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The Big Conversation

Episode 78: Why markets aren't being impacted by inflation

This week we review the two conundrums at the heart of the inflation debate: lower yields and low levels of employment despite huge demand for jobs. CPI data made a new multi-decade high and yet bond yields rolled over. Is the demand for jobs reflecting a lack of suitable employees or is it an opportunistic attempt to hire labor at a low cost?  In this week’s Chatter, Catherine Yoshimoto - Director, Product Management – FTSE Russell (an LSEG business) runs through one of the major liquidity events for the market, the reconstitution of the FTSE Russell indices such as the Russell 1000 and 2000.

  • The latest US CPI print again beat expectations with the core reading, ex food and energy, hitting its highest level since 1992. On the face of it, these look like dramatic moves that confirm a structural shift in the inflation narrative. But despite this, the US 10-year government bond yields have almost immediately rolled over, making a three-month low of around one point four five percent. So why doesn't the bond market see a significant risk that the current bout of inflation will be prolonged? In this episode of the Big Conversation, we look at the employment and inflation conundrum that's creating uncertainty for the direction of US yields. 

    [00:00:38] Bond bears make the valid case that yields are merely consolidating after the huge round trip they've gone through over the past year. When viewed on the logarithmic chart, we can see just how extreme these moves have been with yields taking a breather at the key resistance level. The next move in yields will define the outlook for risk assets. Lower yields were previously a positive for growth stocks such as tech and Internet sectors. Since November of last year, these have fallen out of favor as people rotated towards the reflation trade, while bond yields had increased to one point seven five percent by the end of March. US CEOs are revealing a strategy that reflects little expectation of future growth, with a preference for buybacks rather than capex. Buybacks have been increasingly concentrated within the cash rich tech sector so that despite the moving yields, the NASDAQ has again made a new all time high. Furthermore, JP Morgan CEO Jamie Dimon has said that they are hoarding cash because there's a very good chance that inflation is here to stay. The problem is it'll be hard to get sticky inflation if banks aren't lending and customers aren't willing to borrow. Hoarding cash is deflationary, not inflationary, as is choosing buybacks over capex. And these are the strategies that many US CEOs are now pursuing. So why are bond yields struggling? Is it just a period of consolidation or is this something more? Two potential clues lie in the Treasury General Account and the reverse repo account at the Fed. Reverse repo has now ballooned to over 700 billion dollars, fueled primarily by a surge of over half a trillion dollars in the overnight reverse repo facility. Commercial banks are running out of options for their cash balances and are shifting them towards this facility. The Fed continues to buy bonds in the open market as part of its QE operations. The commercial banks get credited by the Fed, but they can't find ways of making this cash work for them. In order for clients to be able to take loans, they need collateral such as high-quality bonds that they can then post back with the lenders. The market has been starved of high-quality collateral. Yields on the US three-month note have been dipping in and out of negative territory. The US two year has been flatlining around 15 basis points for over a year. While the Fed is taking bonds out of the market through its QE operations, the Treasury has been draining the reserves in its current account, the Treasury General Account, rather than issuing bonds to finance their spending. During this period in which the has Treasury turned to the TGA, bond yields have been in a steady decline. We've seen some robust demand for bonds when there has been an auction reflecting the need of bonds as collateral. Therefore, with banks hoarding cash, the Treasury withdrawing cash was draining the number of bonds in circulation, it's no surprise that corporates are looking at buybacks using their own cash piles rather than looking to borrow for capex programs. Until this dynamic is changed, it's unlikely that we get any true inflation beyond the bottlenecks and the base effects that have been in play. The problem with bottlenecks is that the increase in input costs will impact margins if overall output and productivity remain sluggish. If we look at the absolute level of US industrial production for manufacturing, we can see that it is still well below pre-pandemic levels and well below the 2018 highs. In the US, CPI has been running high, but many corporates have been happy to let the bottlenecks run and benefit from those higher prices rather than invest in new production facilities in anticipation of future growth. But even here, we can see some of the drivers of higher inflation, such as used car prices and lumber futures, are starting to reverse. The rise of lumber futures has been a poster child for the rise in the inflation narrative. But lumber's dropped 50 percent from the highs. Bottlenecks create price rises, which eventually destroy demand. US hot rolled steel has soared nearly 300 percent since the end of 2020. This is inflationary, but also destructive of margins, and the impacts of lumber and other inputs have started to take their toll on the housing market. Perhaps the biggest conundrum is US employment. The payrolls data is still all over the place, having missed expectations by a long way. But this reflects the difficulty in collecting data and making meaningful comparisons when there are still so many distortions at work across the whole data. When we look at the participation rate, it has failed to regain the pre-pandemic levels. This suggests that the long term unemployed have increased, though many would argue that if you incentivize people to stay at home, then they will. A particular focus for many people is the huge surge in the JOLTS job opening data, which shows that US companies are advertising for over nine million new hires, another record. It certainly looks like an impressive number, but in reality it's only just above the long-term trend. But if the number of job openings is equal to the shortfall in labor of around nine million people versus pre pandemic levels, then that must surely be inflationary, or at least that's how the thinking goes. And on the surface, it certainly looks the case, it looks like there is a huge demand to hire. But again, part of the explanation is the bottlenecks created by a decline in the mobility of cheap international labor. Child care issues are preventing many parents from being able to take work. There's a shortfall of tanker drivers in the US and truck drivers in the UK. But another quirk here is that the number of US job quits has also made a new record high. Again, the trend suggests that the rise is not as impressive as the chart initially appears. But it begs the question if there is so much demand for jobs, why so many people quitting them? This partly boils down to price. There is huge demand for jobs, but what if that is it a low price? There might be huge demand for labor at a minimum wage, for instance, but not so much demand if labor is pushed up 40 percent above the current asking rate. Corporates  want to hold onto their margins. It doesn't yet look like they're willing to pay up for labor. In fact, the choice may either be taking on new employees at a low wage or using technology instead of paying those high wages. The QUITS number could reflect this. As Jeff Snider of Alhambra Partners has pointed out, if you're working in anticipation of being paid better when the economy picks up, but then find that wage increases never materialize, then you're probably going to walk away from that job. The jobs outlook, therefore, may not be as robust as the jobs opening figures suggest. Prior to the pandemic, the labor market looked like it was tight, and yet wage inflation was still nonexistent. And it doesn't look like the corporate sector has meaningfully moved away from that dynamic. So what does all of this mean for bond yields? The Fed fears a loss of control in the bond market. If yields surged higher before they could reassure the market with yield curve control then risk assets would take a massive hit. Is the three point two percent level that rang the bell on the S&P in 2018 the clearing level for yields or is it now much lower given the increase in debt. So far, they will be reassured by the response of the bond market to the move in CPI. But if they really want the economy to run hot, they need to see economic growth and wage growth, not asset price inflation and rising commodity prices. Treasury Secretary Janet Yellen has talked about higher yields being good for the economy. And this is the tightrope that policymakers have to tread. Higher interest rates that reflect the current squeeze higher in prices would be good if it wasn't for the massive levels of debt that exist across the global economy. In the 1970s, one of the inflationary killers was the cost of mortgages, which were tied to longer dated bond yields. Furthermore, an increase in U.S. yields could be counterproductive. We've seen that the US dollar has benefited from high yields relative to Germany this year, when those US yields have been rising more than German yields, the dollar has been rising too, and a rising dollar is one of the other major risks for global assets. We therefore have a conundrum. Both the inflation camps - persistent or transient - have strong foundations. Many examples of current inflation should be transient, but policymakers continue to stimulate demand while supply remains constrained. If the labor market is broken, then corporates may need to start increasing wages. But so far it looks like their interest in hiring is only if the price is right. In the meantime, supply chain problems and higher input costs are starting to impact global industrial production margin levels. High yields remain an outside risk, but only if they surge in a disorderly manner. Policymakers will try and avoid that. If the dollar moved higher than discretionary money that has bet on the global reflation trade would be under pressure and there would be a race for the exit. Copper has been a market leader in the reflation trade, but it fell four percent on Tuesday, the 15th of June, and is testing the big uptrend. These are still early days, but both the labor market and the bond market are pointing to a dangerously one sided bet on many reflation assets. The contrarian view may be that inflation is persistent, but positioning is still long of reflationary assets. In conclusion, we need to ask whether the positioning in reflationary assets can hold out for a pickup in true inflationary indicators such as wages and global economic growth. Both the persistent and transitory camps may be correct, but as ever, it will all be about a matter of timing. 

    [00:09:27] Next week, we're going to see the Russell reconstitution, and this is a major market liquidity event that involves many people participating in the US equity market. In the next section, I talked to Catherine Yoshimoto of FTSE Russell, about how this works. 

    Roger [00:09:44] The Russell reconstitution is a massive liquidity event and the reconstitution or rebalancing as some people know it reflects the need to alter the makeup of the major indices to reflect changes in the market capitalization of all the companies across the Russell universe. 

    Speaker 2 [00:09:57] Reconstitution essentially resets the membership of the Russell Indexes, such as the large cap Russell 1000 and small cap Russell 2000 indexes. Eligible US stocks are ranked by their size as of the rank day in May, and the changes are implemented on the last Friday of June or the Friday prior if the last Friday is the twenty ninth or thirtieth in order to ensure proper liquidity in the markets. Our transparent and thoughtful reconstitution process ensures an orderly rebalance, which includes using primary exchange closing prices from NYSE and NASDAQ to complete this year's Rusell US indexes reconstitution. NYSE listed stocks utilize NYSE's auction mechanism, while NASDAQ listed stocks utilize NASDAQ's closing cross mechanism to execute shares from each stock at a single price on Friday, June twenty fifth. The largest and smallest companies in the Russell 3000 and the break point between large and small cap indexes reflect the changes in the markets over the years, based on the relative size of companies in the US equity market. The breakpoint dropped in 2020 following the Covid crash, and this year's record high breakpoint of five point two billion dollars demonstrates how the markets have recovered since last year. This demonstrates why we reconstitute the indexes annually to capture changes like this on a regular basis. 

    Speaker 1 [00:11:10] The reconstitution takes place at a specific time, but the calculations for the changes are announced much earlier to give investors time to prepare. 

    Speaker 2 [00:11:17] We like to call Russell reconstitution one of the most anticipated and orderly index rebalancing events because of the transparency that we provide into the methodology that we use, and the communication that we provide to the market into what's changing. Preliminary changes to the index is based on data as of May 7th ranked day this year were announced on June 4th, which was followed by query week. For performance purposes, the changes take effect at the open of Monday June 28th, however, most trades are anticipated to occur at the close of June 25th. 

    Speaker 1 [00:11:46] The size of the funds that are tracking these indices are absolutely vast and that's why the resulting flows can have such an impact and why investors need to take note. 

    Speaker 2 [00:11:55] Russell recon day is one of the largest trading days in the US equity markets, with more than one hundred billion dollars traded across the NYSE and Nasdaq exchanges on recon day in 2019 and 2020. Ten point six trillion dollars in assets are benchmarked to the Russell Indexes as of December 2020, based on third party sources. Of the ten point six trillion dollars benchmarked, seven and a half trillion dollars track the Russell growth or value indexes. Furthermore, one point nine trillion dollars in passive or index fund assets are tracking the Russell Indexes with an average fund size of almost six billion dollars. And these are the investment managers who are tracking the indexes closely by replicating the indexes positions, 

    Speaker 1 [00:12:39] A large number of stocks will be added or removed from the various indices, and this can have a significant impact on individual names as well as an impact on sectors if the same types of stocks have been rising or falling in tandem. 

    Speaker 2 [00:12:50] The Russell Indexes are a modular set of benchmarks. The membership of the Russell 1000 and Russell 2000 indexes will be reset so that the Russell 2000 members that have grown past the banded market cap above the five point two billion dollar break point. So in this case, the upper break point, the banded top, if you will, of the band away from the breakpoint is seven point three billion. So those Russell 2000 index members have to exceed the seven point three billion dollar threshold in order to be reassigned to the Russell 1000 and Russell 1000 members whose market cap have dropped below the banded market cap of three point six billion dollars at the bottom of the band will be reassigned to the Russell 2000 index, so that the Russell Indexes continue to include companies that represent their respective market segments. Fifty-six companies are being added to the Russell 1000, a majority of which are migrating from the Russell 2000 index. Forty-five companies are moving from the Russell 1000 to the Russell 2000 index. Five IPOs are being added to the Russell 1000 and thirty-eight to the Russell 2000 two hundred seventy one companies are joining the Russell two thousand index, and three hundred twenty three companies are departing, with two hundred eighty six companies moving to the Russell Microcap Index from the Russell 2000 index. And of course, the entire index inclusive of the Russell Microcap Index is the Russell 3000E index. We typically talk about the Russell 3000, which is the Russell 1000 plus the Russell 2000, but inclusive of those micro-cap names at the bottom of the eligible universe, up to 4000 stocks is the Russell 3000E index. So this index, after net additions of more than four hundred fifty securities this year, will include more than thirty eight hundred securities representing almost forty eight trillion dollars in total market cap, an increase of fifty two percent from 2020. Sector weights for the Russell Indexes are an outcome of the companies being re-ranked and reassigned to the new indexes. We use a framework called ICB, so we aren't setting sector weight targets, again they are just an outcome of the securities being rolled up into the new indexes that they are being reassigned to. So for the Russell 1000, the sector shifts are relatively minor, with modest increases in technology and consumer discretionary weights. For the Russell 2000 index, the largest increase by two percentage points is in health care, offset by the largest decrease in consumer discretionary decrease of about two and a half percentage points. 

    Speaker 1 [00:15:26] The major reconstitution of an index can create significant opportunities for investors in individual names. Asset managers had become more adept at managing the changes and minimizing the impact. But all investors should be aware of what's happening and monitor their own stocks within these indices.