The Big Conversation
Episode 144: How to break high inflation
This week James Helliwell uses best-in-class data to make sense of the markets in the wake of the latest inflation data. With core CPI hitting a 40-year high despite seeing a slowdown in the headline data, investors are increasingly concerned by the broadening of price pressures, and the potential for this to fuel a wage spiral as workers demand increases to keep up with the cost of living. But might the Fed’s rate hikes bring this to an end by creating higher unemployment?
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James [00:00:00] As volatility remains elevated and equities in particular see erratic daily swings as liquidity is drained from the financial system, investors seem desperate for direction in the midst of the current bear market. Given the Fed's relentless focus on fighting inflation, might the signal come from the labour market?
James [00:00:16] That's The Big Conversation!
James [00:00:23] Last week provided the latest updates on inflation, with many investors bracing for bad news... Ahead of the report, a survey of hedge fund positioning reported by Goldman's Prime Brokerage unit revealed that clients had been net sellers of equities for the past 5 straight days, with the largest net selling occurring the day before the CPI print. What's more, as opposed to this representing the liquidation of long positions, hedge funds were selling stock short at a ratio of 5 to 1 as the S&P 500 tested new lows. In other words, traders were already positioned for CPI coming in a lot hotter than expected.
James [00:00:57] At first take the headline CPI print perhaps didn't seem so bad, in fact, it slowed for the third straight month and reached the lowest level seen in 7months. But much of this seemed to be driven by lesser than expected increase in fuel prices, which didn't capture the sharp rally in oil that was seen in October so far. And furthermore, it was the stickier things like the cost of shelter, and healthcare that saw faster than anticipated growth, and have been persistent contributors to inflation.
James [00:01:26] And this showed up in the arguably, more pertinent core CPI number, which came in ahead of expectations and rose to a 40 year high. And had some on Wall Street preparing for a jumbo rate hike at November's FOMC meeting.
James [00:01:39] Whilst this provided a stark contrast to the slowing momentum in the headline data, albeit driven by declining fuel prices; which have since reversed, it seems that the volatility in the wake of the report was a result of extreme speculative positioning rather than a fundamental shift in the inflation theme.
James [00:01:56] And this becomes clearer when viewing the market from a technicians perspective. Looking at the S&P 500, we can see that the low of the day came as price tested 3500. Before staging that intraday reversal. Not only is 3500 a widely watched level and round number, but it also coincides with a 50% retracement of the rally from the March 2020 low to the high seen of January of this year. In other words, technical factors were also behind the bounce, despite the inflation data.
James [00:02:26] But is this a sign that we could be nearing a bottom as equities stop going down on seemingly bad news? As the saying goes, there's nothing quite like price to change sentiment, and bear market rallies do tend to catch investors off guard. But if history is anything to go by, then this may prove to be premature and there might well be a new low yet to come.
James [00:02:47] To explain this, we need to understand that CPI tends to peak during or after a recession. In other words, it seems unlikely that inflation will subside without a full blown recession.
James [00:03:00] And it doesn't seem like we're there just yet, as recessions also tend to coincide with a surge in unemployment. And right now, whilst business activity is undoubtedly slowing, the unemployment rate remains at just 3.5%, which is as low as we've seen in the current cycle, post-pandemic.
James [00:03:16] Now, you could argue that unemployment is a lagging data set, but initial jobless claims have yet to show a meaningful increase either. Despite the Fed implementing the fastest series of rate hikes in decades, the number of claims remains subdued and well below the levels that have historically occurred during recessions. Could it be that perhaps this time is different and we don't see any deterioration in the jobs market despite a recession? Or perhaps that the Fed pulls off the economic miracle of a soft landing, bringing inflation under control without triggering a recession at all?
James [00:03:47] It seems unlikely... But that's what the fast money seemed to be betting on in calling a peak in inflation. But this may once again prove to be premature, just as it did in June, when we saw the market rally on the false hope of a pivot.
James [00:04:00] Whilst equities saw a technical rally following that inflation print, fixed income traders moved to price in even more aggressive rate hikes, as can be seen in the implied Fed funds rate.
James [00:04:14] The 5yr breakeven rate; which gauges market derived inflation expectations, also ticked up and added to the 20 basis point gain, that has been largely driven by the rally in crude oil that we mentioned earlier, and also explored in last week's episode.
James [00:04:27] With core CPI rising to its highest level since 1982 and the energy crisis far from resolved. Any further strength in crude will spell bad news for inflation optimists. And if history is any guide, then the Fed funds rate may need to match or exceed the level of core inflation in order to truly vanquish it. And given that core CPI currently stands at 6.6%, it suggests that the terminal rate may end up a lot higher than current expectations.
James [00:04:53] However you cut it, it seems that inflation will likely remain a threat to investors and consumers alike, and there's little doubt that this will perpetuate the demand for higher wages amongst workers. And this is certainly on the Fed's radar, given the stickiness that wage inflation brings.
James [00:05:09] And this is why the labour market is key to the inflation conundrum and the direction of monetary policy going forward. If the recent pay agreement for US rail workers is anything to go by, which included an immediate 14% hike and a 24% increase by 2024, then employers could see their cost base increase dramatically. Though in reality, it seems that beyond the critical point, companies will look to make cutbacks in order to defend their margins, which inevitably spells layoffs.
James [00:05:36] And this might well be the catalyst for a national rise in unemployment, and would get us closer to that earlier scenario where a recession brings a peak in inflation, and most likely interest rates with that too.
James [00:05:47] Investors will no doubt be paying close attention to company guidance during earnings season in an attempt to glean insights around cost reduction initiatives. And others may follow Intel, who last week announced plans to cut up to 20% of their workforce, citing a demand slowdown.
James [00:06:02] So whilst the rally in oil may have further to run and could put further upward pressure on inflation, this really is a story of wage expectations and the labour market for investors trying to time a Fed pivot.
James [00:06:15] To better understand these dynamics, I chatted to Indrani De, Head of Global Investment Research at the London Stock Exchange Group, about some of the key trends and structural changes taking place beneath the surface of the labour market and how these might influence the outlook for inflation, rate hikes, and risk asset.