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Welcome back. When inflation comes in lower than expected, and stocks can’t manage a rally, something is going on. Not sure what it is. Are you? Email me if so: robert.armstrong
Cheaper used cars leave markets cold
We know the August inflation report was more or less good news, because Treasuries rallied. Mr Market seems to have seen nothing in the consumer price index numbers to make him think the Fed will move it’s tapering/tightening schedule forward.
Core inflation (which leaves out food and energy) rose just 0.1 per cent from last month and 4 per cent from a year ago. That’s the slowest rate in six months. Used car prices, though still a third more expensive than a year ago, were a little cheaper than last month, suggesting that one of the worst and most visible of the reopening bottlenecks is easing.
So, yay. But a lower-case yay: the good news was not good enough to plug the slow leak in stock markets. The S&P 500 hissed lower again yesterday, and has now deflated by 2 per cent from the highs of earlier this month.
While reopening inflation is giving way — witness those used car prices — some observers see underlying sources of cyclical price pressure. Here is Paul Ashworth of Capital Economics, in a note to clients:
Both rent and owners’ equivalent rent increased by 0.3 per cent month on month, illustrating that the cyclical pressure coming from very tight labour market conditions is seeping into consumer prices. The unprecedented surge in other measures of rents suggests there is a lot more about to come down that pipeline . . . [We] expect further declines [in reopening inflation] over the coming months . . . But, look under the hood, and what we see is cyclical inflation pressure continuing to build
I spoke to Ashworth yesterday. “The pandemic sparked a very dramatic labour shortage,” he told me, as health worries, lack of childcare, enhanced government benefits, early retirements and perhaps even a societal reassessment of work/life balance all coalesced. His worry is that wage pressure jumps to other “sticky” prices — paradigmatically housing — and this leads to a wage-price spiral (for children of the ’70s such as myself, wage-price spirals were the monster our parents scared us with when we were naughty).
Concerns like these are backed by this chart:
Wages are rising, but not nearly at the rate one would expect given the unprecedented explosion in the number of unfilled jobs — 3m more than pre-pandemic levels. How long can this gap endure? (The average hourly wage data probably understate wage inflation because of the return to work of many low-skilled hospitality workers in recent months, which also explains the downward spike this spring, with the arrival of vaccines.)
And if the CPI data do not convince you that there is not a cyclical increase in “sticky” prices, maybe this map of urban rent increases from Apartment List, a rental search site, will convince you:
In yesterday’s letter I called those who think that the markets are not pricing in enough inflation risk “inflation neurotics”. I look at that map and wonder if I was too harsh.
Ashworth thinks it will be some time before the penny drops for inflation sceptics such as Federal Reserve chair Jay Powell:
“It will be a mixed picture over the next 12 months. It is difficult to know if the Fed will have to move. We expect inflation and core inflation to be down next year. But the question is, does inflation get all the way down to [the Fed’s] target? There will be a period of six to 12 months where Fed officials will be able to say, ‘there you go, it’s coming down’ . . . But then the reopening effects will give way and the cyclical components inflation will predominate. That is when it will become clear to the Fed that inflation is not transitory.”
Fund managers own lots of stocks, and are sad
One chart neatly sums up the September edition of Bank of America’s much watched fund manager surveys:
The proportion of the 232 fund managers surveyed by BofA who think the US economy is set to improve has recently plummeted, from more than half to a small minority. Yet despite the pessimism, three-quarters of the managers remain overweight stocks. This is a rare combination, as the chart shows.
The pessimism theme runs right through the survey. The managers’ expectations for profit growth, profit margins and inflation are all coming down. The proportion taking “higher than normal risk” is rolling over. Few managers now think small caps or low-quality stocks will outperform. Cash allocations, while low, are starting to rise.
At the same time, though, the managers want nothing to do with bonds. A whopping 69 per cent are underweight fixed income (light blue lines):
Finally, the proportion of managers who say they have hedged their equities against a sharp fall in the markets is the lowest it has been in three and half years.
I looked at all this and thought “dreary complacency”: pessimism mixed with the belief that stocks will always remain the place to be, regardless. I put that phrase to David Jones, one of the BofA strategists behind the survey, and he said he preferred “bearish bulls”:
“People are certainly long equities, maybe not quite as long as they have been, but they just can’t justify putting a marginal dollar into fixed income at these yield levels. So what else are they going to do?
“So you are seeing this dissonance between the macro outlook, which is darkening, and continued investment in equities . . . Equity flows have been incredibly strong; year to date for 2021 I think they are equivalent to the last 10 or 15 years . . . We are headed for a trillion-dollar year.”
Jones’s team thinks the tension between sentiment and allocation is most likely to be resolved by declining enthusiasm for equities. They think the end of this year could be tough for stocks. The big reason? They think the 40-year bull market for bonds is over, ended by Covid and the political, fiscal and monetary changes that the pandemic has wrought. The super-low interest rates that have kept stock valuations high are set to rise. Change is coming, gradually or quickly. This year’s massive flows could dribble back into cash and bonds, or come out all at once, in a disorderly rush.
I’m not sure I buy Jones’s macro thesis. I am sure, however, that the BofA survey shows a significant change in market sentiment. The ground is shifting.
One good read
The FT’s economics editor Chris Giles is excellent on how both sides of Brexit have shifted into damage control mode.
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