The past week saw rising anxiety about a flattening yield curve rise to a crescendo. The 2s10s spread narrowed to as low as 40 bps before recovering and ending the week at 46 bps. Coincidentally, the BoA Global Fund Manager Survey showed an overwhelming majority of respondents hold believe the yield curve will flatten.
Even though it hasn’t inverted yet, an inverted yield curve has signaled recessions in the past. This raises two key questions for investors.
- What’s the near-term outlook for inflation?
- Is the Fed willing to drive the economy into a recession in order to fight inflation?
The Fed’s dilemma
Let’s begin with the good news. The 5×5 inflation expectations (blue line) remains tame, even as current inflation indicators such as core CPI (red line) skyrocket seemingly out of control.
The bad news is that global central banks are tightening into a slowdown. Global manufacturing PMIs are falling. The percentage of OECD countries with rising leading indicators is tanking.
Similar evidence of economic deceleration can be found in the US from a variety of sources. This is just one example.
Against a backdrop of an elevated reading in the monetary policy component of the Economic Uncertainty Index, how does the Fed resolve this dilemma?
The view from Oregon
Well-known Fed watcher Tim Duy of SGH Macro Advisors and the University of Oregon conducted a Bloomberg podcast interview and provided some answers. The podcast lasts about an hour and well listening to in its entirety, but the main points are summarized below.
Duy believes the Fed is deeply behind the inflation-fighting curve and unknowingly made a policy error. He characterized the COVID shock as a snowstorm and not a persistent loss of demand. Policy makers did not understand the situation at the time and responded with a full suite of fiscal and monetary stimulus.
As the snowstorm passed, the economy experienced a fairly rapid recovery. Arguably, quantitative easing was not necessary past mid-2020 because financial markets were already functioning well by then. In short, the Fed’s policy error was to pile on too much monetary stimulus. The Fed should have begun to tighten in 2020 as a monetary offset against fiscal expansion.
Hindsight is always 20-20. In retrospect, it would have been politically very difficult for the Fed to withdraw stimulus in 2020 in the midst of a COVID shock, especially when no vaccines or treatments were in sight.
As the economy stabilized and vaccines began to become available, successive COVID waves saw less and less economic impact. The economy experienced a strong jobs market recovery, it led to growing inflationary pressures that the Fed was late to spot.
As a consequence, Duy believes inflationary pressures have embedded in psychology. The Fed needs to get rates up to neutral quickly, which amounts to about 150bp by year-end.
The challenge is to break a nascent psychology that’s leading to an inflationary spiral. Companies have shown that customers are willing to accept price increases in response to rising input costs. This is leading to more and more inflationary pressures.
The traditional way of breaking an inflationary spiral is through the wage growth mechanism. Historically, wage growth expectations are very sticky. Unless the Fed can guide expectations back down, it will have no choice but to induce a recession to crater wage expectations.
The optimal outcome is a series of rate hikes, followed by a moderation of inflation back to 2%, and a tight jobs market.
What about the Fed Put? Duy said that any Fed Put exists mainly for the credit markets, not the stock market. The Fed doesn’t care very much if stock prices fall unless it’s a 1987-style crash. It will act should credit spreads blow out, or if liquidity in the banking or financial system seizes up as it did during the GFC or the Russia Crisis.
Inflation hysteria
Tim Duy is a seasoned Fed watcher with a strong track record. But I believe Duy may be suffering from a case of inflation hysteria that has gripped the markets in the past few weeks.
Ned Davis Research has a 22 component Inflation Timing Model and it just rolled over into neutral. Historically, neutral readings have been constructive for equity returns.
While anecdotal evidence indicates that companies have been able to pass on price increases, which is contributing to inflationary pressures, that effect may be a bit of an exaggeration. FactSet reported that near 75% of S&P 500 cited “inflation” on earnings calls, which is a worrisome development.
However, net margin expectations are in retreat sequentially by fiscal quarter and fiscal year, indicating that some companies are experiencing difficulty passing on price increases, which is a positive for the inflation outlook.
Given the high number of S&P 500 companies that have cited “inflation” on Q4 earnings calls, have net profit margin expectations for the S&P 500 for Q1 2022 and CY 2022 been revised? The current net profit margin estimate of 12.3% for Q1 2022 is slightly below the estimate of 12.4% on December 31, while the current net profit margin estimate of 12.7% for CY 2022 is slightly below estimate of 12.8% on December 31.
While the conventional approach to the economic policy of breaking the inflationary spiral is through the wage link, another way is to break the operating margin link if companies cannot pass on price increases. While large-cap S&P 500 is showing some minor margin pressure, small businesses are experiencing much greater margin pressure, which is a positive development for the inflation outlook. The January NFIB Small Business Survey shows that prices are skyrocketing.
Even as prices rose, earnings have been in a downtrend, indicating margin pressure.
A CNBC report indicated that small businesses lack bargaining power with suppliers and customers, which is squeezing margins.
“They are getting squeezed by supply chain disruptions and inflation and workforce shortages and already had to reinvent themselves a few times over in the past few years, and are running out of options,” said Kevin Kuhlmann, who leads the NFIB’s government relations team. “They are continuing to adapt … but you can only increase prices so much before you might see a loss,” he said.
A slowdown, but no recession
While I am not inclined to front-run model readings, New Deal democrat, who monitors a series of coincident, short-leading, and long-leading indicators is calling for an economic slowdown in 2022, but no recession.
The long leading forecast remains weakly positive. Mortgage rates in particular are now a negative for the housing market. Yields on bonds from 1 year duration out through the intermediate maturities have continued to increase, anticipating Fed rate increases, as the Miller score has been suggesting for months…
The expansion is decelerating, and will continue to do so. In context, what is really happening is that a white hot economic Boom is ending, and a more normal, somewhat patchy, expansion will continue for a while. When the leading indicators that I have tracked consistently for over 15 years signal a downturn, I will not hesitate to tell you so. Now is not yet.
Subsequent to the publication of that analysis, NDD concluded that the trend in retail sales is foreshadowing a job market slowdown in the coming months. Despite January’s positive surprise, real retail sales have not exceeded the high from last April.
Retail sales, one of my favorite “real” economic indicators, rose sharply in January, up +3.8% for the month before inflation. After inflation, “real” retail sales were still up +3.1% for the month, although they are still down -2.2% from last April’s peak:
Note that these comparisons almost certainly will turn negative in March. Probably more important is that, as shown in the first graph above, they have been essentially flat since last April. That’s not recessionary, but it’s not good either.
In short, this report remains consistent with a slowdown in the consumer sector of the economy.
Next, let’s turn to employment, because real retail sales are also a good short leading indicator for jobs…That’s because demand for goods and services leads for the need to hire employees to fill that demand. The exceptions have been right after the 2001 and 2008 recessions, when it took jobs longer to catch up, as shown in the graph below, which takes us up to February 2020.
The signs are lining up for inflation pressures and employment growth cool off in the next few months. It will take the pressure off the Fed to tighten.
In addition, the flattening yield curve may not as strong a signal of recession odds in the current circumstances. The conventional metric for measuring the yield curve is the 2s10s, or the yield spread between a 10-year and 2-year Treasury note. Historically, an inversion in the 2s10s has been a strong indicator of a pending recession. This time may be different. In the past, a flattening 2s10s has been confirmed by a flattening spread between the 10-year Treasury yield and the 3-month T-Bill. This time, the two series have diverged. This can be explained by a strong rise in the 2-year Treasury yield that was not followed by the 3-month T-Bill.
The divergence can be explained by market expectations that the Fed will raise rates, which has put upward pressure on the 2-year while the 3-month rate, which represents current policy, remains low. This is a divergence to keep an eye on. It may be a signal that the market tightening consensus has gotten ahead of itself and the odds of a recession may not be as high as believed.
Inflationary pressures will begin to ease in the next few months and so will the trajectory of monetary policy.
Be cautious and prepare for opportunities
Investing in the current economic environment of uncertainty will be challenging. I reiterate my recommendation to be cautious in equity positioning with an overweight on defensive sectors and high quality stocks (see A 2022 inflation tantrum investment roadmap).
The bearish impulse of the current market cycle isn’t over. The S&P 500 surged off the March 2020 bottom by exhibiting a series of “good overbought” conditions as defined by over 90% of S&P 500 stocks over their 200 dma. The “good overbought” advance petered itself out in mid-2021. While the jury is still out on whether the market will consolidate sideways as it did in 2004 and 2014, or undergo a major downdraft as it did in 2010 and 2011, similar episodes have not ended until the percentage of S&P 500 above their 50 dma dipped below 20% (bottom panel).
Investment-oriented accounts should also begin to accumulate positions in large-cap high quality growth stocks. When the narrative pivots from strong inflation to slowing GDP, FANG+ stocks are likely to catch a bid as investors pile into quality growth in as growth becomes scares. Growth stocks, and in particular technology stocks, are becoming washed-out. The latest BoA Global Fund Manager Survey shows that respondents have stampeded out of the tech sector while believing that long US technology is the most crowded trade.
The Ned Davis chart is another case where using averages over a long period can lead confidently to the wrong conclusion. Yes, on average, the neutral zone has led to a 6% average annual gain. But, if you look on the chart at the first surge up in inflation in the 1970’s when Arthur Burn’s infamous Fed first lost control of inflation (like now), the move from the peak in 1973 (where we are rolling from today) down through the neutral zone to the low point at the end of 1974. That 1973-1974 bear market was the worst since the Depression. It was ugly. Future examples of the DJII going through this zone must have been very good to have the ‘on average’ at plus 6%.
My read is that like the infamous Burn’s Fed, the current Fed has lost control. The first surge in inflation in the early 1970s, was underappreciated by them and they stayed behind the curve until Volker came along a decade later.
Few people today remember inflationary times or lived through them. The population’s ‘inflation expectations’ will be an unreliable gauge and likely way too low.
Central Bankers are now embarking on a full-on war with inflation. D-Day is the March Fed meeting, with many battles to follow. Anzio and the Battle of the Bulge, defeating Rommel in Africa, on and on. On the Pacific front, Iwo Jima, and naval battle before the atom bomb finally ended the war. You get my point.
The Fed is SERIOUSLY behind the curve. Since the turn of the century, they have been overly timid about taking tough monetary measures. This has led to bubble after bubble. Tough measures are needed now. If they shy away as the Burn’s Fed did in the 1970’s, the inflation war will be very long with much damage with some future Volker dropping an atomic bomb to stop it. Or they might go the way of ancient Rome and let high inflation ruin the empire because it’s a continuing, easier short-term political path.
Ken & Cam,
Just a few questions;
1)How much of a factor in our current inflation do you see the supply chain issues in percentage terms? e.g. say 50% ?
2) When these supply chain issues ease do you see inflation coming down by the % you nominate above?
3) What do you see as the main causes of inflation as well as supply chain issues? e.g. low interest rates, oil prices or stimulus money or other ?
Thanks for your feedback.
Gordon
I have been through many times since 1970, when the Fed has started raising rates after stocks have been in a bull market and the economy is good. EVERY time, trusted market strategists call for a ‘soft landing’. Unfortunately it NEVER happens. We ALWAYS have a hard landing with a recession. As Cam says, recessions are bull market killers.
If that is the case again, forget the future analyst earnings estimates that investors are hanging their hat on. They will be downgraded big time as the Fed’s war on inflation rages on and a recession happens.
In a hard landing environment, only profitable companies will survive since buyers of junk bonds of no-earnings meme stocks will no longer be there. Cathy Woods owns a a bucket full of no-earnings stocks with sexy business plans that need constant new money (junk bonds and new stock issues) to offset massive continuing losses. That dumb money goes away in a hard landing.
Sorry to be so bleak but sometimes reality sucks.
If I understand it correctly, the thesis for winter chill is:
A. 1973/1974 recession is a template for 2022/2023.
B. Powell Fed is no better/different than Burns Fed in tackling inflation.
C. Reasons for why inflation is high are irrelevant
D. Recession is the only cure.
E. Fed always tightens too much.
If my memory serves me right, oil shock was one of the major reasons – an exogenous event. US was totally dependent on oil imports.
The Fed is focused on both jobs and inflation. Fed functions differently. Economy is remarkably different now.
Just because Fed is behind the curve, it’s not evident that recession is the only path.
Yes, business cycle is not dead. There will be a recession some time in the future.
Excellent analysis by Cam and Ken. In previous posts it was stated that IEF never ended in red two consecutive years. It closed in red in 2021 and YTD. Can we spot a nice entering point? Or maybe it could be the first time it loses by two consecutive years?
Be patient. The turning point is just ahead. I’ll write about that soon.
I see a big decline at some point in 2022. But I also think the indexes rally before that happens.
I’ve lived through all the recessions since the Seventies as an adult.
(a) In January 1973 I dropped out of college, hitchhiked around the country, and worked a stream of jobs that introduced me to people and cultures I would never have encountered otherwise. Unemployment levels were high. I recall passing around a can of beans and a loaf of bread with a bunch of guys in a parking lot outside Tucson. Several months later (after a month of washing dishes at a restaurant in central Washington) I would drive along the Columbia River Basin with one of the short-order cooks on his way to visit family in California. Hands down the best drive through the prettiest vistas in my life. My next job was at a tennis ranch in Carmel Valley – you’ll find some of the nicest people in the world among those who live day to day just above the poverty line. Clint Eastwood’s career was taking off with the second of his Dirty Harry movies.
(b) During the 1980-82 recession I was in the midst of my first graduate program. Working weekends and summers making $6 to $7/hour was enough to keep my student loan balance under 10k upon graduation. Life was simple and uncomplicated. I caught Judy Collins, Bob Dylan and Miles Davis at Hill Auditorium in ’81. Watched ‘The Empire Strikes Back’ twice one summer.
(c) I moved to California at the start of the 1990-91 recession. Too busy working and starting a new career to notice the recession. It was a few years later, after I’d bought my first home, that my neighbor mentioned the price I’d paid was 30% lower than it had been a year or two earlier. Since then, I’ve noticed that housing recessions/recoveries lag economic recessions by a period of months to years. I watched my home value continue to decline every year for the next few yeasr – until the dot.com boom jacked prices up almost parabolically into Y2K.
(d) Parabolic rises will almost always lead to another recession. We relocated to our current home in early 2003. The previous owners lost their jobs following the dot.com bust, tried unsuccessfully to reinvent themselves/ start their own company, and moved back East. I recall seeing their young son playing of the floor of what is now my office.
(e) The 2008-9 recession was IMO widely telegraphed. I made repeated mention of freeways clogged with brand new Navigators and Benzes. Radio ads offering home loans to anyone with a pulse. The iconic story of a husband and wife who earned $600/wk qualifying for a 750k home. I predicted that our home would decline in value over the next few years – and in fact it pulled back almost 50% to our original purchase price.
(f) The Great Recession of 2020 was, as we all know by now, the anti-recession. The fact that home prices would lag the economic hit was so ingrained in me that I advised my older kids against buying their first home in late 2021. Prices had actually edged higher in 2021, and I was afraid they would regret the move. I was dead wrong. Following the +20% spike last spring their homes were +30% above their purchase prices and had they waited would have been priced out.
(g) The recession of 2022? If there’s one thing I’ve learned it’s that life and the markets are unpredictable. The Fed may or may not excessively tighten. Regardless of what the Fed does, we may or may not experience a recession. If a recession comes, the markets may or may not pull back significantly. If they do pull back, they may do so from substantially higher levels.
Losing my bearings- the Great Recession dates in the post above are off by a year. My kids bought their homes in late 2020 (after prices had unexpectedly edged higher following the pandemic crash), and it was in the spring of 2021 when home prices here experienced a +20% spike.
From a sentiment standpoint, the past two weeks has been about as negative as I can recall.
Every time sentiment has approached these levels, it’s been my experience that a buying opp has either arrived or is around the corner. That’s pretty much my entire rationale for scaling in last week.
Fear is a powerful factor and while your observations about sentiment are rational, it has to be seen in the context of what the newsflow has been. How confident can you be right now that energy prices and other inflationary forces are going to come down without a recession? And even without a full scale Ukraine invasion taking place, can we assume that Germany will ratify Nordstream 2 and happily rely on cheap Russian gas for the foreseeable future while Russia continues to export oil to the US and other western countries? Will Russia reaccelerate ammonium nitrate exports? The Fed has not even started to take action and as long as there is no action the fear of them losing control of inflation is very much in place and not even completely irrational. Don’t even get me started on the ECB and them losing control of inflation. The turnaround will be difficult to time. There is another CPI report coming up in March and so on.
Other notable divergences on the 10y-2y vs 10y-3m chart are: 1994 and 2004. Both were years when the fed started to hike the rates when the inflations were “hot”.