(Rareview) Forecasters underestimated the scale of the pandemic rebound, the inflationary impact of the stimulus packages, and the fact that it wasn’t transitory. These same forecasters and models now expect us to believe there will be a “soft landing” from a starting point at which a “soft landing” has never been achieved.
CPI Is Just Math
Markets are convinced about inflation slowing down aggressively, but is it possible for CPI to fall to 2% in Q1 2023?
If the monthly percentage change from now to March 2023 is 0.9%, CPI YOY will be 11.7%.
If the monthly CPI increases by 0.6%, CPI YoY will be 8.8%.
If the monthly CPI does not increase (i.e., 0% MoM) every month from August 2022 to March 2023, annualized inflation will be 3.1%.
We will need to have a contraction in monthly inflation readings to reach the inflation target set by the Fed.
Wages
Long-time readers of Sight Beyond Sight® know we believe paid forecasters are hazardous to investing. That said, there is one employment expert we work closely with – Andrew Zatlin at Southbay Research. He consistently ranks in the top 5 for forecasting the monthly employment report and weekly jobless claims. Notably, he is the only forecaster that is top-ranked in both categories.
Using a Star Wars metaphor, we believe Zatlin has uncovered a “disturbance in the Force.” We add a layer to his analysis. Neither is widely observed in Wall Street research currently.
Zatlin notes that 30% of the US working population will see wage hikes in five months because they are indexed to CPI. Specifically, he highlights California as the big story because the State represents 12% of the US working population.
New regulations stipulate that minimum wage hikes are capped at 3.5% unless CPI is 7.5% or higher as of June 30, 2022, which they were.
That means there will be a 7.5% jump in the minimum wage for medium/large employers (>25 employees) and a 15% jump for smaller employers (>25 employees).
He further argues those higher wages in California will drive inflation across the country because of the State's outsized impact on food, manufacturing, and imports.
His bottom line is that inflation fighters will have to contend with a significant portion of the country receiving another round of 7%+ wage hikes in January.
This dovetails with the monthly employment report last week that decisively exceeded expectations. As a result of labor market strength, companies were given further latitude to raise prices. This is a prime example of an embedded wage/price spiral.
To add insult to injury, we point you to a similar setup for Social Security.
The Social Security Administration bases its cost of living adjustment (“COLA”) on a basket of goods and services called the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).
It is expected to be the most significant COLA since 1981. The agency will make its official COLA announcement in October, basing that decision on the previous three months of inflation data — which means the number could be higher than 8%. The agency's COLA takes effect in December, with the updated benefits paid out beginning in January 2023. The average monthly Social Security check is ~$1,658, which means beneficiaries could see an increase of $132.64 per month in early 2023, bringing the average check to about $1,790.
Ironically, this COLA could force some citizens into a higher tax bracket. Also, much of the higher COLA could be eaten up because of Medicare premium increases, which typically also rise yearly. This is a prime example of “stagflation.”
Overall, the critical issue is that 50% of core CPI is services, ex, healthcare, and that figure is primarily driven by wages. The Atlanta Fed median wage number is now close to 7%, well above the 4% highs of the last cycle. Put another way, the stickier inflation readings continue to show that even as core goods pressures fade and gas prices come down, the inflation the Fed worries most about will stay elevated.
The One Thing We Are Most Mindful Of
The Federal Reserve and Wall Street promised inflation would fall below 4.0% by December. Despite their poor track record, investors believe them. Therefore, the most significant risk for portfolio construction is inflation that ends the year decisively above 4.0%.
We believe the fulcrum inflation level for whether the Fed’s reaction function remains in “Old Testament mode” is 5.5%. Why? That level removes ambiguity about the stickiness of inflation and the longer length of time it structurally resets higher.
In this instance, the Fed will not be able to ease in the first half of 2023, and the cuts will get removed and potentially turn into hikes. It translates to a terminal rate of at least 4.0%, or 50-100 bps higher than the current market pricing.
We believe the market’s forgiving reaction to missed inflation targets would end and be replaced by “a vengeful central bank that continues to smite us.” In that scenario, recession risks would rise significantly.
To mitigate this risk or take advantage of this asymmetry, it is prudent to implement a fixed income yield curve steepener between December 2022 and March ch 2023. This is the beauty of the short-term interest rate market – you can “digitally” recreate various scenarios.
Warning: We believe market agents are too focused on peak inflation or the rate of change (RoC) slowing. This year's inflation has peaked is last year's inflation is transitory.
Also, there is too much emphasis on market-based measures of inflation (i.e., breakevens, CPI inflation swap market, etc.). We believe professionals who have these positions on will ultimately be punished.
Too many are looking at the wrong variables when analyzing inflation in the context of the Fed’s reaction function.
We acknowledge that “headline” inflation may soon peak, led by a fall in energy prices. However, we are mindful that this may come at a time when optimism towards crude oil, as measured by the net length in oil futures contracts, is now the lowest since April 2020, when the barrel traded at a negative price. That is astonishing, while much of the world is plunged into an energy crisis and OPEC just last week warned of spare capacity exhaustion.
When fighting inflation, we believe it is not about the cyclical ups/downs regarding transitory factors (i.e., supply chains, energy prices, etc.). Instead, it is about psychology and the length of time high inflation becomes entrenched into the system because of “sticky” factors (i.e., wages, rent, etc.). This is far more important regarding a hiking cycle and Fed pivot. That is why we are more focused on the structural backdrop.
