"That’s how songs happen. They piece themselves together."
- Paul Simon
For anyone who is not especially musically inclined (like myself) but still curious about how musicians come up with songs, there’s a great interview from 1970 between Dick Cavett and Paul Simon that revolves around Simon’s creative process for writing A Bridge Over Troubled Water.
As process fans ourselves, it was both relatable and interesting to hear how his process entailed iteration and incorporation of several different styles from a Bach Chorale to the influence of the Gospel group, the Swan Silvertones. He explained, step by step with the assistance of his guitar, how what began as a simple idea and melody in his head evolved into a fully finished piece of musical art.
It made me reflect a bit about our process here at Hedgeye and how each quarter we combine the Quads with the Signals and the Themes to arrive at a probabilistic framework for the macro path forward.
Back to the Global Macro Grind…
Before we get into inflation – the focus of today’s Early Look – let’s take a brief detour and consider some recent data.
Two days ago, the NFIB released its March Small Business Economic Trends survey. When asked about their expectations for the economy to improve in the next 6 months, Small Business Owners reported a 14-point M/M decrease to a -49 reading. That’s the lowest reading in the history of a series that dates back 48 years. It is rather remarkable that when one considers some of the larger economic environments over the past half-century including the GFC and 1980’s almost 15% inflation, Small Business Owners are currently saying they feel worse about their business’ future than at any point previously.
Interestingly (and relatedly), the same survey found that the net percent of owners raising average selling prices in March increased 4 points to 72%, seasonally adjusted. This also marks the highest reading in the 48-year history of the series. For context, the next highest reading, 67%, occurred in the mid-1970s (Q4 1974 to be exact). Guess what inflation was in December 1974? 12.1% Y/Y. Guess what it was 1 year later? 7.1% Y/Y. Two years later? 5.1%. Now, guess what happened to growth during 1974. The economy was in recession that entire year. Last question: Guess what the S&P 500 returned in 1974? It was down -31% in absolute terms and down -43% in real terms (with inflation at +12%).
At the consumer level, Michigan’s consumer confidence expectations component printed a reading of 54.3 for March. This series goes back over 80 years to 1951. In those 80+ years there have been just 5 prior episodes of (narrowly) lower readings: 1974, 1980, 1991, 2008, 2011. Four of those periods proved to be recessionary. The only exception was 2011 during the European Sovereign Debt Crisis (right on the heels of the GFC).
Michigan also survey’s consumers asking them about their expected change in financial situation one year forward. The most recent March reading was 92. There have been just two prior episodes of comparable readings in the history of this series, which dates back to 1978. The first was 1980. The second was 2008, and 2008 posted a reading of 96 (4 points above the March reading).
Confidence surveys are often dismissed as soft data, for as Andrew Carnegie famously said, “As I grow older, I pay less attention to what men say. I just watch what they do”. To be fair, confidence surveys reflect what people say. But the starkness/extremis of the periods comparative to today is undeniable.
Taking a step back, it is intuitive that confidence is requisite for larger purchases – things like homes and autos. We’re already seeing a noticeable retreat in certain categories. For example, one high-end proxy (second home purchases) has declined by -35% (seasonally-adjusted) in just the two months from January to March, and that is before a significant GSE pricing change added roughly a point to second home borrowing rates effective April 1st. Confidence is also requisite for investment.
Now, let us turn to inflation.
If you are younger than 40 years old, you haven’t lived through higher U.S. inflation than what was printed on Tuesday, and I would argue that unless you are at least 55 years old you wouldn’t have much of a memory of the purchasing power dynamics of the late 1970s/early 1980s either. As most investors tend to skew younger, and are largely retired by their 60s, that leaves a relatively small collective market wisdom, i.e. experience, for inflationary dynamics.
Google agrees. Google Trends News Search for “inflation” and you will find that current news searches on inflation are running at their highest level since the data began in 2008 and are currently ~8x the level of search interest for most of the prior 13 years.
None of this should be surprising to anyone who has followed our work. Our call was consistently for accelerating inflation throughout 2H20 and FY2021 and disinflation in 2022. The War in Ukraine triggered a further energy rally that pushed out the peak in inflation to March/April from where we had expected it to be earlier this year, but the outlook for the rest of the year has not changed.
We expect disinflation, fueled initially by energy costs and used vehicle prices, to begin in Q2. It will begin somewhat slowly – as many phase transitions do – as there will be lagged, residual lifts from shipping costs and shelter inflation offsetting it to an extent in Q2, but 2H is when disinflation will gather momentum.
Base effects are a key component of this dynamic. Consider that since 1948 there have been 7 bouts of inflationary shock, including the current period. The six preceding shocks lasted, on average, 24 months as measured from trough to peak CPI. The max was 28 months while the min was 20 months. The current shock began in May 2020 with CPI 0.3% and we are now 23 months removed from then (1 month shy of the average). In terms of magnitude, CPI has risen 820 bps in those 23 months (from 0.3% to 8.5%). The historic average of those prior episodes was 710 bps. Why such tight dispersion around the duration mean? Two reasons: base effects and policy changes – we’ll get to the latter in a moment.
But first, where is the inflation coming from? On a weighted basis, the largest contribution factors are transportation, shelter, and food. These three categories account for ~94% of current inflation while their basket weights are just 72%. Notably, transportation and energy prices are largely already at/past peak. As yesterday’s Early Look mentioned, Energy prices would need to move dramatically higher from here to further accelerate inflationary pressures – we specify those precise levels in our Q2 Macro Themes deck. Used vehicles – a massive contributor at ~15% of total CPI on a weighted basis – are now in retreat based on both the latest Manheim data as well as the March CPI data.
Curious about Shelter and Food – the other two big contributors? We detailed the outlook and timeline for those in our Q2 Macro Themes presentation. To summarize, Shelter should peak this Summer and become disinflationary over the course of 2H. Food is more complicated with various lead/lags at play across the different commodity and fertilizer inputs.
Now, let me spend a moment on policy. This is where, at least historically, things get a bit more interesting. In the five inflationary shocks since 1953, the average policy response has been to increase Fed Funds by 6.5%. The concomitant increase in the 10-year treasury yield, however, has averaged just 2.2% across those same periods. In other words, we’ve seen the bond market consistently sniff out the growth-imperiling implications of those massive rate hikes. Today seems no different with ~19 hikes effectively priced in by year-end inclusive of the QE Shadow Rate lower-bound contribution (+~5% to effective Fed Funds, all told) with a 10-year treasury yield that has lifted by 1.1%.
As we’ve stated often, the faster the Fed goes, the more things they’re going to break. While they’re tightening cycles have historically averaged 28 months in the previous 5 inflation shocks, this time they’re on pace to get most everything done in less than half that time because they’re late and playing catch-up. That swiftness of acceleration in policy is likely to break things harder than the economy or the market is prepared for. The bulk of that realization will manifest this quarter.
As Paul Simon said, Songs piece themselves together. So too, do macro environment phase transitions.
Immediate-term Risk Range™ Signal with @Hedgeye TREND signal in brackets:
UST 30yr Yield 2.40-2.90% (bullish)
UST 10yr Yield 2.34-2.87% (bullish)
UST 2yr Yield 2.28-2.55% (bullish)
High Yield (HYG) 79.22-81.58 (bearish)
SPX 4 (bearish)
NASDAQ 13,118-14,109 (bearish)
RUT 1 (bearish)
Tech (XLK) 144-155 (bearish)
Gold Miners (GDX) 38.01-41.16 (bullish)
Utilities (XLU) 73.28-77.60 (bullish)
Healthcare (PINK) 26.84-28.28 (bullish)
REITS (XLRE) 48.05-49.99 (bullish)
Shanghai Comp 3150-3279 (bearish)
Nikkei 26,120-27,461 (bearish)
DAX 13,895-14,576 (bearish)
VIX 19.04-26.10 (bullish)
USD 98.85-100.65 (bullish)
EUR/USD 1.077-1.103 (bearish)
Oil (WTI) 92.74-105.76 (bullish)
Nat Gas 5.66-7.12 (bullish)
Gold 1 (bullish)
Copper 4.59-4.82 (bullish)
Silver 24.31-26.19 (bullish)
To your continued Success,
Josh Steiner
Managing Director
