The Prices People Pay Part 2

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Inflation is everywhere. It’s inescapable. We are paying more for food. We are paying more for flights. We are paying more at the pump. We are paying more for pretty much everything.

The Consumer Price Index (CPI) is still running hot. Friday’s report was not good. It not only came in ahead of expectations for May; The 8.6% report is the hottest of this cycle. We haven’t seen inflation this high since 1981. Core prices, which strip out food and energy, were flat with April. They were expected to fall. So much for peak inflation. It’s still not behind us. It’s the primary problem for the Market. Inflation is not slowing because the price of Oil keeps rising relentlessly. I wrote last week about why Oil matters. It matters big time.

The inflationary pressures are most noticeable in food, energy, housing and transportation. Supply chain strains are playing a major role too. Energy is expensive and in short supply. Gasoline stockpiles declined for the 10th straight week. The Strategic Petroleum Reserve fell by a record amount. OPEC (the Organization of Petroleum Exporting Countries) is barely budging. Apparently they can’t. Of the 23 nations in the OPEC+ alliance, only Saudi Arabia and the United Arab Emirates have spare production capacity. It will be tough to offset a supply gap created by the sanctions on Russia. This is all happening with China in lockdown. A reopening China will consume significantly more energy.

The Market rally in June was based on expectations of inflation cooling. The Bond Market rallied, sending yields lower. The price of money fell. Stocks recovered. That reversed this week. The Market began pricing in a ~75% probability of another 1/2 point rate hike in September, following what’s been considered a lock for 1/2 point hikes in June and July. The May CPI report should make that September rate hike a lock now too. In fact, a 3/4 point or 1% hike at one of these meetings can’t be ruled out.

Treasury yields jumped this week, making the price of money more expensive. It was most pronounced in the front-end of the curve. The 2-Year Treasury yield hit the highest level for the cycle at 3.06% Friday. The 10-Year yield jumped to 3.15%. The spread between 10’s-2’s has narrowed to less than 10 basis points. Both the 30-Year and the 10-Year Treasury yields are lower than the 5-Year. The Bond Market is sending another message. The yield curve is inverting again, reflecting the Market angst.

The American people have changed their tune. The prices they pay have them cutting back on purchases. A Washington Post poll showed nine in ten Americans have started bargain-hunting for cheaper products. Three-quarters are dialing back their spending on restaurants and entertainment, or simply delaying purchases. Bank of America said customer card transactions continue to grow at or near double-digit growth rates. The big problem is gas stations are sucking away many of those Dollars being spent. Those are Dollars that could be going to restaurants and other areas. The University of Michigan Consumer Sentiment survey just came in at its lowest level ever. Baked into that low reading is also the housing market: Housing is starting to stall. Mortgage rates hit a new cyclical high (the cost or affordability is 40%+ higher in a little over a year), causing mortgage purchase applications to make a 2-year low. With the US Economy 70% consumer spending, this behavior change will be felt this Fall and into Winter.

Earlier in the week, the World Bank cut its estimate for 2022 global growth to 2.9%. That’s down from 4.1% back in January. No surprise, the driving factors were the surge in energy and food prices. The negative impact from Covid and the war in Ukraine are major factors too. The bank also warned of a “protracted period of feeble growth and elevated inflation with potentially harmful consequences for middle and low-income economies alike.” Things sure have changed in 6 months.

The European Central Bank announced an end to their QE and interest rates will increase in July. That is a big U-turn for Europe, which has been stuck in 8 years of negative interest rates. Driving the decision was the macroeconomic forecasts. They’ve changed. The ECB now anticipates annual inflation in Europe at 6.8% this year, 3.5% next before sliding to 2.1% in 2024. These are all higher than their March projections. They still seem low. GDP growth is expected to be 2.8% in 2022, 2.1% in 2023, and 2.1% in 2024. They don’t have recession modeled ahead. That could change quickly.

These comparisons to the 1980s continue to conjure up ghosts of Stagflation. That is the undesirable combination of stalled economic growth and high inflation. It triggers memories of the Oil price shock and sluggish economy which led to a so-called double-dip recession by the
1980s.

Stocks had been going sideways of late, basing after the sharp declines from April and May. Bear Market rallies tend to suck people in. They give the impression that the worst is over and investors fear missing out. Then they get hit again. The Bull-Bear tug-of-war is giving ground back to the Bears. There seemed to be a lack of conviction in both directions as sentiment swings between the earnings and economic slowdowns which anchor the Bearish narrative and the peak inflation/peak Fed tightening themes that are seen as tailwinds for the Bulls. Inflation is decisively in the Bear corner.

The US Economy is much more fuel-efficient now compared to then. The Digital Age has brought new and innovative ways for growth and productivity. But food and fuel will always matter. Those are the prices we will always pay. Those prices are up. They’re staying up. The Fed can’t get a grip on prices. They were slow to move. They’re going to have to speed up. The Market doesn’t like it.

Corrections and economic slowdowns are part of the cycle. They’re never fun, but they are necessary for sustainable health. Importantly, these inflation numbers are in the rear view mirror. They’re behind us. But the higher-than-expected CPI report for May proved inflation is not slowing; At least not yet. Hang in there. We continue to maintain our defensive positioning with hedges and large levels of cash. We plan to stay that way until this environment clears up.

Have a nice weekend. We’ll be back, dark and early on Monday.

Mike

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