LIZ ANN SONDERS: Hi, everybody. Welcome to the November Market Snapshot. In this video, I will share our latest thoughts on inflation, which is, let’s just say, clearly less transitory than what the Fed expected when it first added that word into its lexicon. In fact, during the latest post-FOMC Meeting press conference, Fed chair Jerome Powell used the word ‘persistent,’ clearly the opposite of transitory, 11 times. Now, even if as the FOMC statement noted, the factors behind inflation’s rise are, ultimately, transitory, price pressures and their causes and effects are broadening, including the labor market’s impact on inflation, which I’ll discuss as well.
So let’s start with a quick, long-term look at the most common inflation metric, which is the Consumer Price Index. And the chart here shows the headline reading, which includes food and energy prices. As you can see although inflation has jumped, it does still pale in comparison to the inflation of the 1970s era. And as many remember, certainly me, I’m old enough, that was a toxic combination of weak growth and incessantly rising inflation, but, also, really weak productivity and a high and deteriorating unemployment rate. And it’s the absence of that labor market weakness, the high and deteriorating unemployment rate, that perhaps surrenders the label of stagflation not yet applicable.
Now, a specific metric or index borne out of that ‘70s stagflation era was the so-called Misery Index. Again, those of us more mature will probably remember that. That’s simply the addition of the inflation and unemployment rates. And as you can see, although it is the openly elevated relative to where it’s been recently, it’s well lower than it was during the 1970s.
I think there’s maybe a better explanation for what’s happening today. I believe we have transitioned from what’s called procyclical inflation when high demand pushes up prices to countercyclical inflation when high prices push down economic activity.
Now, the pandemic has been characterized, as we know, by massive shifts in consumption patterns that has resulted in huge relative demand shifts. And that’s been alongside the well-known acute supply bottlenecks, including, more recently, these labor shortages. So let’s look at today’s unique labor market conditions and tie them into the inflation outlook from here.
So this chart looks at the combination of job openings and what’s called the quits rate. That measures the percentage of the workforce voluntarily quitting their jobs. So not only are job openings well higher than the number of people currently unemployed, the quits rate has gone parabolic. That near 3% reading means that nearly 3% of the entire US workforce quit their jobs in the latest month for which the data is available. This phenomenon even has a catchy new title. They’re calling it the Great Resignation.
But such a high quits rate does suggest confidence in finding another job. It’s also likely driven by these interesting stats. When you look at annual wage growth for job stayers, it’s currently about 3.5% but for job switchers it’s a much higher 5.5%. So there’s the incentive.
Now, admittedly, there are many ways to measure wage growth, with one of the broadest being the Employment Cost Index, and that’s what’s shown here, ECI for short. In particular, the biggest increase has been within services occupation as you can see with the yellow line. Although overall employment costs, which are those light-blue bars and for workers outside of services, that’s the darker blue line, have also been accelerating. Now, productivity needs to be tied into labor market conditions, as well, both as an economic driver, but also an inflation driver.
Now, in terms of another way to measure labor cost as it ties to productivity, the unit labor cost, ULC metric, is defined as how much businesses pay workers to produce a unit of output, and it includes both wages, but also benefits. As such, labor productivity increases can offset the impact of wage increases on unit labor cost. Unfortunately, the latest data on both moved in the opposite direction, and in the wrong directions, basically, not in the right way.
Now, this data is quarterly, and as you can very clearly see here, very, very volatile. Yes, for the third quarter, unit labor costs were up at whopping 8.3%. Productivity fell by 5%. But not only, again, is this data highly volatile, there is still so much pandemic-related noise in so many economic numbers, not least being these. But for now we need to chalk this up as a negative.
Now, in terms of inflation’s impact on workers, themselves, the chart here takes a long-term look at real average weekly earnings. And this is for production and non-supervisory workers, so, basically, not the bosses. By looking at real earnings, we are subtracting inflation from nominal earnings. And for all the fanfare around the surge in wage growth, unfortunately, the bite of inflation has been significant enough to cause this recent plunge into negative territory of real earnings. Now, we’ve seen a bit of a retreat back up, but this is something worth watching.
Now, there is some good news. The gains of lower wage workers have been exceeding price inflation in recent months, while price inflation has been outpacing the wage gains of higher wage workers. Now, admittedly, higher income households are better positioned, of course, to weather this higher inflation storm, especially given their elevated savings since the pandemic erupted. But the good news is that the trends for lower wage workers are encouraging, especially because their wage gains are above inflation.
Now, inflation pressures broadly help explain another interesting thing that has happened, which is the shift in consumer confidence in terms of the component questions asked each month in the case of the survey done by the Conference Board. So as shown here, there is an historically wide spread between consumers view about their present situation, which remains fairly healthy, you know, thumbs up, not bad, and their expectations about the future. Those have weakened notably. In fact, as you can see, the spread has never been this wide, this low, other than heading into recessions, historically. Now, not to worry, we’re not making a recession call, but have been pointing out that some of what’s happening in the economy, including the inflation backdrop, including this unique consumer confidence circumstance, suggests maybe some premature aging in terms of where we are in the cycle.
Now, on that subject, the pandemic-related surge in corporate profit margins is likely to come under some pressure near-term, given the spike in input cost, including labor cost, for most companies. One way to measure that is to look at the spread between the Producer Price Index, the PPI, and the Consumer Price Index, the CPI. So the first measure is basically input prices, and then what is being filtered through to consumer prices. As you can see, wider spreads historically have been met with weaker equity market performance. So it is arguably a risk factor going forward, to the extent there is not a narrowing to come. A risk factor maybe broadly for the market, but certainly for a metric like profit margins.
Now, there may be some better news on the horizon suggesting that some peaking in this supply bottleneck problem maybe underway. There’s an index I track called the Citi Inflation Surprise Index, which measures how inflation data is coming in relative to consensus expectations. And as you can see, it is off the recent peak, albeit from an historically high peak.
Now, if you look at that table below the chart, you’ll see that the S&P 500 has had, maybe not surprisingly, weaker performance historically when inflation surprises were in their highest zone, versus when in the lowest zone. Interestingly, though, small-cap stocks have fared better than the S&P historically in the higher inflation zones, which, by the way, could help explain some better performance down the capitalization spectrum recently. So that’s just an interesting bias towards smaller cap stocks driven by this inflation story.
But here is, perhaps, the key message with regard to inflation in the stock market. It matters, absolutely, but so does the economic backdrop. So I’ve got two back to back charts here.
The first tells the story historically, but tied just to inflation. So the chart simply looks at inflation regimes between 1950 and the first quarter of this year. So, basically, we’re looking at the period just prior to the start of this year’s inflation spike. And as you can see, when the CPI measure of inflation was declining, historically, stocks performed much better than when inflation was rising. That shouldn’t be much of a surprise.
But take a look at this next chart, which puts inflation in the context of overall economic growth. And we’re measuring that by just annual real GDP growth, so that’s inflation adjusted real GDP growth. And if you look at that first pair of bars, that represents the lowest quartile of GDP growth. It does show that stocks were notably weak when inflation was rising. At the same time, GDP was weak. However, look at the pair of bars to the far right. Stocks actually performed better during rising inflation than during falling inflation if GDP growth was in its highest quartile of growth. And the moral of the story is that it’s both the inflation and economic growth backdrop that matters for market performance.
Now, third quarter GDP growth was weaker than expected. It was still positive though, and the outlook for the fourth quarter and into next year remains fairly right. In fact, for now, anyways, suggests a healthier backdrop than if inflation was spiking and economic growth was really, really deteriorating into negative territory.
Now, as an addendum to that moral, keep an eye not just on inflation trends, but the trajectory of the economy, as well, as it’s the combination that drives market behavior, not one or the other.
Thanks, as always, for tuning in. We’ll look forward to next month.
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