper." Yet, 40% of millennials stated that lower mortgage rates influenced their decision to purchase a home in 2021, compared to only 11% in 2020. I wonder what the home buying activity would look like should mortgage rates rise substantially? We will have to watch this closely as mortgage rates recently rose to a 21-month high of 3.45%. Just one year ago, the 30-year mortgage rate stood at 2.65%.
That's an increase of 80 basis points. To put that in some perspective, the average home price in the U.S. is $266,104. The difference in interest on a home of that value at a 2.65% mortgage rate as opposed to a rate of 3.45% is more than $2,000 annually. Is that enough to dissuade home purchases by millennials? Maybe not. But what happens when rates go to 4.5%? Now you're looking at an additional $4,900 in interest costs on the same value home. You might say 4.5% is way too high for mortgage rates to end in 2022. However, if the Fed ends up raising rates 3-4 times this year, 4.5% on the 30-year mortgage rate is not out of the question.
Retail Sales and Consumer Sentiment. The good news about Fed policy is that we can see real data to let us know how the consumer is responding to higher inflation and higher interest rates. The Retail Sales number for December was released this morning and the data showed a slowdown in spending. The market was expecting a modest slowdown of -0.1%, but the real number was -1.9%. in addition, the preliminary January reading of the University of Michigan's Consumer Sentiment index came in worse than expected.
The projection was for a slight decline of 70.0 for January versus 70.6 for December. However, the preliminary reading was 68.8. In fact, the trend for consumer sentiment has been downward sloping at the same time inflation has been increasing. The reality is that the market is grappling with how much consumer behavior will be effected by rising inflation and higher interest rates and can the economy absorb the new Fed policy of 3-4 interest rate hikes this year.
The markets are already responding by shifting from expensive stocks - technology, communication services, and healthcare - and moving to less expensive stocks - energy, financials, and consumer defensive. We will be watching to see if this becomes a broader trend. However, the S&P, Dow Jones Industrial Average, Nasdaq Composite, and Russell 2000 indices are all lower for the year. It is early, as we are only two weeks into the new year, but the current trend is not good so far.