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Goods Inflation Likely Moderating — Inflation Focus Shifts to Services and Wage Costs — Economy Slowing-Mild or Deep? — Fed Must Avoid 70’s Stop-and-Go Rate Policy Errors — Equity Market Hopes – Is That a Strategy?

Date Posted: August 2, 2022

GDP Second Quarter Decline — First Real Signs of Economic Slowing — -First Quarter Quirky Decline Masked Internal Growth

The government’s “advance” estimate for second-quarter GDP showed a 0.9% decline. In comparison, GDP for the first quarter of 2022 declined 1.6 percent. This would suggest first quarter GDP showed weaker results than in this most recent quarter. However, because of the quirks in the calculations, first quarter GDP actually showed better performance and, in our view, actually grew. The 1.6% decline in the first quarter masked the fact that economic activity showed continued growth as measured by Final Sales to Domestic Private Purchasers (+3.0%). Despite strong final sales, lower net export numbers and reduced inventories dragged down overall GDP (see Figure 1). Separately, first-quarter Gross Domestic Income (GDI) increased 1.8% — GDI represents the income side and GDP the expenditure side of the national accounts — the results should be similar. The discrepancy between lower GDP and higher GDI brings into question first quarter results. In the second quarter, Final Sales to Domestic Private Purchasers came in flat — little changed. (Second quarter GDI will be reported in about a month.) Much lower agriculture inventories and reduced residential construction penalized second-quarter growth. However, overall broad signs of weakness in the quarter leave little doubt that an economic slowdown likely began. The NBER definition of a recession emphasizes it “involves a significant decline in economic activity that is spread across the economy and lasts more than a few months.” Despite two consecutive quarters of declining GDP, strong labor markets plus both increasing GDI and final sales to Domestic Private Purchasers makes it unlikely that the first half will meet the NBER definition of a recession.

Figure 1

Contribution to Real GDP by Sector (%)

Source: The Daily Shot

Chair Powell Labelled Funds Rate Neutral — With Both Core PCE and CPI Inflation Higher — Negative Real Funds Rate — Accommodative, Not Neutral

Headline CPI reached over 9% in June leaving the Fed little choice at its July 26-27th meeting but to raise the funds rate by 75bps, to a target range of 2 ¼ to 2 ½ percent. At the Fed’s press conference following the meeting, Chair Powell indicated that rather than providing forward guidance, rate decisions will be made meeting by meeting depending on the data received. Between this July’s meeting and its next meeting on September 20-21, the Fed will receive data from two employment and CPI reports which will help determine the level of future rate hikes. The Fed still expects the funds rate to reach 3¼-3½% by year-end and possibly 50 basis points higher in 2023. At the same press conference, Chair Powell labeled the current Funds Rate Neutral — neither accommodative nor restrictive, basing his assumption on the 2.4% ten-year breakeven inflation rate calculated by the Fed (see Figure 2). The Fed’s favored measure of inflation — core PCE Index — increased 4.8% in June. For many observers, this level of core inflation would imply a negative real funds rate and, therefore, accommodative, not neutral — and not the positive real rate needed to moderate inflation.

Figure 2

Ten-Year Breakeven Inflation Rate

Source: Federal Reserve Bank of St. Louis

Fed’s Failed 70’s Experience — Stop-and-Go Rate Policies — May Be Repeated If Fed Cuts Rates Too Soon

The Fed’s failed stop-and-go rate policies during the inflationary seventies, if repeated, may determine how successful the current strategies will prove. During that high inflationary period, each time the economy showed weakness, the Fed cut rates with the hope that inflation would peak. Instead, each time when the economy recovered, inflation reached even higher levels (see Figure 3). Finally, then Fed Chair Volker shocked the economy by raising the funds rate to nearly 20%. That past experience shows how hard it can prove to be to finally pull down sticky inflation. Certainly, circumstances leading to the current levels of high inflation differ from the seventies — the pandemic and the war in Ukraine. Nonetheless, that prior record may lead to similar errors if the Fed pulls back its funds rate strategy too quickly at early signs of either economic or inflation slowing.

Figure 3

Fed’s 1970’s Stop-and-Go Attempts to Bring Down Inflation

Source: The Wall Street Journal, Labor Department, Federal Reserve

CPI Core Inflation Peaking? — Declining Energy Prices Should Lower Headline Inflation — Further Declines in Core Inflation Should Follow

Unlike rising headline CPI inflation, core CPI inflation — which excludes food and energy — reached a high in March at 6.5%, then declined to 5.9% in June — still three times the Fed’s 2% average inflation target (see Figure 4). A recent study by the St. Louis Federal Reserve Bank showed a high correlation between heavily energy-weighted commodity indices and the headline Personal Consumption Expenditures Index (see Figure 5). Not surprisingly, this study supports the conclusion that recent declines in energy prices, particularly for gasoline, will lead to lower headline inflation early in the second half of 2022 — already leading to improved consumer sentiment. In addition, with some delay, core inflation will also likely decline further, as energy costs feed into a broad swath of products. Shelter costs — representing roughly one-third of CPI weighting — and services—influenced by higher labor costs—will likely continue their upward march.

Figure 4

CPI Inflation — Headline vs. Core — Past 12 Months — Seasonally Adjusted

Figure 5

Correlations Between Commodity Price Changes and Measures of PCE Index Inflation

12-Month Percent Changes, 1/1995-12/2019

Source: Federal Reserve Bank of St. Louis

Supply Factors Contributed to More Than Half of PCE Inflation — Opening Supply Chains — Bloated Merchandise Inventories — Result: Moderating Inflation Expectations for Goods

A Federal Reserve Bank of San Francisco study concluded: “… supply factors are responsible for more than half of the current elevated level of 12-month PCE inflation.” Based on that Bank’s analysis, outside of the Fed’s direct influence on demand, supply chain loosening will prove important to bringing down inflationary pressures on goods. A recent Bank for International Settlements (BIS) study stated, “recessions risks crucially hinge on persistence of supply factors.” A series of government fiscal stimulus programs produced unusually high demand last year for products not routinely purchased — such as refrigerators and furniture — straining supply chains. This year, consumer buying will likely return to more normal patterns, as well as shifting more of their demand to services. That greater normalcy shows up in declining global supply chain pressures, as reported in the New York Fed’s Global Supply Chain Pressure Index (see Figure 6). Loosening supply chains also produced both declining delivery times and order backlogs (see Figure 7). Improving supply chains ultimately flowed through to increasing inventories (see Figure 8). The resulting bloated retail inventories led general merchandise stores to increase price discounting activity to move out their excess stocks. Increased price discounting activities should moderate inflation expectations for goods — to the benefit of the economic outlook.

Figure 6

Global Supply Chain Pressure Index — June 2022

(Standard Deviation from Average Value)

Source: New York Federal Reserve Bank of New York, Bureau of Labor Statistics

Figure 7

U.S. Supplier Delivery Times and Order Backlogs Falling

Source: FactSet, ISM Manufacturing PMI Supplier Deliveries and Backlog of Orders Subindexes, Fisher Investments

Figure 8

Retail Inventories/Sales Ratio: General Merchandise Stores Total Business — 1/2017-5/2022

Source: U.S. Census Bureau,

Moderating Goods Inflation Shifts Focus to Service Inflation and Labor Costs

As supply chain backlogs loosen for goods, inflationary focus will then turn to services and thereby to labor costs and tight labor markets. The Employment Cost Index (ECI), considered the best measure of workers’ wages, shot up a record 5.7% in June (see Figure 9). Labor-intensive service sectors, which in total generate over two-thirds of GDP, prove very sensitive to wage cost pressures. The Atlanta Fed’s Wage Cost Tracker showed service sector wages jumped 6.6% in June compared with a year earlier. To bring wage costs down and thereby service industry inflation, the Fed will need to weaken the economy sufficiently in order to loosen the labor market for services. In doing so, members of the Fed’s Open Market Committee projected overall unemployment will rise to 4.1 percent in 2023 compared with 3.6 percent today. In comparison, many economists think it will take roughly an unemployment rate of 5 percent to lower wage inflation. Historically, rising unemployment rates represent a lagging economic indicator (see Figure 10). Therefore, the Fed might hold off cutting rates further while waiting for higher unemployment rates to confirm a deeper economic decline. That rate cut could then prove too late to moderate an economic slowdown.

Figure 9

Employment Cost Index Percent Change Year/Year

Source: Federal Reserve Bank of St. Louis

Figure 10

Unemployment Rate — NBER-Dated Recessions

Source: Federal Reserve Bank of St. Louis

Excess Consumer Savings and Liquid Consumer and Corporate Balance Sheets May Delay or Limit Potential Economic Weakness — Declining M2 Money Stock — Economic Weakness/Lower inflation

Excesses lead to recessions. In this business cycle, high inflation may be sufficient to prove the case. As frequently quoted, Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than output.” Figure 11 shows the strong influence of M2 growth on the 2020 inflationary spike. More recently, M2 showed a reverse pattern with declining growth. If this decline continues, it will increase the chances for both economic weakness and lower inflation. In line with that, the Conference Board’s Leading Economic Index also shows an increased likelihood for a similar outcome (see Figure 12). Many economists call for, at worst, a mild economic downturn, based on excess consumers’ savings totaling about $1.5 trillion — admittedly declining — as well as strong balance sheets for both consumers and corporations (see Figure 13). In the 2008 Financial Crisis, weak balance sheets for many major financial institutions helped crater the economy. Unlike that period, today’s balance sheet strength of those institutions increases the probability that economic weakness or a downturn will prove relatively mild.

Figure 11

M2 Money Stock — Compounded Annual Rate of Change

Source: Board of Governors of the Federal Reserve System

Figure 12

Conference Board U.S. Leading Economic Index M/M

Source: Conference Board, Daily Shot

Figure 13

Liquid Financial Assets — Household and Corporate Balance Sheets ($Trillions)

Source: Blackstone Investment Strategy, Federal Reserve, and Have Analytics as of 3/31/2022

Investment Conclusions

Equity Market Hopes — Is That a Strategy? The recent equity market rebound, in part, may reflect investors’ hopes that inflation will decline fast enough to cause the Fed to reverse its rate policies early in 2023. These hopes also reflect investors’ experience that financial markets can lead or force the Fed to reverse policies. The “Fed Put” weaned a generation of investors. However, recent history shows how difficult it proved to forecast inflation. Therefore, unless a recession hits hard, the Fed could disappoint expectant investors as it fights inflation further into 2023. This leads to continuing some defensive strategies outlined in our past commentaries. The use of selective defensive strategies seems appropriate in light of uncertain outlooks for both inflation and the economy. Adding to that uncertainty, unfortunately, decisions of just one man, one leader — Putin, can heavily influence the outlook of both — see sections below.

Looking Through Investment Downturn — One strategy investors should consider would be to look through this uncertain economic period and investment downturn to take advantage of attractive stock valuations. Figure 14 from LPL Research shows previous market bounce backs from first half declines. Whether or not history repeats itself, today’s relatively depressed market valuations for those quality companies that can show consistent growth for both earnings and dividends should prove attractive investments.

Figure 14

Second Half S&P 500 Index Performance Following First Half Declines

Source: LPL Research, Fact Set 6/21/2022 — Performance Back to 1950 Incorporates Predecessor Index the S&P 90

Energy — The “Putin Shock” will lead to a rethinking of energy security. For example, the U.K. government recently reversed its decision and approved Shell’s Jackdaw natural gas development in the North Sea— “to protect energy security.” The proposed “climate” legislation before Congress which adds greater focus on energy — green, nuclear, and fossil fuels. This overall shift in focus will require updating “Green” planning to determine realistic timing required to reach economic scale and energy security. Those changes could result in expanded investments in the energy industries, including “Green,” nuclear, and fossil fuels. Businesses producing and servicing those industries should benefit.

Security — The new period of geopolitical rivalry represented by the growing security “alliance” between the two great Eurasian powers — China and Russia — will likely prove beneficial to companies supplying defense equipment and services. The Ukraine war will prove a testing laboratory, similar to the Spanish Civil War, for developing new military strategies, tactics, and advanced weapons. The old global rules order disappeared with the invasion of Ukraine, forcing countries to make major reassessments of what weaponry they will require and substantially increasing their defense spending. Both domestic and non-U.S. defense companies will likely benefit from a long-term period of greater emphasis on defense.

Displacement and Replacement — The “Putin Shock” will also lead to a broad list of displacements and replacements. Putin will likely continue to use Russian agricultural exports as a weapon. Global companies providing increased productivity using precision farm technology systems and equipment should see increased demands for their products and services. The same will also prove true for developing new sources of key hard commodities and their processing facilities. In the latter case, new sources of key hard commodities/processing will also prove critical in meeting demands from alternative energy and electric vehicle industries. The current “climate” legislation proposal before Congress provides incentives to move such sources to North America and countries with which the U.S. maintains trade agreements.

Fixed Income and Alternatives — With aggressive actions taken by the Fed to bring down inflation, economic slowing will likely follow. A slowing economy will, over time, increase the attractiveness of fixed-income securities. Shorter-duration Treasury notes should also prove effective to offset higher equity market uncertainties. As recommended in previous commentaries, a select group of alternative investments also fits that portion of the portfolio historically committed to fixed income