Despite a strong annualized Q1 GDP of 6.4%, expectations for an even stronger Q2 number, and an economic recovery that is widely considered to be significantly stronger and faster than expectations, the economic news started to sour a bit this week. Building on last Friday’s negative employment report shocker, this week saw weaker than expected results in consumer sentiment and retail sales. The big news, however, was from April PPI and CPI reports.
The University of Michigan’s Consumer Sentiment Index unexpectedly fell 5.5 points to a reading of 82.8 on inflation worries. Economists polled by Reuters expected a third straight monthly increase, and had been estimating a strong reading of 90.4. Meanwhile, The Commerce Department said on Friday that retail sales were flat on the month, falling short of expectations of a 1% gain. Core retail sales fell 0.8% on the month, rather than rising 0.7% as expected. On the positive side, according to the Federal Reserve on Friday, manufacturing production rose in line with estimates at 0.4% last month after surging 3.1% in March.
This week, the BLS reported that the Producer Price Index rose 0.6% from March. Year over year, the PPI spiked 6.2%. The results indicate another “hot” report, as economists were expecting a 0.3% monthly increase in April and a 3.8% year over year number. The heat was also emanating from the April Consumer Price Index report. April CPI rose 4.2% from a year earlier vs. expectations of a 3.6% increase. The month-to-month gain was 0.8% against the expected 0.2%. Core CPI increased 3% from the same period in 2020, and 0.9% on a monthly basis. The respective estimates for core CPI were 2.3% and 0.3%. To put these “hot” results in perspective, the increase in the annual headline CPI rate was the fastest since September 2008, while the monthly gain in core inflation was the largest since 1981.
After the CPI data was released, the eurodollar futures market, which gauges U.S. interest rate expectations, reacted. According to Reuters, eurodollar futures are now anticipating around an 80% chance of a rate increase from the Federal Reserve by December 2022 and the market sees a total of three hikes by December 2023. This pulls forward the date of an expected rate increase by several months. Senior rates strategist at TD Securities Gennadiy Goldberg, referring to the growing number of data points revealing hotter than expected inflation, said, “Markets are getting nervous about the rise in inflation….” Interestingly, the TD Securities strategist went on to temper these concerns, not with actual data, but with a reference to the assurances of numerous Federal Reserve voices that expect inflation will moderate later in the year.
This tension between actual emerging data points and Federal Reserve assurances is starting to escalate. In a “touch-’em-all” Wall Street Journal Op Ed piece titled “The Fed is Playing with Fire,” revered investor and fund manager Stanley Druckenmiller aired his concerns over Fed mishandling of a host of interrelated issues, including asset bubbles, inflation, the bond market, and US Dollar reserve currency status. Druckenmiller wrote that:
“With Covid uncertainty receding fast, and several quarters deep into the strongest recovery from any postwar recession, the Federal Reserve’s guidance continues to be the most accommodative on record, by a mile…. Even after trillions spent to prop up the bond market, foreigners have continued to be net sellers. The Fed chooses to interpret this troubling sign as the result of technicalities rather than doubts about the soundness of current and past policies…. Just because the Fed hasn’t faced big trade-offs in recent decades doesn’t mean trade-offs aren’t coming or that they no longer exist…. Inflation is already at historical averages. Serious economists soundly rejected price controls 40 years ago. Yet the Fed regularly distorts the most important price of all—long-term interest rates. This behavior is risky, for both the economy at large and the Fed itself.”
Druckenmiller’s scathing commentary continued in a CNBC interview later in the week: “I can’t find any period in history where monetary and fiscal policy were this out of step with the economic circumstances. Not one.” He went on to add that this extreme Fed mishandling is occurring in the context of “a raging mania in all markets.” For those worried about misguided faith in the Fed and the potential for severe unintended consequences from any Fed policy mistakes, the implications of Druckenmiller’s critique are chilling. Mr. Druckenmiller is not alone. His concerns are shared by many.
On Friday, a voice of concern was heard from inside the Federal Reserve itself. Dallas Federal Reserve President Robert Kaplan, an outspoken rogue member of the Fed family whose views are frequently not aligned with Fed consensus, is not totally sold on Fed policy wisdom. According to Reuters, speaking on inflation data, Kaplan said, “What you don’t know is…whether that starts to get embedded in inflation expectations, and you worry that inflation expectations start to get to be more elevated, and then you are getting them elevated to a level that is not consistent with anchoring them at 2%.”
Kaplan’s concerns over the inflation expectations side of the story seemed to be justified by Friday’s University of Michigan survey. As always with inflation, it is expectations for future inflation that could be the biggest wild card. A rise in expectations may pose the biggest risk of escalating the problem and entrenching inflation in the economy on a longer-term basis. In the survey, consumers’ estimates of inflation shot up to 4.6% for this year and 3.1% for the next five years. That’s the survey’s highest reading for both measures in more than a decade.
Karim Basta, chief economist for III Capital Management, said in a note to investors on Friday, “It remains surprising how many Fed officials describe expectations as ‘well anchored’ despite those expectations measures being very much on the move. Perhaps if they miraculously stopped here they could be seen as well anchored, but that doesn’t appear to be the case….” If the divide between the data and the Fed continues to widen, expect the number of concerned citizens to grow and become increasingly vocal and alarmed.
This tension between a dug-in Fed insisting on ultra-dovish policy and facts on the ground arguing for a tightening cycle is clearly starting to build. What’s at stake here is the risk of painful inflation, asset bubbles, the national debt, and a future of crushing interest expense burdens, bond market stability, and the US dollar’s purchasing power and it’s longer-term reserve currency status. Perhaps a less appreciated risk, with all sorts of significant implications including market prices, is Fed credibility. Confidence in the Fed at this point in the cycle may be the glue holding the equity bull market thesis together. As long as the Fed is accepted as Oz the great and powerful, the market has been comfortable putting aside the cautionary PE multiple for a more pleasing preference for the bullish Fed-backed QE multiple. If undeniable inflationary developments on the ground continue to assert themselves and firmly take root, the Fed’s apparent omnipotence and credibility may be another bubble that bursts.
If the great and powerful Fed is revealed to be little more than a collection of mere mortals hiding behind the curtain, it will instigate a crisis of confidence and necessitate, on the part of the investment community, a significant realignment back toward deep fundamental analysis and risk assessment. If the PE multiple and fundamentals reassert themselves, that may well be last call at the punchbowl. At MWM, we’re looking downfield at these risks and doing the work necessary to identify well-positioned hard assets offering deep fundamental value.
As for weekly performance: It was a volatile week for prices. The S&P 500 was down 1.39%. The yellow metal was up 0.37%, silver lost 0.44%, platinum declined 2.53%, and palladium was down 1.00%. The HUI gold miners index had a nice week, up 1.60%. IFRA, the I Shares US Infrastructure ETF, was down 1.14%. Energy commodities were higher on the week. Oil rallied 0.72%, while natural gas prices were up 0.10%. The CRB Commodity Index was lower, slipping 1.77%. Copper was down 2.11%. The Dow Jones US Real Estate Index ended the week down 1.23%, while the Dow Jones Utilities index was down 0.24%. The dollar was modestly higher on the week, up 0.11%. The yield on the 10-year Treasury was up 3 bps.
Have a great weekend!
Chief Executive Officer