Magical Disinflation Theory
This week, the S&P 500 broke below its rising trend channel that has defined the rally off of December lows. The channel trend break sets up a possible back test of clustered S&P breakout levels and support zones in the $3,900 to $4,000 range. How the S&P 500 navigates that clustered support zone will provide a key technical indication of market direction going forward. A successful retest followed by a renewed rally will set up a case for more positive price action. A failed retest that breaks below support will be a strong indication that the stock market’s Goldilocks moment has passed.
At the start of the year, markets enthusiastically relegated 2022 and its laundry list of economy- and market-relevant issues to the wastebasket of history. The new year came with new hope, but suddenly—if unsurprisingly—2023 is turning back the calendar and broadcasting issues eerily reminiscent of its 2022 predecessor.
The case for a swing back to “risk-off” markets was bolstered significantly this week by the most concrete signs yet that “immaculate disinflation” is a hope, not a strategy, and that victory over inflation won’t come easily. The 1960s brought us the “magic bullet theory”; 2023, on the other hand, seems to have conjured “magic disinflation theory.” With an economy plagued by inflation fever throughout 2022, markets in 2023 have fixated on an immaculately perfect scenario in which inflation crashes back down to the Fed’s 2% target and stops on a dime (thus avoiding a deflationary scare). All the while, growth chugs comfortably along and the economy avoids any accidents or recessionary side effects from Fed policy. Magic disinflation would, in theory, enable an imminent end to the Fed hiking cycle, a subsequent Fed pivot to stimulative rate cuts, a soft landing for the economy and markets, and a resumption of the good old bull market bubble days of recent years. The scenario has mouthwatering appeal for market bulls. It’s neat, tidy, and conveniently pleasing—but it’s also, unfortunately, totally fanciful.
Inflation was unquestionably the story of this week. A structurally tight labor market, strong credit growth, Western quantitative tightening offset by Eastern quantitative easing, and recent loosening of market-based financial conditions were all manifest this week in reheating inflation data and other economic data prints of the hot–not healthy variety.
First it was Tuesday’s January Consumer Price Index (CPI) report that set the inflationary tone for the week. Headline CPI increased 0.5% month-over-month (M/M) for its strongest gain in three months and a marked acceleration from last month’s upwardly revised 0.1% M/M increase. The year-over-year (Y/Y) reading came in at 6.4% vs. the 6.2% expected. Meanwhile, core CPI increased in line with expectations at a 0.4% M/M pace (matching the increase in December and up from October and November levels) for its 32nd straight monthly increase.
Of additional concern, while used car prices (a key bellwether of the overall inflation trend since Covid) declined 1.9% in the January CPI and represented a significant disinflationary input, they have skyrocketed an alarming 4.1% so far in February. The reversal of used car price disinflation increases the threat of realizing a renewed trend toward hotter-than-expected inflation data in next month’s report. The data also confirmed that consumers have now been victimized by 22 straight months of negative real “inflation adjusted” wages.
Ratcheting up the temperature on the inflation gauge further was Thursday’s wholesale January Producer Price Index (PPI) release. Rising producer prices tend to lead consumer price increases. In that light, the significantly hotter-than-anticipated PPI results were a special cause for concern. Headline M/M PPI increased 0.7%, well above the expected 0.4% consensus, and even over the hottest 0.6% forecast. January’s unexpectedly strong M/M jump marked an unsettling turnaround from December’s 0.2% decline that was upwardly revised from an initial -0.5% reading. Year-over-year, PPI increased by 6% compared to the 5.4% expected. Core PPI also registered hot. Month-over-month core was 0.5% vs. 0.3% expected, while year-over-year core PPI was 5.4% vs. the 4.9% expected.
All in all, life just got significantly more complicated for Powell and the Fed. At this point we’re seeing only one month’s data, but it looks as if loose financial conditions and rallying markets have already started to feed back into economic demand and inflation. In addition, the Atlanta Fed’s wage growth tracker, while slightly off the peak, stalled in January at the same level as December. Overheating wage growth is a key to perpetuating inflation, and the wage tracker continues to run hotter than at any time before 2022.
The picture from economic data this week was mixed, but generally confirmed the economic heat observed in the CPI and PPI. New US home construction retreated for a fifth straight month in January, and disappointed expectations as elevated mortgage rates, creeping higher again, continue to hit housing demand. On the other hand, homebuilder sentiment rebounded significantly.
On the manufacturing front, it was a tale of two cities. The New York Federal Reserve’s latest Empire State Manufacturing Survey’s general business conditions index rose dramatically to -5.8, up from January’s reading of -32.9, significantly beating expectations for a -18.2 reading. So after a sharp drop in January, manufacturing activity this month remains in contraction territory and continues to decline, but at a greatly reduced pace. Painting the mirror-opposite of the NY Fed’s M/M change, the Philadelphia Fed’s Manufacturing Survey performed an elegant cliff dive to -24.3 in February, down sharply from January’s -8.9 reading and significantly overshooting the -7.4 expected.
Most significantly, the retail sales print this week significantly bucked its recent weakening trend observed in November and December. January nominal retail sales spiked to 3% after the prior month’s negatively revised 1.1% decline. The results blew past the Bloomberg consensus estimate of 1.7%. The volatility of the series lately may be partially attributable to the belief that a much larger than normal number of consumers this year deferred holiday purchases during November and December in order to take advantage of post-holiday January discounts. If we smooth out the data, while keeping in mind that nominal retail sales data is bloated by inflation, it tells the story of a consumer still willing to spend more for the same amount of “stuff” in order to keep up living standards. The game, however, is getting late, and the dynamics are unsustainable.
This week, the New York Fed’s Household Debt and Credit Report for the last quarter of 2022 showed that consumer credit card balances have reached a record high, and that the $61 billion quarter-over-quarter increase was the biggest ever increase in data back to 1999. The Q4 credit card binge was half the full year total of $130 billion, itself an annual record. But credit borrowers aren’t just turning to plastic at a record pace, they’re missing payments as well. The NY Fed data also showed that delinquency rates are now surpassing pre-pandemic norms.
Worse still, according to the NY Fed, “This is particularly concerning for younger borrowers who are disproportionately likely to hold federal student loans that are still in administrative forbearance. Some of these borrowers are struggling to pay their credit card and auto loans even though payments on their student loans are not currently required.” The simultaneous acceleration in both plastic swipes at cash registers and delinquency rates into 2022 year-end strips the luster off Wednesday’s strong retail sales data.
The debt binge is a late-cycle phenomenon (we saw the same thing heading into the great financial crisis). It’s unhealthy and unsustainable, but not surprising. When looking at the spread of incomes and savings versus the inflation adjusted cost of living, a record shortfall is now evident. The gap, or shortfall, is the largest ever in data back to 1950. If you want to understand the boom in credit card balances, understand that the average consumer, unless willing to accept a lower standard of living, now requires $7,500 of annual debt to fill the shortfall left by the gap between disposable personal income and the cost of living. So, unless magical “immaculate” disinflation solves the problem, maintained levels of retail sales accompanied by an ongoing boom in credit card balances is not a sign of health, but a slow-motion train wreck in progress. As HAI mentioned last week, banks see the dynamics unfolding. That’s why they’re increasing loan loss provisions and have quickly tightened lending standards to levels always historically consistent with recession or crisis.
Now, while loosening financial conditions and rallying markets have sent a short-term demand impulse into the economy, the long-lead economic indicators continue to decline into ever-deeper recessionary territory. Corroborating the recession signal from the historically perfect Conference Board Leading Economic Index, the Economic Cycle Research Institute (ECRI) updated its long-lead economic indicator this week. ECRI’s indicator has now sunk to low levels rivaled only by the decline seen heading into the great recession era in data going back to 1994. As ECRI’s Lakshman Achuthan described this week, “That decline [in the long-lead index] is a recessionary decline… The weakness in the index is just undeniable.”
Fed tightening policy acts on economic activity with long and variable lags. As Achuthan observed this week, the majority of the rate hikes seen to date, “certainly since last summer, are only beginning to hit the economy now. And [ECRI] had a recession call on before that, based on the big cyclical components of the economy which are cycling down pretty darn hard. I don’t know how severe this recession is ultimately going to be, but [the long-lead index] would argue for it being more severe than mild.”
The critical point is that ECRI’s recession call is based on the cyclical downturn the model identified off the post-Covid boom. The effect of Fed efforts to tighten policy are essentially to assist the negative momentum of an economic cycle whose gears have already clicked into a setting that, all else equal, is running towards contraction. If in the wake of recent inflationary data the Fed responds by upping its inflation fight with a hawkish policy follow-through, the question as it pertains to recession is less one of if and more of when and how bad.
As previously stated, all in all, life got significantly more complicated this week for Powell and the gang. Loose financial conditions and rallying markets have already started to send a short-term demand impulse into the economy, one that is stalling disinflation or outright re-stoking inflation. With the fed funds rate still well below CPI, Powell and the Fed must face the hard truth observed by legendary hedge fund manager Stanley Druckenmiller when the first ballot hall of fame investor noted that, “Once inflation gets above 5% it’s never comes down unless fed funds have gotten above the CPI.” That means that Powell has a whole lot more work to do if he wants to keep his promise to bring inflation down to the Fed’s 2% target “unconditionally.”
Conversely, with the threat of recession already looming as we move later into 2023, Powell must also face another hard truth expressed this week by economist Mohamed El-Erian. In light of the recent data, El-Erian warned that, “I don’t think [the Fed] can get CPI to 2% without crushing the economy.” So, to Druckenmiller’s point, you can’t get inflation down to target without further jacking fed funds significantly higher, but, to El-Erian’s point, if you jack rates to the level needed to get CPI to 2%, you’re “crushing the economy.” The Fed’s choice leaves much to be desired.
If the Fed gives up on the 2% target, settles for high inflation, perpetuates a sick economy, and buys time for the government’s worsening fiscal situation, it eviscerates credibility and invites a prolonged 1970s-style stagflationary crisis that could take on devastating, incendiary, Austrian crack-up-boom characteristics. Finish the job on inflation with higher rates for longer into a recessionary economic downturn, and the Fed invites the hardest of hard landings. One route or the other, the Fed’s choice is rapidly approaching. The message embedded in this week’s data is clear. It argued loud and proud that the “easy” part of the inflation fight is over. While “magic disinflation theory” sounds great, it doesn’t work in the real world—just in the magical “Neighborhood of Make-Believe.”
Weekly performance: The S&P 500 was down 0.28%. Gold was down 1.30%, silver lost 1.63%, platinum was lower by 3.19%, and palladium got smacked lower by 2.12%. The HUI gold miners index lost 4.77%. The IFRA iShares US Infrastructure ETF was up 1.64%. Energy commodities were volatile and lower on the week. WTI crude oil dropped 3.98% while natural gas continued plunging to new lows, down 9.51%. The CRB Commodity Index lost 1.87%, and copper gained 2.24%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 1.21% on the week, while the Vanguard Utilities ETF (VPU) was up 1.20%. The dollar was up 0.23% to close at 103.78. The yield on the 10-yr Treasury gained 8 bps to end the week at 3.82%.
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
