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Weekly Update 10/14/2022: Inflation MEasures Remain Elevates as Earnings Season Commences

  • JP Morgan releases earnings reporting strong results beating expectations and raising guidance
  • Wells Fargo releases earnings soundly beating expectations
  • Accenture wins $189 million Centers for Disease Control and Prevention (CDC) contract
  • Boeing 737 Max Jet lands in China for first time since 2019; they also announce a solid 96 jet orders for September
  • Johnson & Johnson releases announces positive results for its ulcerative colitis therapy drug Stelara (ustekinumab) in a Phase 3 trial

Domestic Economic News

One interpretation of the moves in the bond market this week is that fixed income traders may be suggesting the Federal Reserve has their forecasts right. The dot plot – or forecasts for the Fed funds rate provided at the FOMC’s last meeting – suggest that the fed funds rate will very likely be at 4.25%-4.50% by year end. With the CPI figures released this week the market is suggesting that may actually move higher to the 4.50%-4.75% range. Bond traders are pricing in exactly that – a 75bps rate increase at their November meeting and now the distinct possibility we see another 75 bps increase at their December meeting. Beyond that the peak rate in the forecast is about 4.625% which implies after they are done this year there would be two more 25 bps rate hikes. Again after the CPI numbers were released this week the marked pushed up the Fed funds peak expectations to between 4.75%-5% - not surprising given the numbers we witnessed on Thursday which we describe below. This would imply actually three 25 bps additional hikes at some point after year-end. Whether that comes all at once or in stages remains to be seen and that will depend on the data that comes in between now and then. Then at some point in the distant future rates will come down to a long term rate which is lower than that - the Fed refers to that as the terminal rate. They are saying – in simplistic plain English terms – the actions they are taking now will result in inflation coming down which we all agree is important and also it will slow the economy. Their view is it will not necessarily put us into a recession but if a recession occurs it should be relatively short and mild. Despite equity traders going bananas – some of which is just algorithmic trading programs used by hedge funds which have in general done terribly in recent years – when we look at the yield curve it seems to us that the more rational fixed income traders are actually buying into the Fed’s view giving them credibility.

How do we come to that conclusion? Well the bond market has rates pretty much exactly where we expect the Fed is forecasting they will go. If fixed income traders believed – as some equity traders seem to believe – that the economy was going to crater because the Fed is going to go too far – well then we would argue that longer term interest rates would actually be much lower than they currently are. At the time of writing this section of the weekly, the Ten-year U.S. Treasury was sitting at 4.05% and this was immediately after the release of the CPI figures. This would imply a longer term terminal rate of between 4.0%-4.25% which seems reasonable to us. Can the economy handle a more normalized interest rate environment? It remains to be seen but having managed money for 25 years – while the rate environment continues to be a little bit quirky – it actually seems like a more normal interest rate environment than we have seen for a number of years. If fixed income traders had a really dim view of the longer term economic outlook then the Ten-year would be trading at a lower interest rate right now. We are approaching a slowing economic environment here in the U.S. from a position of strength in terms of the employment picture – and that is really important to keep in mind. Bonds – short term Treasuries and intermediate term corporate bonds have become an attractive asset class again – while equities - once the Fed does ease their foot off the brake pedal and we see inflation come under better control – offer attractive upside from these levels in terms of both price appreciation and rising dividends. So far this year in fact while asset prices are down, of the 41 SGK Core Stocks in our portfolio, 25 have raised their dividend and the year is not over yet – we are confident there is more to go.

On the inflation front, the news was really not that shocking or better put – it no longer seems to shock traders. Prices paid to US producers rose in September by more than expected, suggesting inflationary pressures will take time to moderate and keeping the Federal Reserve on its aggressive interest rate-hike path. The producer price index for final demand climbed 0.4% from August, the first increase in three months, and was up 8.5% from a year ago, Labor Department data showed Wednesday. Excluding the volatile food and energy components, the so-called core PPI increased 0.3% in September and advanced 7.2% from a year earlier. The median estimates in a Bloomberg survey of economists called for a 0.2% monthly increase in the PPI and a 0.3% rise in the core. While supply chain disruptions have generally improved, costs rose for energy, foods and services. Two-thirds of the increase in the PPI was traced to services as prices for travel and accommodation, food retailing, portfolio management and hospital inpatient care. The government’s consumer price index on Thursday is expected to show another solid advance, highlighting still-rapid and broad inflation that will probably lead Federal Reserve policy makers to boost their benchmark interest rates another 75 basis points next month. Many companies have successfully passed on much, if not all, of the increases in input and labor costs, but it’s unclear how long they can continue to do so as consumers begin to balk at higher prices. Wednesday’s report showed goods prices increased 0.4%, reflecting higher energy and food costs. Food prices climbed 1.2%. Excluding food and energy, the index of goods costs was unchanged. Services prices increased 0.4%, the most in three months.

A closely watched measure of US consumer prices rose by more than forecast to a 40-year high in September, pressuring the Federal Reserve to raise interest rates even more aggressively to stamp out persistent inflation before it becomes entrenched. The core consumer price index, which excludes food and energy, increased 6.6% from a year ago, the highest level since 1982, Labor Department data showed Thursday. From a month earlier, the core CPI climbed 0.6% for a second month. The overall CPI increased 0.4% last month, and was up 8.2% from a year earlier. The median forecasts in a Bloomberg survey of economists had called for a 0.4% monthly rise in the core and a 0.2% gain in the overall measure. The advance was broad based. Shelter, food and medical care indexes were the largest of “many contributors,” the report said. Prices for gasoline and used cars declined. The report stresses how high inflation has broadened across the economy, eroding Americans’ paychecks and forcing many to rely on savings and credit cards to keep up. While consumer price growth is expected to moderate in the coming months, it’ll be a slow trek down to the Fed’s goal. Policy makers have responded with the most aggressive tightening campaign since the 1980s, but so far, the labor market and consumer demand have remained resilient. The unemployment rate returned to a five-decade low in September, and businesses continue to raise pay to attract and retain the employees needed to meet household demand. On the heels of a solid jobs report last week, the CPI report likely cements an additional 75-basis point interest rate hike at the Fed’s November policy meeting. Traders solidified bets for the jumbo-sized hike next month. Stock futures fell sharply and Treasury yields rose following the report.

Applications for US unemployment insurance increased to a six-week high, driven in part by a jump in Florida claims in the aftermath of Hurricane Ian. Initial unemployment claims rose by 9,000 to 228,000 in the week ended Oct. 8, Labor Department data showed Thursday. The median estimate in a Bloomberg survey of economists called for 225,000 new applications. The four-week moving average, which smooths out volatility from week to week, increased to 211,500. Continuing claims were little changed at 1.37 million in the week ended Oct. 1. On an unadjusted basis, initial claims increased by 32,275 to 199,662 last week. The advance was led by a 10,368 jump in Florida after Hurricane Ian destroyed homes and businesses across the region, likely ranking among the costliest storms in US history. Puerto Rico, which was devastated by Hurricane Fiona last month, continued to see an elevated number of claims. Despite a recent decline in job openings and a rise in layoffs in sectors including technology and financial services, employers continue to hire at a strong pace. The US added more than 260,000 jobs in September while the unemployment rate retreated to a five-decade low, government data released last week showed. As we mentioned above – the employment picture in the U.S. remains relatively strong.

US retail sales stalled last month as shoppers grew more guarded about discretionary purchases amid the worst inflationary environment in decades and rising interest rates. The value of overall retail purchases were little changed in September after an upwardly revised 0.4% gain in August, Commerce Department data showed Friday. Excluding gasoline, retail sales were up 0.1%. The figures aren’t adjusted for inflation. Seven of 13 retail categories declined last month, according to the report, including a drop in receipts at auto dealers, furniture outlets, sporting goods stores and electronics merchants. The value of sales at gas stations fell 1.4%, reflecting cheaper fuel prices, but they’re now climbing. It’s not clear the extent to which Hurricane Ian, which devastated Florida and parts of South Carolina late last month, impacted the data. That likely kept local residents from dining out while encouraging them to stock up in advance of the storm. The weaker retail sales data underscore how consumers are feeling a bigger pinch from rampant price pressures. As inflation shows few signs of slowing, many Americans are still relying on credit cards and savings to keep up, and shelling out more on essentials leaves little leftover for discretionary purchases. On a positive note, consumer sentiment rose last month. The University of Michigan’s preliminary sentiment index increased to a six-month high of 59.8 in October, reflecting an improvement in buying conditions for durable goods. The median estimate in a Bloomberg survey of economists called for a reading of 58.8. This was overshadowed in Friday trading though because with that report, US year-ahead inflation expectations rose in early October for the first time in seven months and the long-term outlook also crept up, a potentially worrisome development for the Federal Reserve as it tries to keep views anchored. Consumers expect prices will climb 5.1% over the next year, up from 4.7% in September, according to a survey from the University of Michigan. They see costs rising at an annual rate of 2.9% over the next five to 10 years, a pickup from 2.7%, data Friday showed. The Fed does pay attention to these figures as several FOMC members have mentioned expectations on inflation are important. “Continued uncertainty over the future trajectory of prices, economies, and financial markets around the world indicate a bumpy road ahead for consumers,” Joanne Hsu, director of the survey, said in a statement.

On another more positive note, optimism among US small businesses edged up in September as firms grew less downbeat about the outlook for sales, while a smaller share said they raised prices. The National Federation of Independent Business overall optimism index rose 0.3 point to 92.1 last month, the group said in a report Tuesday. Five of the gauge’s 10 components increased. Despite rising for a third-straight month, the measure is historically low. The survey’s inflation metrics continued to ease. The net share of owners raising prices fell 2 percentage points to 51%, the lowest in a year but still well-elevated. Almost a third of owners plan to increase prices in the next three months, the smallest share since January 2021, and labor compensation plans also eased. Still, 30% of respondents see inflation as the single most important issue impacting small businesses, a slight increase from August. Labor remains the next-biggest problem. Owners continued to report difficulty attracting qualified applicants and filling open positions. “Inflation and worker shortages continue to be the hardest challenges facing small business owners,” NFIB Chief Economist Bill Dunkelberg said in a statement. “Even with these challenges, owners are still seeking opportunities to grow their business in the current period.” One in 10 owners expects lower real sales in the next three months, the fewest since March. A net 5% of firms said sales fell over the past three months, a slight improvement from a month earlier. Some 44% of owners said they expect business conditions to worsen over the next six months, up 2 percentage points from August. The smallest share of owners since June 2021 reported open positions last month, but at 46% it’s still historically elevated. Firms are mostly struggling to hire in the transportation, manufacturing and construction sectors. The number of respondents planning to hire in the next three months climbed to the highest level since May.

Interest Rate Insight and the Fed

Federal Reserve Vice Chair Lael Brainard laid out a case for exercising caution as the central bank raises interest rates to curb high inflation, noting that previous increases are still working through the economy in a time of high global and financial uncertainty. “Moving forward deliberately and in a data-dependent manner will enable us to learn how economic activity, employment, and inflation are adjusting to cumulative tightening in order to inform our assessments of the path of the policy rate,” she said Monday in remarks prepared for a speech in Chicago to the National Association for Business Economics. “Monetary policy will be restrictive for some time to ensure that inflation moves back to target over time.” US central bankers appear to be readying their fourth straight 75 basis-point increase in interest rates when they meet Nov. 1-2 as they try to slow the economy and lower inflation. Brainard noted that central banks around the world are tightening concurrently, and weaker demand abroad could spill back into the US. She also warned that lags in policy could impact the economy in the months ahead. “We are starting to see the effects in some areas, but it will take some time for the cumulative tightening to transmit throughout the economy and to bring inflation down,” she said. “Uncertainty remains high, and I am paying close attention to the evolution of the outlook as well as global risks.” The Fed vice chair expressed similar concerns last month, though since then most of her colleagues at the central bank have reiterated their support for aggressive rate hikes without joining her in offering reasons for caution. The Federal Reserve needs to quickly get to a level of interest rates where policymakers can feel comfortable pausing in order to reduce the risk of overshooting, Chicago Fed President Charles Evans said. “Front-loading was a good thing, given how far below neutral rates were. But overshooting is costly, too, and there is great uncertainty about how restrictive policy must actually become,” Evans said Monday in remarks prepared for a speech at a National Association for Business Economics conference in Chicago. “This puts a premium on the strategy of getting to a place where policy can plan to rest and evaluate data and developments.” The Chicago Fed chief pointed to recent projections published by the US central bank which showed officials expected to raise their benchmark federal funds rate to just above 4.5% next year, from the current target range of 3% to 3.25%. The Fed has been raising rates rapidly since March, when the federal funds rate was nearly zero, in a bid to curb the highest inflation in four decades. While we agree there is no question for the need to continue to raise rates, we do agree that at a certain point taking a breather and evaluating the impact would be a healthy step and provide everyone with a reprieve. Federal Reserve officials committed to raising interest rates to a restrictive level in the near term and holding them there to curb inflation, though several said it would be important to calibrate hikes to mitigate risks. “Several participants noted that, particularly in the current highly uncertain global economic and financial environment, it would be important to calibrate the pace of further policy tightening with the aim of mitigating the risk of significant adverse effects on the economic outlook,” according to minutes from their Sept. 20-21 gathering released Wednesday in Washington. During the meeting, US central bankers agreed to boost the benchmark lending rate 75 basis points for the third straight time, lifting it to a target range of 3% to 3.25% as they combat stubborn inflation pressures. “Many participants emphasized that the cost of taking too little action to bring down inflation likely outweighed the cost of taking too much action,” the minutes showed. US stocks fluctuated following the release, while Treasury yields remained lower and the dollar was little changed. Traders maintained bets that the Fed will raise rates again next month by 75 basis points. Basically there were no real surprises in the meeting minutes after they were released.

Impactful International News

The heads of the International Monetary Fund and World Bank warned of a rising risk of a global recession as advanced economies slow and faster inflation forces the Federal Reserve to keep raising interest rates, adding to the debt pressures on developing nations. In the US, the world’s largest economy, the labor market is still very strong but is losing momentum because the impact of higher borrowing costs is “starting to bite,” IMF Managing Director Kristalina Georgieva said Monday. The euro zone is slowing as natural gas prices soar, as is China due to Covid-19 disruptions and volatility in the housing sector. The IMF calculates that about one-third of the world economy will have at least two consecutive quarters of contraction this year and next, and that the lost output through 2026 will be $4 trillion. At the same time, policymakers can’t let inflation be a “runaway train,” Georgieva said at a virtual event kicking off the IMF and World Bank’s annual meetings. “If you don’t do enough, we are in trouble.” She added that fiscal support should be well-targeted so that it doesn’t fuel inflation, and that the world needs to help emerging and developing economies hit particularly hard by tightening financial conditions. World Bank President David Malpass, speaking alongside Georgieva, warned that there’s a “real danger” of a worldwide contraction next year. The dollar’s strength is weakening the currencies of developing nations, increasing their debt to “burdensome” levels, he said. Just one more reason for the Fed to pause at some point and evaluate the worldwide impact of their actions. Bank of England Governor Andrew Bailey on Tuesday urged investors to finish winding up positions that they can’t maintain, saying the central bank will halt intervention in the market as planned at the end of this week. “My message to the funds involved and all the firms is you’ve got three days left now,” Bailey said at an event in Washington on Tuesday. “You’ve got to get this done.” The pound fell against the dollar to trade 0.5% lower at $1.0997 after the remarks. The Bank earlier on Tuesday expanded the range of its bond-buying program to include inflation-linked debt for the first time to avert what it called a “fire sale” that threatens financial stability. While the central bank has always said its support will end Friday, a lobby group representing UK pension funds had urged Bailey to extend the program at least until the end of the month. The “essence” of an intervention to support financial stability “is that it is temporary,” Bailey said. “It’s not prolonged.” The reaction in markets was immediate – stocks and bonds had been rallying with the Dow up over 300 points and it quickly turned negative before finally closing just 36 points higher on the day. We track the currency markets and the pound at day’s end had fallen close to a full percentage point relative to the U.S. dollar. “Two weeks is not enough, and more needs to be done,” said Daniela Russell, head of U.K. rates strategy at HSBC. “Pension funds are taking steps to address their liquidity issues but they are currently chasing a moving target as yields have continued to rise.” Bailey has been wrestling with the turmoil in markets since Chancellor of the Exchequer Kwasi Kwarteng announced plans for £45 billion ($50 billion) of unfunded tax cuts in an effort to boost the long-term growth rate for the UK economy. The central bank governor told his audience that he’d worked round the clock for several nights in a row in order to devise the market intervention. Officials at the bank had tried to come up with a policy that would have directly targeted stresses emerging in so-called Liability Driven Investment strategies, but they had been prevented from implementing them due to a “structural issue,” Bailey said. That had led them to introduce the bank’s initial pledge to buy long-dated gilts. “In the end, we couldn’t make the targeted intervention into that particular sector,” Bailey said. “So we had to announce that we went by conventional bills.” Unfortunately the situation in England with the instability in their Gilt market is fraying already fragile trader’s nerves and some resolution their balancing fiscal policy with monetary policy is clearly needed. By week’s end Kwarteng had been fired and Prime Minister Truss had backtracked on a number of items. There still remained a high level of uncertainty related to the situation in the UK and we will be following this closely.

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