As they say, there are two types of economists – those who don’t know and those who don’t know, they don’t know. We’re making educated guesses just like everyone else. But here are some impressions we think are worth considering after Friday’s surprise CPI report and market sell-off:
- Theoretically, it is difficult to get control of inflation until the Fed Funds rate is above the inflation rate. Using any inflation measure one might choose, the Fed has likely only just begun its tightening cycle.
- Our sources tell us that it will be the Fed Funds rate rather than balance sheet runoff that will be the principal tool used in fighting inflation.
- Flows into equity and bond market mutual funds and ETFs indicate that old habits die hard. Inflows into the Ark Innovation fund (-57.6% YTD) have exceeded flows into the entire Energy sector (+61.6% YTD). This is the first year of bond market outflows since 2013.
- Time is an important element in fighting inflation. The longer it takes to defeat, the more it gets reflected in longer-term inflationary expectations – wages, contracts, etc.
- Nearly 14 years of Q.E. has trained many investors to think in V-shaped patterns when it comes to financial pain. The “Fed put” appears unlikely to be operable until a financial crisis emerges that is sufficiently large to threaten the banking system.
- We remain cautious on long-duration assets with few cash flows to mitigate the reinvestment risk associated with higher inflation. More than 15% of the companies in the Russell 3000 are still trading at more than 10x sales. Dividends are likely to make up an increasingly larger percentage of total return.
- The inverse relationship between inflation and earnings multiples is clear and robust. Strategas’ own econometric model suggests that the forward PE on the S&P 500 should be about 15x.
- The current weakness in productivity will drive up unit labor costs and put downward pressure on margins. As a result, we are currently forecasting 2023 S&P Operating Earnings of $233. The bottom-up Street forecast is $251.
- It is not uncommon to see a series of bear market rallies in the context of significant and long-last bear markets.
- The most underestimated risk by investors today is Congress moving forward on legislation to raise taxes in a reconciliation package. Some members of Congress and the Administration have convinced themselves that only tax increases can lower inflation. Our clients have placed a near zero percent probability of such an event happening. The betting markets place it at 37 percent.
Traditional and "Modern" Down Theories Confirming Declines Industrials & Nasdaq
As Charles Dow began the process of tracking the markets, and by extension, the economy, through his eponymous indices in the 1890s, he postulated that a major movement in the Industrials could only be “confirmed” by a similar movement in the Transports. About 20 years ago, we developed the idea of a “modern Dow Theory” using the Semis to confirm movements in the broader NASDAQ. Currently, it appears that both the Transports and the Semis are confirming the declines in the broader Indices.
Higher Inflation of the 1970s was a process; Back Luck & Bad Policy Contributed
Inflation started with “guns and butter” under the Johnson years and was given a giant shove when the U.S. abandoned the gold standard in 1971. By the time William Miller became Chairman of the Fed in 1978, inflation was largely considered to be insolvable – at least politically. To the extent to which inflationary expectations play a significant role in setting wages, inflation is a moving target. The longer one waits to really fight it, the more difficult it is to vanquish. In this regard, we believe the debates over whether inflation has peaked miss the mark for both policymakers and investors. The fact that the CPI is already at 8.5% means that the Fed has already made a policy error and that far more tightening is necessary if it has any hope of bringing it back down to anything near its target of 2-2.5%. With luck, policymakers will not compound the errors the Fed has already made by a variety of harebrained schemes attempted in the 1970s. Recent state proposals to “ease the burden” of inflation through direct payments to their citizens will only elongate this process.
Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments. Data provided by Refinitiv.