Looking for inflation in all the wrong places

Last week, I suggested that even though Fed Chair Powell voiced a balanced view of inflation, a voting bloc of hawks (Waller, Bostic, Barkin, and Bowman) on the FOMC may be a key obstacle to the market expectations of a June rate cut. Indeed, Atlanta Fed President Raphael Bostic reiterated his view last week of one rate cut in 2024 and the first cut should occur in Q4.


Based on the speeches of Fed speakers, a divide of opinion is appearing in the FOMC. On one hand, Fed Chair Powell has said that January and February PCE reports represent a bumpy path to the Fed’s 2% inflation target, hawks such as Governor Waller have raised concerns about the persistence of inflation and asked, “What’s the hurry [to cut rates]?”

As well, Chicago Fed President Goolsbee revealed that he wrote down two rate cuts for 2024 in his dot plot projection, which is a surprise as he has been regarded as a dove. Moreover, he stated that if inflation continues to move sideways, it raised doubt as to whether the Fed should cut at all. Minneapolis Fed President Kashkari also revealed that he wrote down two rate cuts for 2024, and also openly wondered if the Fed needs to cut if progress on inflation stalls.

Is it time to say goodbye to a June rate cut? What about the expectation of three cuts this year?
As a reminder, the Fed targets headline PCE as its main inflation metric. Both headline and core PCE rose in January and February after a series of tame readings in late 2023. The key question that concerns Fed officials is the last mile inflation question. How persistent is inflation and what’s the path to the 2% target? Investors may gain some insights from the FOMC meeting minutes, which are due to be released in the coming week.



Not your father’s inflation scare

From one perspective, the market’s perception of inflation appears tame as conventional inflation hedges are not signaling any signs of anxiety. From a global perspective, even though the CRB Index staged an upside breakout from a multi-year base, the relative performance of the stock markets of resource extraction countries are weak.



The technical picture of inflation hedge sectors and industries look more constructive by comparison. Most are forming saucer-shaped relative bottoms. Even then, they have rallied into relative resistance zones that may need a prolonged period of consolidation before they could emerge as market leaders.



Bad inflation vs. good inflation

Yet, some Fed policy makers are worried about the persistence of inflation even though conventional inflation hedge vehicles are not behaving well. What’s the story?

That’s because analysts are confusing the concepts of “bad inflation” and “good inflation”. Bad inflation is what investors saw in the 1970’ and early 1980s, which is a period of both cost-push and demand-pull inflation that drove up inflationary expectations. Hard asset are hedges against outbreaks of “bad inflation”.


By contrast, “good inflation” is a by-product of an economic recovery and stronger growth expectations. As long as economic growth produces positive productivity gains, mildly higher prices, or “good inflation”, should not be feared.


< div style="text-align: left;">I would argue that the U.S. is experiencing a period of “good inflation”, as evidenced by the pivot in market consensus from a soft-landing to a no-landing scenario.


Here are the key differences between the two scenarios. A soft landing sees strong economic growth, but inflationary pressures fall and the Fed cuts rates in order to bring real rates down.


A no-landing scenario sees strong economic growth which creates persistent “good inflation” pressures, supported by strong fiscal spending and a compliant Fed that doesn’t tighten monetary policy. The soft-landing scenario translates into a stock bull and bond bull. The no-landing scenario is positive for stocks, but neutral to negative for bonds because of higher inflationary expectations.


No-landing ahead

The market consensus is shifting toward the no-landing view as growth expectations expand.
The Atlanta Fed’s GDPNow nowcast of Q1 GDP growth is 2.5%.


The NFIB small business survey is a useful indicator of growth as small businesses have little or no bargaining power and they are therefore useful barometers of the economy. The latest survey shows that the small business outlook has turned the corner and growth expectations are rising.


Meanwhile, over on Wall Street, forward 12-month earnings estimates are strongly rising.


The latest ISM survey shows a manufacturing recovery and strength in prices paid, which is a sign of “good inflation”.


The slightly stronger-than-expected March Jobs report confirmed the recovery narrative. Headline employment rose by 232,000, well ahead of the estimated 160,000, and average weekly hours rose 0.1 from 34.3 to 34.4. The participation rate rose from 62.5% to 62.7%, which is a sign that a growing economy is drawing people into the workforce.


As growth and inflation expectations rise, the term premium should follow. This will put upward pressure on yields and downward pressure on bond prices.


I have documented how labour productivity has risen. Even though productivity readings are noisy, they may rise further as companies adopted Artificial Intelligence technology into their processes. Early studies show an average 25% leap in productivity upon the adoption of AI.


We are still early in the AI cycle game. The U.S. Census conducted a study of AI adoption between September 2023 and February 2024. It found that “bi-weekly estimates of AI use rate rose from 3.7% to 5.4%, with an expected rate of about 6.6% by early Fall 2024”.


Positioning for a no-landing outcome

Putting it all together, the market consensus is pivoting toward a no-landing outcome. While inflation may be somewhat persistent, investors who try to hedge inflation under a no-landing scenario using conventional hard asset vehicles will be disappointed.


Instead, the leadership is showing up in cyclical industries. Instead of positioning in energy and mining, investors should focus on cyclical industries like infrastructure, homebuilding and semiconductors, all of which are exhibiting leadership qualities.


The persistence of cyclical leadership is likely to continue at least until the end of 2024. John Butters at FactSet pointed out that the earnings growth of the Magnificent Seven is forecast to decline into H2 2024, while earnings growth of the rest of the 493 in the S&P 500 is expected to rise. This will provide a fundamental tailwind to the rest of the stock market and a rotation from growth to value for the remainder of 2024.



Fiscal dominance = Bad inflation?

In summary, market expectations are shifting from a soft-landing to a no-landing outcome, which should be bullish for stock prices and neutral to bearish for bond prices. Investors should position for the elevated inflation readings from a no-landing scenario in cyclical stocks.


That said, I am sympathetic to the view that the current era of fiscal dominance will eventually resolve in a period of bad inflation or stagflation, which is inflation with little or no growth. The non-partisan Congressional Budget Office has projected significant budget deficits for the next 10 years.


As a consequence, projected net interest expense is expected to rise, both as a percentage of federal government revenue and of GDP.


However, this era of fiscal dominance may not be a disaster. If developed economies like Singapore can sustain a debt/GDP ratio of 170%, and Japan can sustain one of over 250%, the U.S. will survive, especially in light of its exorbitant privilege of the USD as a major reserve currency that sustains demand for Treasury paper.


I am speculating, but under the circumstances it would not be surprising to see the Fed shift slowly to an unwritten 3% target for inflation from its current 2%, which would involve either more monetary easing or some form of financial repression. That’s when bad inflation starts to appear and hard assets become the market leaders. But that’s a 2025 or 2026 story.Gold, which is the classic inflation hedge, has staged a decisive upside breakout to new all-time highs, but the breakout was not confirmed by TIPS prices, which is not signaling runaway inflation.


That’s because most of the demand is coming from central bank buying, specifically the PBoC. Central bank activity tends to be more price insensitive. If and when bad inflation starts to appear, gold prices have the potential to soar.


For investors, conventional hard asset inflation hedge vehicles will have their day, but not yet.