A Colleague Joins the TEN-year Club & an Inflation Update

Tim and Ryan sit down to reflect on Ryan reaching 10 years at TEN Capital, and how much he’s come to mean to clients and colleagues.

FIVE THINGS YOU SHOULD KNOW

Equity Markets – rose this week with U.S. stocks (S&P 500) up 1.95% while international stocks (EAFE) gained 2.67%
Fixed Income Markets – also moved higher this week with investment grade bonds (AGG) up 0.18% while high yield bonds (JNK) gained 1.26%
Central Bank Pushback – After recent stronger-than-expected economic data, Central Bank officials both domestic and abroad have pushed back on the notion that there will be an imminent pause on rate hikes. Two more Fed officials spoke this week that rates should be pushed higher, while markets are now pricing-in a 4% peak to Euro-area interest rates as inflation remains elevated.
China Rebounding? – After abandoning their COVID restrictions the Chinese economy is starting to show signs of a stronger rebound. The manufacturing sector saw its biggest improvement in over a decade while the housing markets showed signs of stability. All eyes will be on next week’s National People’s Conference where President Xi’s government will announce their updated growth target.
Key Insight – [VIDEO] Tim and Ryan sit down to reflect on Ryan reaching 10 years at TEN Capital, and how much he’s come to mean to clients and colleagues. [ARTICLE] We update our outlook on inflation and share some insights from analysts we respect, including a great piece from Scott Grannis with lots of interesting charts.

INSIGHTS for INVESTORS

Where is Inflation headed?

After a great start to the year markets have pulled back the last few weeks on renewed fears that inflation may prove stickier than previously hoped. Such fears may be premature despite January’s surprising inflation report.

As we saw with today’s ISM Services report which came in a bit lower than January’s reading (55.1 vs. 55.2), there is reason to believe growth may be in the much hoped for “goldilocks” zone with continued expansion, albeit at a modest pace, without the type of reacceleration that would further stoke inflationary concerns.

The 10-year Treasury falling back below 4% is another positive sign as well, as the 10-year has been a far better predictor of future rates than any Fed governor.

The reality is regardless of the size of the Fed’s next rate or speculation on inflation, it’ll be a couple months until any can say with great confidence what the path of inflation is. That said, as the guest article from oft-cited Scott Grannis covers the evidence strongly suggests that downward trend is still very much intact.

What’s an investor to do?

Here at TEN we’ve begun to lock in gains from our trades of the last few years, and position into some exciting areas within fixed income with the belief that over the next few years inflation and interest rates should fall, which will be beneficial to our new holdings.

In the short run, we continue to encourage clients to look at their cash holdings and still sub-par CD’s and consider alternatives that can provide considerably more income to help preserve their wealth while inflation still runs well above its long-term average. As Bloomberg columnist Alexis Leondis noted this week, “Certificates of deposit are one of the oldest, safest bank products around, but investing in shorter-term CDs right now just isn’t worth it. Yet people are still flocking to them.”

You can do better, we can help.

Below you’ll find the article from Scott Grannis which should provide some encouragement that things are still improving on the inflation front. Not mentioned in this article, but recently noted both by Scott and Brian Wesbury of First Trust, among others, is the continuation of encouraging developments with regards to monetary supply which peaked a year ago and is falling at the fastest rate since the Great Depression (a good thing). (see accompanying chart)

As Grannis noted in another piece “the growth of M2 with the year-over-year change in the CPI, which is shifted one year to the left in order to show that money growth leads inflation by about one year. This chart further suggests that the year-over-year change in the CPI will gradually fall to the Fed's 2% target over the course of this year, thanks to the huge deceleration in M2 growth over the past year.” (see accompanying chart)

Remember to look beyond the simplistic and hyperbolic headlines in your efforts to find the truth and keep your focus on what you can control.

We are always here to help with either.

Have a wonderful weekend,

Tim and the team at TEN Capital

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Inflation fears are overblown

By Scott Grannis (Chief Economist from 1989 to 2007 at Western Asset Management Company)

Stock market bears are fixated on the belief that inflation is not only "running hot" but also "accelerating." Nothing could be further from the truth.

Some charts that help put things into perspective:

Chart #1

Chart #1 shows that existing home sales have fallen by 36% in the past year. This is extraordinary. Given the lags in reporting this data, the reality is likely worse. We are in the midst of dramatic weakness in the housing sector.

Chart #2

Chart #2 shows the likely culprit: a once-in-a-lifetime surge in the cost of borrowing money to buy a house. 30-yr fixed rate mortgages are now back to 7%, which is more than double the level that prevailed just over a year ago. Combined with rising home prices, this has increased the cost of buying a house by at least one-third in a very short time span. It's likely that the market has not yet had time to fully adjust to this new reality. It can only mean further weakness in the housing market.

Chart#3

Chart #3 shows that applications for new mortgages have dropped an astonishing 58% in the past year. The Fed missed the signs of rising inflation (they should have been watching M2 growth years ago) and now they have slammed on the brakes and are talking tough. Sharply higher interest rates, in turn, have dramatically affected the public's ability and willingness to buy a home. There is no question that monetary policy has had a dramatic impact on the real economy and on prices. Conclusion: the Fed should stand pat and watch how things evolve from here.

Chart #4

Chart #4 compares the level of 30-year fixed mortgage rates (white line) with the 10-yr Treasury yield (orange line), and the spread between the two (bottom half of the chart). This is what happens when bond yields surge unexpectedly: investors in bonds and mortgages have been burned (it's been the worse bond market in many lifetimes) and now they are twice shy. Demand for these securities has collapsed, pushing mortgage rates to an almost-unprecedented level above that of 10-yr Treasury yields. Normally this spread would be about 150-200 bps, but now it's over 300. The bond market has amplified the Fed's tightening efforts. It's VERY expensive to borrow at fixed rates these days.

Chart #5

Chart #5 shows that natural gas prices have truly collapsed, falling by way more than ever before in a short span of time. Traders say it's due to warm weather in the East. Regardless, this is an important source of energy for vast swaths of the economy, and it equates to a powerful deflationary force. And let's not forget that oil prices have plunged 35% from their highs last May. It's not just the weather; commodity prices are down across the board over the past 6-12 months. Monetary policy is undoubtedly one of the reasons.

Chart#6

Chart #6 tells us that the bond market feels pretty good about the outlook for inflation. The spread between 5-yr Treasuries and 5-yr TIPS is now less than 2.5%, which means that the bond market expects the CPI to average less than 2.5% per year for the next 5 years. Higher interest rates have convinced bond traders that the Fed has done enough. Chairman Powell, are you listening?

Chart #7

Chart #7 compares the relative prices of services, non-durable goods, and durable goods. What an amazing divergence! Service prices are largely driven by wages, and durable goods prices have fallen thanks in large part to Chinese exports (which began to get underway in 1995). Durable and non-durable goods prices have been flat for the past 5-6 months, while service sector prices continue to rise. The Fed presumably worries that wages and low unemployment rates will continue to drive inflation higher. Do they really want to see bread lines showing up all over the country? Wages don't cause inflation: they are driven by productivity and the imbalances between the supply and demand for money.

As for productivity: since 1995 service sector prices have increased 3 times more than durable goods prices! In rough terms, that means that one hour of the average worker's time today buys 3 times as much in the way of durable goods than it did in 1995. No wonder nearly everyone is able to afford to carry a super-computer, high-end camera, and internet connection in his or her pocket.

Chart #8

Chart #8 shows the year over year changes in the Personal Consumption Deflators (with the Core version being the Fed's favorite measure of inflation). Both rates came in a few tenths of a percent higher than the market expected. Does that sound like inflation accelerating? Or running hot? No. Inflation pressures peaked many months ago. Both of these measures are on track to show year over year gains that are much lower than their current level. It takes time for monetary policy–which is undoubtedly tight—to work its way through the economy.

We just need to be patient.

DATA, JUST THE DATA

Data points this week included:

U.S. Durable Goods Orders – fell -4.5% in January, the biggest monthly decline since April 2020. However, with the volatile transportation sector excluded orders were up 0.7%
U.S. Consumer Confidence – saw an upward revision to 67 in February for the highest level in over a year. We also saw inflation expectations for the year revised lower to 4.1% from 4.2%
U.S. Pending Home Sales – saw a surprising 8.1% boost in January for the biggest hike since June 2020. Home sales have now risen for two consecutive months, but are still down -24.1% year-over-year.
U.S. ISM PMI – rose slightly to 47.7 in February from January’s two year low as companies continue to slow outputs to better match demand for the first half of 2023.
U.S. Jobless Claims – fell by 2,000 last week for a total of 190,000 initial claims. Continuing claims also fell to 1.655 million, the lowest level in 4 weeks.