"All of humanity's problems stem from man's inability to sit quietly in a room alone." - Blaise Pascal
Access all of this week's charts used in today's writing and Macro Corner Episode 28: Chart Booklet
Check out last week's podcast episode on the Macro landscape: Macro Corner Podcast, Episode 27
Email [email protected] with any questions as it pertains to today's article or any Macro Corner podcast episode -- we are more than happy to discuss!
Let's start with where the macro week began, which was Tuesday's CPI report coming in lower than expected at 7.1% Y/Y headline and 6.5% on core. Breaking things down into sub-components, contributions to Y/Y headline looked as follows:
Outliers on the upside and downside were rather interesting as food as well as some service-related areas were showing a steep increase while other services slowed. Airfares, for instance, showed a -3% M/M comparison along with health insurance -4.3% on the month. On the flip side, admission to sporting events was up 7.5% from October to November.
Looking at CPI-subindices more broadly, however, there continues to be clear a clear trend from good to services inflation with housing acting on a lag. Tying the CPI print into the Fed on Wednesday, the committee is steering market attention to Services Less Rent Of Shelter. While the Y/Y number has slowed from 8.2% in Sep. to 7.3% in Nov., the services less rent of shelter component is mainly driven by more sticky wage inflation in services. What does that mean? Similar to rents, wages don't reset all at once given how wage negotiations work. While some employers may have adjusted employee compensation this year, other unions may drag negotiations into next year. That dynamic may result in a degree of stickiness. Jay Powell also acknowledged that goods inflation steeply rolling over is exactly what the FOMC has anticipated with housing following the expected lag. It appears, the "only" point of concern is wages, which in turn means labor force participation and deteriorating demographics. Nevertheless, Powell's goldilocks press conference shouldn't shift the entirety of our focus to the positive side. Instead, the Fed Chair emphasized caution against loosening too quickly and therefore staying the course until the job is done. Furthermore, Jay Powell made it clear that the main channel through which the Fed can "control" inflation is financial conditions. As you can see on slide 8 of the chart booklet, financial conditions have eased recently as stocks & bonds have rallied and the Dollar has declined. To be more precise, he did point to the significant tightening since the bottom in easy conditions but made it clear that over time, it's important to see financial conditions restrictive enough to return inflation to 2% on average.
The committee revised core PCE estimates for this year up from 4.4 - 4.6 to 4.7 - 4.8; for 2023, they did revise them higher as well from 3.0 - 3.4 in Sep. to 3.2 - 3.7 on Wednesday. The committee also raised their estimates for unemployment from 4.1 - 4.5 in Sep. to 4.4 - 4.7 with real GDP revised down from 0.5 - 1.5 to 0.4 - 1.0.
While Powell was less hawkish than feared, the cumulative impacts of tightening may have started to affect consumer spending (directly or indirectly.) Retail sales slowed -0.6% M/M on Thursday, putting the Y/Y number at 6.5% (down from 8.3% in Oct.) While these are nominal numbers, how much more can consumers spend going forward after consumption got propelled by trillions of excess savings from 2020-2022? The only two retail sales sub-components that saw a sequential acceleration were electronics (although still negative on a Y/Y basis) and food & beverage stores. Broadly speaking, however, all areas have decelerated since October of 2021 -- nominally that is still very elevated, though.
Thus, as millennials hit their peak-spending years, activity may remain relatively elevated all things considered. Moreover, those same consumers might start to see wage increases above the rate of inflation in 2023 and 2024, which further spurs absolute spending levels (hard to see accelerations, however.) That in turn explains some of the reasons behind goods consumption as measured by PCE well above 2007-2019 trend with real services expenditures back to trend. The issue with that landscape is that structural undersupply of labor in conjunction with energy scarcity and underinvestment in fixed assets can lead to corporate margin compression. Margin compression has its multiplier effects as corporate spending gets cut. Nevertheless, areas that increase productivity and enhance efficiencies (i.e. technology, automation, cloud) can continue to thrive.
Somewhat surprisingly, as treasury yields have settled in recently, so have breakeven inflation rates. Lower breakeven rates have to be interpreted through the lens of secular inflation expectations, which the market appears to price at pre-Covid type levels. Thus, unlike some underlying dynamics in the economy suggest, inflation breakevens continue to look through cyclical inflation for the time being.
Questionable dynamics for corporations come hand-in-hand with central banks globally committed to the fight against high prices; as Christine Lagarde emphasized during Thursday's ECB meeting, the European CB is "in for a long game." She also surprised on the hawkish side when stating that it's obvious to expect more 50bps hikes going forward. More importantly, the head of the ECB was adamant that current projections for the terminal rate would not allow a return to the 2% inflation target, which implies that more needs to be done for market expectations to get priced accurately. Interestingly enough, there appears to be a divergence between what the ECB wants and what the market thinks. While the EUR/USD pair rallied during the press conference, the Dollar strengthened in the back half of the trading session. While that was accompanied by a sell-off in risk assets, we need to pay attention to markets rejecting policy; similar to the market rejecting Liz Truss' stimulus package in the UK, will policymakers face market revolts at an increased rate going forward?
With all the hawk talk, inflation may indeed face the cumulative effects of tightening soon, which then leads to an economic slowdown. Demand destruction, however, does not change the economic fabric by which I mean that central bank policy may actually work against solving supply-side issues.
Since I already introduced the ideas behind the graphs that follow, I will save you time and let the charts speak for themselves. All the graphs can be found here: Chart Booklet
Risk assets globally have rallied on hopes of less hawkish central bank rhetoric going forward. I talked about milestones to 2% average inflation last week and it will continue to be a theme going forward. While markets tend to celebrate during periods of inflation deceleration, the Fed and other central banks might stay hostile for too long. While underpinned by ample liquidity for more than a decade, markets face a liquidity headwind as we speak. Combined with relatively attractive risk-free rates, we may indeed face a regime shift during which portfolio managers re-evaluate how they manage money.
Until next time, good luck & good trading.
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