The Credit Strategist Blog
Expectations surrounding April’s CPI report were hyped by media and Wall Street types looking for respite from the deepening bear market. When the number came in at 8.3% versus consensus forecasts of 8.1%, stock market futures moved from black to red and 10-year bond yields popped back above 3%. Day-to-day moves are noise; the direction matters and it is clearly downward. Inflation remains at 40-year highs and one monthly number doesn’t tell us much. The reason for this is that the type of inflation we are dealing with is not transitory (it never was) because its causes are not transitory - they were building for years. As explained in this newsletter, there were four longstanding policy forces feeding inflation - energy, labor, antitrust and monetary policy (and we can add fiscal policy as a fifth). Energy policy (especially green policy) forced the underlying price of energy higher for years. If we want cleaner energy, it is going to cost us. Labor policy (the push for higher minimum wages) forced wages higher as well. People are entitled to a living wage but consumers are going to have to foot the bill. The lack of any meaningful antitrust policy created more industry concentration and gave large industries and their companies enormous pricing power (remember, price increases in areas like healthcare are cumulative). And years of excessively stimulative monetary policy (QT/ZIRP) coupled with drunken-sailor fiscal spending infused the economy with trillions of dollars of excess liquidity that inflated prices (especially asset prices) - and that was before beyond-the-pale pandemic spending. These forces are structural in nature, deeply embedded in the economy, and difficult to reverse - or as we say, they are sticky. They are anything but transitory; they are not going away (except monetary policy - for now). The Fed only controls the fourth (monetary policy) and we are seeing the market effects of its attempt to reverse course (Congress continues to spend wildly, just not as insanely as during the pandemic). If I am correct that these forces rather than transitory ones such as supply chain issues or the war in Ukraine (which is not looking particularly transitory either especially with sanctions that are not stopping Russia but are costing American consumers a lot of money) are the deep drivers of inflation, then expectations of a rapid decline in inflation are unrealistic. Inflation will come down as the economy slows down later this year as consumers reduce spending in reaction to higher prices and many types of business activity slow down with the end of the capital markets bubble. Consumers are borrowing more money than ever (household debt just topped $16 trillion) and wages are trailing inflation; to my mind, these are not signs of strength but household wealth is higher (though concentrated and very unequal) so we have to look at these numbers carefully. Everybody has been conditioned for quick snapbacks from corrections over the last dozen years because the Fed came to the rescue every time stocks sold off. But this time the Fed is causing the sell off so no rescue is in the offing (for now). By July 4th it promises to raise interest rates by at least another 100 basis points and markets appear to be pricing that in. Forward 12-month consensus S&P 500 earnings estimates from Bloomberg are now ~$235.56 which means the market opened this morning at a 17x forward multiple which is in the range of fair value. Of course, consensus earnings are inflated by non-GAAP earnings adjustments but nobody pays attention to that so a lot of the damage may be done. More short-term damage is likely but long-term investors (those with multi-year time horizons) can start looking for stocks trading at decent valuations (investors still need to avoid infinite duration stocks). Inflation didn’t appear out of nowhere; it built up over many years and isn’t going to go gently into that good night. As long as the Fed remains serious about undoing the damage it caused, markets will remain shaky. But the Fed can only do so much - it can’t control energy, labor and antitrust policy and will struggle to get inflation back down to its 2% target (and when it does will be relying on the same flawed statistics that led it to claim inflation was lower than it was over the last decade). We are stuck in the mud thanks to years of less than optimal policy decisions. The best we can hope for is limiting the damage (he who loses the least in a bear market is the winner) and perhaps pray for our policymakers to start learning from their mistakes.