Stocks rallied ahead of tomorrow’s Fed decision. As it stands, we head into a tightening cycle with stocks (S&P 500) down 11% from the record highs (and from the highs of the year).
This decline has reset the valuation on the broad market (lower “P”) — down to a forward P/E of 18.5. That’s above the long-term market average (about 16), but it’s not expensive.
Historically, when rates are low, the P/E tends to run north of 20x. Even if the Fed were to ramp the Fed Funds rate to 2% this year (which would be considered an aggressive scenario), rates are still accommodative (i.e. stimulating growth).
What about the “E” in the P/E?
As we observed in Q4 earnings season, margins are solid – better than the year ago comparison, and better than the five-year trend. Why?
Higher input costs are being passed along to consumers through higher prices. And consumers, while not happy about higher prices, are in a position of strength to maintain their standard of living (with a strong balance sheet and leverage to command higher wages).
For companies, inflation means higher nominal prices, which will result in higher nominal revenue. With that, analysts have been revising UP revenue estimates for Q1. And the expectation is for margins to hold in above 12%, which is above the 5-year average. Add to this, companies are taking advantage of crisis to dial down expectations. This is a formula for earnings beats (yet again) in Q1. And positive earnings surprises are fuel for higher stock prices.
So, we may find that the behavior of investors over the past two months has followed a long-standing investing maxim: “selling the rumor, buying the fact.” In this case, “selling the anticipation of the first Fed rate hike … and buying on the actual event.”
After two years of massive government and central bank intervention, that created almost $6.5 trillion of new money, the Fed will begin reversing these policies on Wednesday.
Despite months of telegraphing this move, we opened this week with the 10-year yield at just 2%. That's also despite a new catalyst that may spike an already high inflation rate (i.e. the recent spike in oil prices).
So, why is the interest rate market not pricing in an impending Fed inflation battle?
Because they are betting on the "demand destruction" thesis. They think higher prices will solve higher prices. In the case of gas prices, we know $4 gas has, historically, proven to be a psychological level that changes consumer behaviors. We saw it in 2008, 2011 and 2012.
But the economy is in a very different position this time.
Ten years ago, consumer and corporate balance sheets were wrecked. The economy was barely growing, even with maximum support from the Fed (QE and zero rates). And the job market was abysmal with unemployment running around 8%, and about a fifth of the employed were "underemployed." With these conditions, add in $4 gas and you will get demand destruction.
Fast forward to today: As we know, asset prices have reset higher (following the onslaught of new money creation). But, very importantly, the job market is tight and wagesare adjusting for the rise in asset prices. And consumer and balance sheets are strong.
The demand destruction scenario is far less likely given this backdrop.
It's when the Fed ratchets rates high enough to reverse hot inflation, that the demand destruction will come. Until then, the sprint on the treadmill will become increasingly faster to maintain quality of life, in the face of high prices.
As we end the week, let’s take a look at the year-to-date performance of global asset prices.
The translation of this graphic: Lower net worth (a quick hair cut in equity values), while simultaneously facing higher prices of everything. No surprise, consumer sentiment has been, and continues to be, tanking.
Is the global war-threat to blame? Or is the Fed to blame?
History would tell us, it’s the latter. The Fed is typically the culprit for ending economic expansions. In this case, the Fed has waited way too long to address the clear inflation formula that has been brewing from the covid policy response.
They will start the rate liftoff next week, almost 800 basis points behind the year-over-year inflation rate.
What was the Fed Funds rate when inflation finally peaked in 1980 at nearly 15%? 17.6%.
What about the spike in 1974-1975? Inflation started to come under control, only after the Fed ratcheted rates up above the level of inflation. In late summer of ’74, inflation was running 11.5%. The Fed took rates up to 13%.
Inflation came in hot this morning, as expected. And with the recent pop in oil prices, the next inflation reading will likely be in the double-digits (year-over-year).
With that, the Fed starts is inflation chase next week (beginning the rate hiking campaign). The European Central Bank began setting expectations for a similar plight this morning (telegraphing an end of bond buying and a rate liftoff).
Let's talk about Europe …
Remember, last week we looked at the euro, as the proxy for trouble in Europe. The common currency of Europe has been on the slide since the Russian invasion in Ukraine. And today, despite a hawkish ECB, the euro ended lower.
There are plenty of things to worry about in Europe. Telegraphing a tightening campaign to address the hottest inflation in 30 years, in the face of downgraded growth is one (thing to worry about).
Another, is ending the asset purchase program (by Q3) that has been the force behind maintaining stability in the sovereign debt market in Europe (i.e. ECB intervention/bond buying has kept countries like Italy, Spain, Portugal and Greece solvent since the days of the financial crisis).
The ECB ending its backstop of the weaker euro zone countries, alone, could create a dangerous spike in European sovereign bond yields.
This, as we are just in the early days of discovering what European (and global) banks are directly or indirectly exposed to Russian debt.
The risk environment had a huge bounce today. But don’t get too excited.
Remember this chart (we looked at last month) …
After two years of a liquidity deluge, we’re now seeing the effects of illiquidity on markets. Translation: The swings become exaggerated.
By this time tomorrow, markets will have digested another big CPI number. And as we’ve discussed, with oil prices gapping higher, people will begin to extrapolate out the next CPI print (for March). It will be bigger (likely, much bigger), not smaller.
On the Russia/Ukraine front: Headlines will continue to create confusion/ whipsaw in markets. Overnight there was (again) talk that a potential cease fire was coming, and perhaps a concession on Ukrainian territory.
The safe assumption: This won’t be a two-week war.
Back in 2014, when Russia annexed Crimea, the timeline was nine months, and the scale of global escalation is far greater this time.
With the above in mind (existing inflation + further commodity supply shocks, driven by geopolitical strife),dips in commodities prices (and commodity stocks) are a buy.
What’s not a buy? Bitcoin.
Bitcoin rallied today on an executive order from Biden to “ensure the responsible development of digital assets.” This followed a statement last night, in kind, by the U.S. Treasury.
This got the crypto-enthusiasts excited, as they assumed this meant the government is taking steps toward accepting and legitimizing private cryptocurrency. It’s precisely the opposite. As the executive order says, “sovereign money is at the core of a well-functioning financial system, macroeconomic stabilization policies and economic growth.”
The government wants to regulate away private crypto and strengthen their monopoly on money through a “central bank backed digital currency.” Remember, back in June of last year, Elizabeth Warren held a hearing on this. Warren made it clear that a central bank-backed digitaldollarwould “help drive out bogus digital private money (bitcoin, stablecoins, etc.).” This executive order starts the ball rolling, toward this goal — and a cashless society (not good).
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We get February inflation data on Thursday, which will show something close to 8% year-over-year increase in CPI.
That’s a hot number that will get a lot of attention. But that will understate the current environment, considering the price of crude oil is up over 30% since the end of February. With that, next month, when we see the March inflation data, it should be double-digits — maybe even something in the teens.
And that would mean a plunge in this chart …
This is the January report on real disposable income (inflation adjusted). As we know, driven by the covid-related government handouts (three rounds of stimulus checks plus an overly generous and prolonged period of federal unemployment subsidization), personal savings soared. Related to that, income spiked — as you can see in the chart.
Of course, now inflation is taxing not only that money, but all of your income (i.e. the blue line is going lower). Worse, by the time we see the February and March data incorporated into this chart, it will be falling farther, and likely knocked off of the path of the long-term rising trend.
That leads us to the next chart …
This is the spread between the 10-year and 2-year Treasury yields. This has declined to 23 basis points. When it goes negative (circled in the chart), recession has followed (between 6 and 24 months) all but one time dating back to 1955.
This brings me back to my July note of last year: “For now, we continue to ride the wave of asset prices. But the damage will come. First, from inflation and lower quality of life. And then, the economic decline is typically is triggered by the Fed. When the Fed finally, 1) acknowledges the hot inflation, 2) stops fueling it, 3) starts chasing it, and 4) ultimately kills it with higher interest rates, then the economic damage will come.“
We’re about to embark on step 3. And the Fed’s budding inflation chase would project a recession that would be consistent with the timeline from the yield curve analysis above.
That said, as we discussed last month, “if such economic disruptions (from Russia/Ukraine) unfold, we can be sure that the democrat-led Congress will quickly resurrect the “Build Back Better” plan to be rubber-stamped.”
So, if this unfolds as such, we should expect more fiscal-funded agenda spending, disguised as a “rescue package.” This fiscal profligacy would only reinforce the trend of devaluing fiat currencies, relative to hard assets (i.e. the commodities price boom).
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As we discussed on Wednesday, “if sanctions were placed on Russian energy exports, there’s no telling how high the crude oil market might spike.”
On that note, Pelosi launched a trial balloon last night, just as futures markets opened, saying that Congress was “exploring legislation to ban import of Russian oil.” Oil traded as high as $130 at the open.
This comes as the national average price for gas had already climbed above $4 a gallon. We’re just a nickel away from the highest national average price on record.
Importantly, this $4 has proven to be a psychological level that changes consumer behaviors. The record high was in 2008, and the national average sniffed around $4 again in 2011 and 2012.
What did consumers do? They pulled back. “Gas guzzling” SUV’s were dumped. They gave then the government in exchange for a check (“cash for clunkers”). And/Or they simply just stopped driving as much (as you can see in the graphic below).
Now, if high oil prices persist (which seems to be the highest probable scenario), it will hurt consumer spending (in at least some areas), but it also feeds into an already hot wage pressure situation, and it feeds into inflation expectations. The latter happens to be the Fed’s biggest fear (i.e. the “unanchoring” of inflation expectations).
With that, what happens when people start expecting the price of everything to runaway. They chase prices (higher, and higher).
That would push the Fed into the ring of a dog-fight. As we’ll see at the end of the week, inflation is already proving to be persistent, and steadily climbing toward double-digits. Remember, the last time the Fed was in this situation (early 80s), they had to move short-term rates ABOVE, the rate of inflation to finally bring it under control.
Despite all of the speculation about the dollar losing status as the world reserve currency … gold losing ground as the safe-haven … and Treasuries being penalized for reckless deficit spending, where does global capital flow when things really get dicey? The dollar. Gold. And U.S. Treasuries.
That's how we ended the week: Flight to safety.
Let's look at some charts …
With two valuation drivers at work (inflation and geopolitical risk) gold is back near $2,000, tracking toward the record highs set August of 2020.
And while gold typically rises, as the dollar falls, in times of global stress, they rise together. Here's a look at the dollar …
And the dollar chart is mostly driven by this chart below (a slide in the value of the euro)…
This is a key spot to watch (the euro) … where we may see some surprises bubble up in markets.
The 2013-2014 Russia/Ukraine conflict resulted in a sharp slide in the euro, involving sovereign debt risks and (related) exposure of European banks to Russia. This time, Fitch calls the bank risks limited (if not small). But there are typically secondary risks in these environments that can bite — like a hedge fund counterparty default, which could create a shock event for the financial system. Keep an eye on the euro.
A predicted-future climate crisis has led to policymaking that has created an immediate energy crisis.
Next up, looks like food crisis.
As you can see in this chart, food prices are near record highs already. This is a squeeze on the standard of living for rich countries. For poor countries, it's full blown crisis. This time it looks like an uglier, more widespread impact is coming.
Unfortunately, we know the energy input isn't improving anytime soon. Nor is transportation (from both energy and supply chain disruptions). Labor? Labor costs are just in the early to middle innings of an adjustment. We have a supply crunch in all three of these inputs.
What about fertilizer? Nitrogen, Phosphorous, Potassium: All higher, nearly double the cost of this input for 2022.
Now we add in a supply shock from Russia and Ukraine – which combine for a quarter of the world's wheat exports.
A year ago, oil was trading in the mid $50s. The national average on gas was $2.59/gallon.
Throughout the past year, we've talked about the glidepath to $100 oil (driven by anti-oil policies). And here we are.
Oil closed above $100 yesterday, and traded over $112 today.
With the Biden administration's pursuit of a "clean energy revolution," we've knowingly ceded control of the oil market to OPEC. And OPEC has every incentive to drive prices higher. As I said last year (and penned in a Forbes piece, here), Get Ready For $6 Gas.
Add to this, we now have the additional catalyst of a potential shock to an already undersupplied market. If sanctions were placed on Russian energy exports, there's no telling how high the crude oil market might spike.
With that, we've talked about the prospects of Biden going the route of price controls. It may be coming.
Remember, last night's State of the Union was all about "costs." He said the word "costs" as many times as he mentioned Putin last night.
He's already alleged price gouging from the domestic oil and gas industry and (similarly) called for an "investigation" into U.S. producers (for the audacity of making wider profit margins on higher prices, which is now controlled by OPEC).
Last month, Biden said he would be "coordinating" with major energy consumers and producers, and will be "prepared to deploy all the tools and authority at his disposal to provide relief at the gas pump."
These "tools" may come in the form of some sort of subsidy, at some point, but a subsidy would sustain the demand dynamic for oil. Apply that to a world that is undersupplied and underinvested in new supply, and the price of oil will continue to rise.
