12.06.2021: A newly reappointed Jay Powell flexed his political capital by declaring inflation may not be transitory after all, suggesting that America’s central bank will need to end its quantitative easing program sooner and setting the stage for higher overnight rates by early next year. The news, when combined with ongoing omicron uncertainty, rattled equity investors. For the week ended December 3rd, the S&P 500 are off 3.5% off its high, while the Russell 2000 index of small cap stocks retraced nearly 12%. Short term Treasury yields rose while longer-term rates fell, suggesting a tightening Fed will result in a slowing economy. Volatility across most asset classes soared, with the VIX doubling from 15 to over 30, reflecting the heightened risk environment.
Meanwhile, consumer confidence plunged to its lowest level in over a decade, as price hikes outpaced wages. The inflation surged is due to combination of supply chain bottlenecks and pent-up demand for goods sourced abroad. Prices, as measured by headline CPI, are 6.1% higher than they were last year at this time, with energy prices posting a 20% increase. Housing, comprising nearly half of the CPI basket, has gotten 4.5% more expensive over the last 12 months.
We believe the Fed has got it wrong and the FOMC will not need to follow through on its aggressive tightening strategy next year. That’s because supply chain shortages are beginning to loosen, and household spending will likely head lower. Call it “animal spirits,” but changes in consumer confidence tends to lead retail sales. The University of Michigan survey reflected slipping confidence in both current conditions and economic prospects. That, against a backdrop of a red-hot jobs market, is remarkable. With confidence in the doldrums, we expect retail sales growth to retreat. Retail sales are 16% higher than it was last November. The sudden surge in selling activity challenged global supply chains. We expect sales growth to slow due to sagging confidence and more difficult comparisons.
Moreover, supplemental income from government checks to middle- and lower-income Americans dried up in recent months. Income distributions which peaked at close to $1.4 trillion in June of last year, fell below $100 billion last month. This will weigh on both confidence and spending as we enter 2022.
At the same time, supply chain problems are easing. While shipping container rates are about double what they were last year, that’s down from 368% as recently as the beginning of the year. Faced with the prospect of long waits for furniture, appliances and building materials, consumers are opting out, leaving unwanted goods to pile up in US warehouses. ISM’s new orders minus inventories, a useful coincident economic indicator plunged in October to below its historical median. The indicator was situated at a 10-year high as recently as May. The US supply chain is quickly un-jamming and could in fact be a drag on Q1 2022 economic growth as inventories are wound down.
Widespread pessimism envelopes equity investors also. A recent survey of American Association of Individual Investors showed that those calling themselves “bulls” were in the bottom decile of its historical range, reflecting inflation concerns, omicron uncertainties and higher volatility. A useful contrary indicator, extreme bearishness has historically ushered in market rallies. In fact, the S&P 500’s return when investors are overwhelmingly bearish is, on average, more than double its return when bullishness prevails.
Meanwhile, the bond market, which is double the size of the equity market and is dominated by institutional investors, holds a more sanguine view. Bond investors have historically held an analytical, rather than an emotional, perspective toward the future. They believe the current inflation flareup will subside while interest rates will not need to go much higher. They project inflation is already near its peak and will rapidly decelerate below 2.5% by 2024, based on current TIPs trading. The Treasury market also suggests the one-year Treasury yield to peak at 1.6% by 2024 before trending toward at 1.5%.
The bond market paints a rosier picture of interest rates and inflation than do equity investors and that’s good news. Given the difference in size and sophistication of the bond market, and its superior track record of prediction, at least relative to the equity markets, we believe Fed fears are overblown and inflation and economic growth will gradually fall to their longer-term trends without much Fed intervention.