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The Big Conversation

Episode 113: Is the fed looking at the wrong data?

This week Real Vision’s Jamie McDonald looks at a growing number of lead indicators that suggest policymakers may be behind the curve on inflation.  As the Fed continues to tell us that they are “data dependent”, the growing question is whether they are looking at the right indicators. With markets becoming increasingly volatile in recent weeks, we identify some of the reasons for the growing unease amongst investors by looking at competing signals coming from the business cycle and inflation data. In the chatter, Jamie talks to Refinitiv’s Michael Smith about some important inflation cues in the US retail sales data. 

  • Jamie [00:00:00] As debate grows, whether the Fed's current path for hiking rates will cause a recession or not, a growing number of indicators suggest that policymakers might be behind the curve when it comes to inflation. So far in 2022, policymakers continue to tell us that they are data-dependent. But the question is, are these data-dependent policymakers, looking at the right indicators? That's today's Big Conversation.

    Jamie [00:00:34] Markets have become increasingly jittery in recent weeks, and there there's no great surprise there. The S&P is up a cool 100 percent since 2020 lows, so selling does become an easier decision after such a strong run. And secondly, investors were wrong footed by the sudden surge in U.S. yields at the start of the New Year. Now we all knew it was coming, but the move was fast and equity markets reacted. Now significantly, the VIX index has an average level of 24 year to date. In fact, it's almost 30 today, and it remains above a threshold which typically requires portfolio managers to be more active in their risk management. And that means, reducing position sizes and potentially putting more hedges in place. And that, in turn, affects markets.

    [00:01:25] The US central bank, the Fed, has the market convinced it's going to move quickly, with now JP Morgan pricing in nine straight rate hikes to 2.25 percent by March next year. All at a time when inflationary pressures might well have peaked. And this conflict is only intensifying as investors become increasingly concerned by the direction of many traditional lead indicators linked to the business cycle and demand for raw materials. Take the Cass Freight Index, for example, which historically has tended to lead headline CPI by about 6 months. The year over year change in shipment volumes has just turned negative, which could be a rather bearish indicator of a future recession and coincident disinflation in the near-term. And there are further signs of a potential slowdown in the real economy. Another key indicator of the US business cycle, the ISM manufacturing PMI, may also have peaked with a reading of 64.7 in March 2021. Whilst that latest reading of 57.6 remains well above the 50-threshold seen as many as signaling expansion, base effects are now contributing to a negative rate of change over the past 12 months, similar to the Cass Freight Index. This has seen a rotation away from certain cyclical sectors, such as industrials, towards more defensive sectors such as consumer staples. It's interesting to note the recent resilience in the relative performance of base materials, because historically they have tended to underperform along with industrials during a downturn in the business cycle. But perhaps this time it is different, with the price of copper and other associated commodities remaining elevated and supporting this sector. Which seems at odds with weakening and the pro-cyclical lead indicators we saw earlier.

    Jamie [00:03:19] Focusing in on another inflation haven, consumer staples are traditionally seen as having greater pricing power to pass on higher costs. The latest US retail sales report, surprised the consensus, with a higher than expected reading showing growth of 3.8 percent month over month. But the unemployment rate has ticked up to 4 percent from a post-pandemic low of 3.9 percent, which has historically signaled a peak in the labour market where workers, think consumers, enjoy the most favourable terms in job security and higher wages. So the question is; for how much longer will consumers be able to absorb higher prices if labour market conditions begin to deteriorate from here? Despite some of the key leading indicators suggesting that inflation may be set to subside with a possible downturn in the US business cycle, there is evidence that considerable cost pressures could persist. Higher energy prices have been one of the main contributors to overall CPI ever since the supply issues took hold in the midst of the pandemic. Although demand was expected to normalise after the apex of the economic recovery, geopolitical tensions have sustained the rally in crude oil, with a WTI benchmark approaching $100 per barrel. And this volatility has not only created a great deal of uncertainty, but it also puts the pressure back on policymakers to intervene in an attempt to control inflation. And longer-term, there is debate about whether energy transition will lead to higher prices for fossil fuels as a result of over investment in renewables. Now this, coupled with other current forces, could establish a new base level for energy costs, which would effectively tax the consumer, even if they are underestimated in future CPI owing to base effects. With so many competing variables around inflation and growth, the Fed is in an unenviable position when it comes to setting policy. Seems that sticking to traditional measures to gauge the true temperatures of the economy and crucially inflation, might not be sufficient in an increasingly complex situation. Given the Fed's self-directed data dependence, there is potentially a lot more information that has yet to be gleaned and could influence their stance on interest rates. And that's why this week in the 'chatter' segment, I sat down with Mike Smith, Global Sales Strategist at LSEG, to discuss retail sales and why you need to dive a little deeper into that headline number.

    Jamie [00:06:03] Mike, thank you so much for joining us. Now we've just been talking about data points, but in particular, what data points, central banks, particularly the Fed, are looking at when they come to making decisions about rate hikes? And I know you've been looking at a few data points recently, so I wondered if you could give us some of your thoughts.

    Mike [00:06:21] Yeah, thanks for having me, Jamie. It's nice to be here. I, sort of got into retail, we had last week we had the retail sales number come out and it was pretty robust it was 3.75-3.8 percent for the month over month. And actually, when you, when you span that out and you look at the the annual number, it's I think 12 or 13 percent year over year, so it's a big number. But when you go out even further and you kind of stretch that chart out you, you can see what we've gone through in 2020,2021, those numbers are really starting to get back, even though they're very obscene, if you want to call it, they're still muted from where we've been. And I think that's something we as people that look at data need to consider. I was listening to a podcast yesterday and the guys were talking about, look these last 2 years it's broken every chart that I have on fundamental or or economic data. So that's the hard part, I think, and you and I were speaking, we have to kind of take everything with a grain of salt when you look at it. And so I started to look into instead of looking at the headline number, well, let's look into the subsectors.

    Jamie [00:07:32] Okay, great.

    [00:07:33] Right. So the subsectors are interesting; the number 1 sector, it's about a 20 percent weight is motor vehicles and parts. Right it's got decent growth over the last year, and in fact, when you take it down and you go into the equities in that space, great, easily explainable, right? If you look at the number and you compare it to the RBOB, the gasoline futures, the correlations like 80 percent or something crazy like that. So it's highly correlated, now it gets out of whack once in a blue moon, but it's an explainable number, we can see kind of where that goes, right? So the Fed, it's a little bit easier to measure for them. They could, they have an idea of what those markets might do a little bit more. But then as you step down into some of the other, like the non- headline categories, you get like clothing and accessories, which is like a 20 something, mid 20s percent growth year over year. The numbers are outstanding.

    Jamie [00:08:30] So does the question become which of, when you break down the subsectors, who is passing on costs and therefore margins are basically not expanding and who isn't?

    Mike [00:08:39] Correct. And I think that's that's some of the things you need to look at as you look into, the equities help you tell that, right? Because there are public companies they have to report. But when you look at the NY sector data, which is pretty much the way everything is broken down, there is hundreds, if not thousands, of companies in each one of those. But we're only getting a small subset of those, either in the index or if you're looking at something like the Russell 3000 or even total public, a lot of them are pink sheets, so the reporting is a little off. But you're looking to see like, what's what are are their gross margins expanding? And they don't seem to be, like they look at they're relatively, you know, a normal growth, which is what a company would try to do, grow margins a little bit.

    Jamie [00:09:21] So it seems like you're seeing a couple of things which are really interesting. One is, you know, you're going to see we're seeing some big headline numbers, but go back, go and look back even further and you realise in the grand scheme of things, you know, just pause for a second because relatively speaking, we're not seeing massive jumps compared to where they've been historically. And then secondly, try and dig down into sort of specific sectors because, some of the numbers, which may look like inflation are just, you know, cost of goods being passed on, but you are seeing some margin expansion elsewhere?

    Mike [00:09:49] Yeah, I mean, I think so, there's 2, there's 2, I found 2 major things in looking at the data. Is one, is there inflation? I mean, yes, but it is is it's really inflationary from the last two years, right? So.

    Jamie [00:10:03] I see. Yeah, yeah.

    [00:10:04] So you saw such a big, big drop. I mean, some of the some of the categories were off 80-85 percent. I think it was, I think it's clothing and retail, was the biggest one. So it dropped something like 85 percent, and then we saw a month-over-month number sometime in April or the summer of 2020 and it was like 400 percent. So when you're off 80 percent to get above 400 percent, when you take that number and you break it down over 20 years, the chart just looks like it continues with a bunch of wobbles. And like I said before, with the broken charts, you're going to see some of that dislocation in the numbers, and it's just really take it with a grain of salt. Now, when we look at some of the raw commodities that go into this, which are causing this, there might be some instances there of things that you know maybe we've seen lumber go up and down, now that plays into the the Home Depots and the Lowe's and those sort of retail aspects of things because people are paying more for lumber. So those are the sort of things that we have to be careful of. And I think the Fed has to be careful of, is what happens when we get back to a little bit more normal? And when I say normal, I mean spending going across all places right, the retail, when I looked at the retail, a very small subset of that is services, and specifically in food and drinking. Right, so that's one of the categories and it's made up of McDonald's, Burger King, Starbucks, and they're all seeing big jumps in year-over-year numbers. And when you look at the numbers for this year, so the IBIS estimates for those their increases are pretty solid 20, 30 percent.

    Jamie [00:11:51] But this includes food delivery services as well?

    Mike [00:11:53] So it includes those fast casuals, those ones that have taken on delivery as part of their mantra, because no one was coming into the restaurants, office or the restaurants, you know, to to go out for lunch. You know, I'm here in the office in NY city today. Normally I'm at home buying lunch, so they're trying to make up for that with the delivery. But the ones that have really started to jump, as we're starting to see this kind of get back to normal, are the sit down places. So that is the area in retail, and then what happens when we get back to travel? Right travel's happening. It's still muted. I think it's causing some of the dislocation in retail too, because you're getting the gasoline on the demand side, you're getting motor vehicles, people are buying RVs, people are doing stuff that they can drive, drive to. I know I haven't taken a really far vacation in the last two years. Everything has been in the northeast area, around, around New York, New Jersey area. So we're driving to everything that's changing and what we do, right? What happens when we start buying airline tickets and booking stuff overseas and that starts to play into, does that mute what you're spending money on?

    Jamie [00:13:03] So this is, this is the tricky situation for central banks and indeed the Fed is; how do they plan a rate hike policy, based on data that's so skewed because we've had a such a topsy turvy few years?

    Mike [00:13:15] Right now, the Fed's in the place of they are trying to land an aeroplane on an aircraft carrier in weird seas at night in a rainstorm. That's their job right now. So there's so much going on to these variables, and I was just I couldn't stop laughing. I shared that with a ton of colleagues about what they have to do, and you see it in the bond markets too. You're seeing the trade of bond traders all over the place. 75 basis points. Oh, guaranteed for you know like 50 basis, oh no, now we're probably at 25. So those numbers are all over the place and I was getting into an argument as the equity guy who knows very little about those markets, with our fixed income team, going, they're not going to do it, they're not going to be able to do it. They're just, it's, they're going to have to slow play this. And almost everyone's watching the Olympics, it's going to be like a curling match. They're going to have to go slow, wait every end and try to see what happens with every stone that goes down and try to figure out, where are we now? What's my next play? How do we, how do we go from here? Because if they go too fast and break things, we're in trouble and we don't know where we where we could be from there.

    Jamie [00:14:26] Well, Mike, thank you for those analogies. We've all got Top Gun with 747s in our heads now, but that's been great chatting to you and thank you very much for coming in.

    [00:14:32] Excellent. Thanks for having me, Jamie. Appreciate it.