A Valentine’s Day Gift from the Government

Yesterday was Valentine's Day. This is typically a day when we receive notes of affection, and some may receive flowers and chocolates. The government though, gifted us inflation data and it was not warm and fuzzy as the day would demand. For the first time in several months, inflation declined, but not as much as expected, bringing the Y/Y changed down to 6.4%. The markets have reacted negatively to the CPI report, the S&P 500 is off 0.6% and yields have increased across the yield curve as of this writing.

Other data acting to support the narrative embedded in the CPI report, that inflation will be a problem longer than many expect, are the January nonfarm payrolls and the recent first-time unemployment claims. First, the first-time unemployment claims are below 200,000 on a weekly basis, suggesting a labor market that remains strong. Second, the January nonfarm payrolls report showed 517,000 jobs were added to the economy. Both November and December were revised higher by a total of 71,000 jobs. This is a great thing for those getting jobs, but we should not be looking to the Fed for a positive response. It will feel more along the lines of getting hit in the head by a snowball (for those of you who have not had the opportunity to play much in the snow, that is a ball of packed ice that is thrown at friends, or undercover love interests as in the case below, typically all in fun, but sometimes not). The snowball that we may get hit with is in the form of additional rate increases from the Fed. Although prior expectations anticipated only one rate hike, possibly two, the current market is pricing in the possibility of a third hike. This would push rates higher and equities lower in the first half of the year.

The real result might not be so bad. First, within the nonfarm payrolls report, most of the jobs were lower paying jobs in the hospitality sector, which has acted to reduce wage growth to 4.4% Y/Y. This is the lowest growth rate in over a year. Furthermore, unit labor costs, which have a greater effect on inflation than wages, have declined to 4.5% Y/Y growth. These two points suggest inflation pressures really are easing across the economy. Second, more companies are reporting lower costs pressures across most input costs, and therefore, are reporting a lower level of price hikes, again suggesting lower inflation pressures in the future.

There is a third point to be made regarding inflation and that is shelter costs. Housing costs in the CPI report are up to 18-months old so we are still seeing rising housing prices reflected in the inflation reports that are no longer present. In fact, current housing inflation data shows prices are falling and over the next 12-months we will see this reflected in the inflation reports, bringing down inflation faster than what we have seen recently. This assumes that we don’t see a mistake somewhere in the world that would push commodity prices such as food and energy higher.

The effect on the capital markets is largely predictable. Fixed income rates are likely to increase, but not as much as the Fed rate increase. Historically, other points along the yield curve rise by less than Fed funds. Following the last rate increase, we should expect rates to decline. In the past, the yield on the 10-year Treasury declines by approximately 1.0% in the first six months following the last rate increase. If the Fed increases three more times, that would be a June increase and the 10-year may rise to say 4.25%, then decline to about 3.25% if true. However, a word that has been used many times to describe the last three years is unprecedented.

We expect equities to struggle the first half of the year as the markets digest the Fed rate increases from last year and this year. Earnings growth is likely to decline more than current expectations are looking for, this puts downward pressure on prices as the PE multiple is reset. We must remember though, that this is creating buying opportunities in both equities and fixed income, so the hearts above both Calvin and Susie are what we should be focused on going forward. Companies that we like but not yet own have seen prices decline from above $300 per share to slightly above $100 or are down 60% or more, so we like them not only from a business perspective but from a stock perspective as well. In fixed income, the higher yields mean we are starting to add duration or increasing the maturities we are buying. Much of last year we were buying short term bonds, and we still are, but we are now also buying longer maturity bonds to lock in the higher rates and as we near the end of the Fed rate hiking, we look to increase our buying of maturity.