Recently, I've gotten into a podcast called "The Rewatchables." The show is a weekly podcast that reviews famous movies of the past and breaks down what is good and what is not so good about the movie. Does the movie stand the test of time? Should the movie have had a different cast?
This week's "Market Musings" is a review of past musings that need to be "remused" as the market is rapidly shifting, but suffering from previously analyzed mistakes. There are multiple issues that need to be revisited in this week's musings - inflation, stagflation, jobs, and more. Here's what we're seeing so far this week...
Stagflation versus Inflation. There are multiple market watchers and analysts stating that we're in a period of stagflation. While we might get there at some point, we're certainly not there yet. As a reminder, in a post last year, we reviewed the conditions necessary for stagflation to exist.
Stagflation is a period of economic decline marked by high inflation and high unemployment. Right now, that is not the case. Unemployment is low, while inflation is high. The Misery Index equals the Unemployment Rate plus the Inflation Rate (CPI), which currently sits at 11.5 and is slightly above the historical average of 9.2. However, the high for the Misery Index is 21.9 from June of 1980. At that time, Unemployment was 7.6% and Inflation was 14.3%. For some perspective, unemployment and inflation are running a little more than half the 1980 levels at the moment.
On the flip side, the Biden administration and the Fed get the "economic darwinism" award for a failure to address inflation. In September of last year, I wrote about the considerable increase in everyday commodities that was already palpable.
Since then, despite assurances that inflation would ease, commodity prices have worsened. Every single commodity that was mentioned in that post, with the exception of Sugar, has continued to increase. On average, the eight commodities listed in the graph have increased another 31% since September of last year. That's on top of the average year-over-year increase of 76% that I wrote about at that time. This kind of inflation is beginning to cause "demand destruction" for those items most affected by the increase in inflation. Consumers are beginning to replace brand names for generic, less-expensive items. Grocery stores are noticing consumers leaving the higher-priced brands on the shelves as inflation has risen.
The Biden administration announced this week that they were approving the largest release of oil reserves since the SPR (Strategic Petroleum Reserve) began nearly 50 years ago. The proposed release, coordinated with other countries' similar reserves, would be approximately 180 million barrels over several months.
While the price of oil has declined 5% this week, history shows that releases from the SPR have not had a significant long-term effect on oil prices. First, the U.S. consumes approximately 20 million barrels of oil on a daily basis. The release of 180 million barrels daily would mean that only 5% of daily consumption would be accounted for by the SPR. As we noted in a previous post, the Keystone Pipeline would have nearly accounted for this amount of SPR release had the project been allowed to be completed. With each release of the SPR, while there is typically a short-term reaction of oil prices to the downside, the long-term trend is usually higher prices. Meanwhile, the administration continues to tell Americans to buy electric vehicles, a notion we have previously flushed out as not a viable near-term solution.
In the graph to the right, it's easy to see in each of the releases highlighted by the blue circles, the price of oil declined temporarily, only to head higher ultimately. It's doubtful that gas prices will ease over the course of this year with OPEC unwilling to substantially increase production and the Biden administration contemplating making companies pay fees on wells they are not using. The reason the wells are not being used is because they are not economically viable, otherwise, the oil companies would be actively pumping oil out of said wells. It's likely that if a fee is passed by Congress, companies will simply turn those wells back on to avoid the fines or simply pass along any fines to consumers at the pump. While stagflation may not be here, expect inflation to only head higher for the time being.
Recession Probabilities Increase. Much of the talk this week has been about the yield curve and the telling signal of recession when the curve inverts. It's important to note that the typical yield curve sign is when the yield on the 2-year Treasury Bond rises above the yield on the 10-year Treasury bond.
As the market senses that long-term risk is no longer worth the premium of a higher coupon payment, the yield curve becomes inverted. Short-term debt captures a higher premium (yield) as risk becomes more uncertain. Earlier this week, the 2yr Yield exceeded the 10yr Yield intraday, but did not close officially inverted. It's likely that the yield curve will close inverted at some point in the coming days, weeks, or months. What is also important to remember is that the inversion of the curve is usually not a immediate warning signal. The average time between yield curve inversion and recession is 13 months.
In addition, as different parts of the shorter end of the curve become inverted, the more imperative the recession signal becomes. Right now, the difference between the 10yr Yield and the 3-month Yield is high. The inversion of those two points on the curve usually forecasts a more imminent risk of recession. According to Bank of America, the risk of recession one year from now due to the 2yr/10yr curve is 20%, while the 3mth/10yr curve recession risk is only 5%. This is something we'll definitely be keeping our eye on.
Spit-ball Economic Analysis. In the podcast "The Rewatchables," the hosts will discuss stuff they uncovered on the movie or the cast they are reviewing. They call it "half-ass internet research." As we take a rudimentary review of the economic data, it's not all doom and gloom. In terms of the stagflation argument, there are still more than 11.2 million job openings according to the JOLTs survey released this week. That means that there is the potential for continued improvement on the unemployment front.
In fact, Continued Claims dropped to another multi-decade low of 1,307k, better than analysts expected. The ADP Private Employment report released on Wednesday showed another 455,000 jobs added, also better than analysts expected. Personal Income increased last month, as did Personal Spending (albeit at a slower pace month-over-month). However, according to this morning's Jobs Report, Average Hourly Earnings, while improving, are still not keeping pace with inflation. Inflation is +7.9% (year-over-year) while Earnings are rising +5.6% (year-over-year). As we enter rebalancing season and 1st quarter corporate earnings season, equities still have some room to run as analysts are still expecting the S&P 500 Index to close above 5,000 in the next 12 months.
To revisit one of the ways we think the Fed is helping control inflation is via the overnight repurchase market.
The Federal Reserve uses an instrument called Overnight Repurchase Agreements, also known as "Repos," to provide lending to banks and financial institutions instead of leaving the money in interest-bearing accounts. Conversely, the Fed uses Reverse Overnight Repurchase Agreements (or, "Reverse Repos") in order to discourage banks and financial institutions from lending out what said institutions have borrowed from the Fed.
In this way, the Fed can offer these institutions higher returns in the overnight market, thereby reducing their incentive to loan out borrowed funds and accept the returns achieved through the reverse repo market. In fact, Reverse Repos hit a level of $1.87 trillion yesterday, nearly matching the record of $1.9 trillion on December 31st of last year. And, it's been working. While Consumer Loan demand has increased, Commercial Loan demand has flattened. Since my last writing on this subject, Commercial Loans have flat-lined while Consumer Loans have increased every month since February of 2021. Last month, Consumer Loans increased the the most in a single month since April of 2018.
Sometimes it's helpful to rehash economic / market analysis to make sure its still relevant. They say history doesn't necessary repeat, but it rhymes. The drums seem to be pounding right now to a similar economic rhythm that bears watching.