"You've Lost That Lovin' Feelin'"
It appears that the fable around inflation being "transitory" has finally caught up to the Fed...and the markets. We could have arrived at that moment when confidence in the Fed has been lost. The markets seem to be acting like the crooning duo of the Righteous Brothers when they sang their hit song "You've Lost That Lovin' Feelin'."
The song was written by the husband and wife team of Barry Mann & Cynthia Weil. They were summoned by the famous recording executive Phil Spector to write a hit for his newly-signed act the Righteous Brothers. The title of the song was originally just a "placeholder" until the writing duo could think of something better. Spector, however, loved the title and that's what was printed on the record when it was released in 1964. It has been estimated that the song is the most played song (over 8 million plays) between radio, television, and movies (famously appearing in Top Gun). The lyrics remind me how the market is currently reacting to the idea the Fed can provide a "soft landing." It seems the market has lost that lovin' feeling for the Fed:
"Now there's no welcome look in your eyes when I reach for you
And now you're starting to criticize the things I do
It makes me just feel like crying (baby)
'Cause baby, something beautiful's dying"
Can the Fed regain the market's trust? Here's what we're seeing so far this week...
"Transitory" Was Transitory. The primary cause (and there are many other underlying causes) for the market selloff is a lack of confidence in the Fed. For almost a year, we were told that inflation was "transitory" and that just wasn't the case. If that little known analyst in Memphis, TN (i.e., me) could see that inflation was a problem in December, 2020 and May, 2021, then how could the teams of brain trusts at the Fed not have seen it?
Wednesday, for the 10th time in the last 14 months, inflation grew at a pace higher than economists expected. While year-over-year CPI declined slightly in April, it was still higher than forecast and running at +8.3%. Since Wage Growth declined last month from +5.6% to +5.5%, inflation remains well above earnings. Yesterday, we learned that April's PPI number was as expected month-over-month, but higher than expected year-over-year. We've seen both PPI and CPI flatten or decline month-over-month in December of 2020 and in August of 2021, only to move higher in subsequent months. So, there's still no clear sign yet of inflation hitting a peak or subsiding.
If we break down the latest numbers inside the CPI, Food at Home (i.e., grocery items) has hit the highest year-over-year mark (+10.75%) since November 1980.
The highest mark ever achieved was August of 1973 (+23.1%). While middle and high-income households may not feel the pinch just yet due to more disposable income, lower-income households are feeling the pinch and may be using credit to make up the difference. In March, American consumers added $31.4 billion to their credit cards (revolving debt), which accounted for a 35.1% increase month-over-month.
Total revolving credit is now approaching all-time highs. Also of note in April's CPI report is the decline in energy prices. That is good news, but likely a short-term phenomenon. The average price of gas was down during April, hitting a two-month low of $4.04/gallon - a drop of $0.19 per gallon. However, due to more Russian sanctions, the Administration cancelling oil leases, and shortage fears, gas prices are back up to $4.43 per gallon - a 10-year high. By the way, the last time Food At Home inflation was this high was in August of 1973. The price of a gallon of gas then was $0.55. If we adjust that annually for inflation, the price was $3.58/gallon - lower than today. It looks like "transitory" was actually "transitory."
Cracks In The Wall. There are now multiple cracks showing up, some similar to 2008 and some similar to 2000. The pressure inflation and interest rates have put on the market is causing other vulnerable areas to reveal their cracks.
Digital currencies are down hard as well as the digital currency exchange. COIN (Coinbase Global) is down 83% from 6-month highs and BTC (Bitcoin) is down 56% from 6 months ago. This is reminiscent of 2000 when internet companies imploded and only the strong survived the bloodbath. Over the last 7 days, the highest risk digital currencies are down 90% on average, while the top 5 cryptos are down only 26% on average.
This could be a consolidation moment for crytpocurrency just like the internet experienced in 2000. Other areas are more reminiscent of 2008, like some of the signals and areas of the economy. The Fed's National Financial Conditions Index (NFCI) has steadily moved higher toward "tight" financial conditions. In August of 2007 the Index hit -0.24 after being at -0.64 (almost 3x more loose) just 4 months prior. This week, the NFCI hit -0.23 after being at -0.61 just 4 months ago. In June of 2007, our Wealth Protection Signal hit the first trigger and recommended 10% cash raise. The S&P 500 subsequently dropped 10% just a month later. The market would go on to make new all time highs by October of 2007, but by then, the Signal had already triggered twice more. This time around, things are a little different but we're also in the middle of the current pullback, so we're not sure yet exactly how this will play out.
Perhaps markets settle down and head higher before hitting the final wall? In 2007, the Fed was already nearing the end of their rate hiking cycle (no one was throwing around the word "transitory" then). Inflation was much more under control then (+4.3% vs +8.3%) and interest rates had averaged 4.4% on the 10-year Treasury Bond over the previous 3 years heading into 2007. This time around, the Wealth Protection Signal has signaled as the market is already down 13%, but the book has not yet been written. In 2007, after the Wealth Protection Signal triggered, it subsequently eased lower, not hitting the Cash Allocated trigger to put the money back to work, but lower still. Don't be surprised if markets ease higher and the Signal moves lower here in the short-term. The key will be whether the Signal triggers again in the next 3-6 weeks. If not, perhaps the worst is done. If it does trigger, the worst may be yet to come.
Most Important: clients should manage their their risk tolerance, review their financial plan, and remain calm. The key to the Wealth Protection Signal is that it's a process. Most clients have no process for when to get out of the markets - other than a gut feeling. Even more important than knowing when to get out is knowing when to get back in. The Signal is systematic on both sides of the trade. If we ultimately head higher and the worst if over (i.e., Black Monday), well only 10% cash was raised, which means 90% of the portfolio is still at work in the markets. However, I would also caution clients that multiple cracks in the system means something else could be at work and more downside could be in store.