Stocks had a whipsaw of a session yesterday, closing mixed after the Bank of England sent a scary message from across the pond. Hawk talk has not and will not let up until things get better… or worse.
All journeys come to an end. Will the pain end? Yes. When? Well, that is the BIG question, isn’t it. Let us lay it all out and see if we can come up with some clues. At a high level, the entire globe is in a bit of economic discomfort. The root cause is global inflation. A perfect storm caused by the post-pandemic boom, still-broken pandemic-era supply chains, the war in Ukraine, and none other than Mother Nature, herself. Hey, it happens, though not often, which is why it feels so uncomfortable. Inflation is not a bad thing, but too much of it causes economic growth to cease and, even more important to politicians, it causes political unrest. As I have written many a time, history is full of headless monarchs who were indifferent to the struggles of their subjects… cake is not a good substitute for bread. Ok, so it is obvious that inflation must be put down and the only way we know how to accomplish that is to… well, increase the pain. That is accomplished by raising interest rates, and in these modern times (possibly even more effective) is to use media to freak out consumers… and stock investors.
Not only is the US’s very own Fed tightening the screws, but also just about every central bank on the globe (Japan is the most prominent outlier). There are only two conditions that would cause central banks to change their strategies. The most obvious condition is a reduction in inflation. The second condition is economic calamity. Raising interest rates during a recession could quite possibly result in peasant uprisings and is therefore, unlikely. So, where are we on those two conditions.
Consumers are still spending, and many sentiment indicators remain healthy. HOWEVER, there are many signs that spending habits are shifting, which is an early sign that Fed policy is on target. Companies are beginning to experience demand “headwinds”. When a company admits to “headwinds”, I can assure you, that it has a very good reason to do so, as it typically causes its stock to lose value. Therefore, while consumption still appears to be strong on face value, it may not persist for too much longer. Earnings are beginning to trickle in AS I WRITE (PepsiCo, PEP, announced a beat and is up by +1.48% in the premarket), and earnings season “officially” begins on Friday. We are likely to hear lots of anecdotal information on sales in the coming weeks which should add to our well of information on this. Once consumption begins to decay, prices will start to moderate. If you want to sell something and no one shows up to buy it, you have no choice but to lower your offering price. Consumption for the moment, however, remains solid. How can that be with all these negative factors rolling around out there? Perhaps William Phillips has the answer.
Ok, now I have you really confused. “Who on earth is William Phillips,” you ask? Phillips was an economist who wrote a paper in 1958 entitled The Relationship between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957. I will save you the pain of reading the paper and simply let you know that it sparked a watershed of further research which resulted in what is known as the Phillips Curve, which detailed the correlation between employment and inflation. Low unemployment is correlated with high inflation, and vice versa. That makes intuitive sense. When there are lots of jobs, consumers are confident, and they spend more money; the increased demand leads to price increases. Additionally, a tight labor market leads to increases in wages, forcing companies to hike prices to cover the higher costs. That is precisely the condition that we are in today. Throw in a tankful of COVID-era stimulus checks and it is no wonder that we are experiencing inflation. Ok, so the Phillips Curve makes sense. More importantly, the Fed follows the Phillips Curve. That means that the central bankers, who are in charge of maintaining a healthy labor market, would like to see that market become… less healthy, in order for inflation to go down. Here is the problem. Last Friday, we learned that the Unemployment Rate, was at a 50+ year low. After that number came out, equity markets sold off and bond yields rose. How long will that persist given all the Fed’s rate hiking? Well, surely not indefinitely, and there are signs that the labor markets might be in for some changes. Not a single day goes by now without reports of large, healthy companies announcing layoffs. A notable one occurred last night WHILE YOU SLEPT, when Intel announced sizable layoffs. The reason cited was weak demand for PC’s. So, consumers ARE actually pulling back. If Intel is doing it, others are sure to follow. By the way, Intel employs 113,000 workers, so the admission is meaningful.
All of these are signs that progress in the fight with inflation is being made. Those layoffs will eventually show up in the economic numbers watched closely by the Fed. Lower demand will cause inflation to ultimately cease. Really, it is a question of when not if. So, the answer to the “when” question, is while we are not there yet, we are getting there, so stay positive and stay focused.
YESTERDAY’S MARKETS
Markets attempted to rally yesterday but were put off by statements made by a Bank of England official warning that the central bank will cease to prop up the countries Gilt market which has been in a free fall (Gilts are the UK’s version of US Treasuries). The S&P500 slipped by -0.65%, the Dow Jones Industrial Average gained +0.12%, the Nasdaq Composite Index dropped by -1.10%, and the Russell 2000 Index advanced by a scant +0.06%. Bonds fell and 10-year Treasury Note yields climbed by +6 basis points to 3.94%. Cryptos fell by -2.42% and Bitcoin slipped by -1.15%.
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