September 19, 2023 – Inflation is likely to accelerate into year-end with ongoing wage pressures and now rising oil and gas prices. Right now, the market is widely anticipating the Fed to go on pause at their next meeting tomorrow, September 20th, but we are likely to see pressure emerge on them to raise rates over the next two meetings. Mike Singleton at Invictus Research discusses how he believes this is setting up for a surprise to the consensus outlook for a soft landing, particularly for the first half of 2024. What moves should investors be making between now and then? Listen in and hear what Mike has to say in today's FS Insider podcast!
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Timestamps:
00:00:00: Discussion on accelerating inflation affecting markets and economic outlook
00:01:02: Start of Singleton's view on inflation data
00:01:27: Further analysis on the consequence of faster inflation
00:02:20: Considerations on how inflation might impact future policy
00:03:06: Evaluation of wage growth in relation to inflation
00:03:24: Discussion on the effect of oil prices on inflation
00:04:37: Forecast on unemployment rate changes in
00:04:45: Exploration of underlying trends driving current inflation
00:05:29: Examination of gas prices' influence on inflation
00:07:02: Correlation between oil and gas prices explained
00:07:35: Speculation on potential for deflationary recession in
00:08:38: Analysis of last week's retail sales number
00:09:07: Overview of income growth for US consumers
00:09:50: Insight on the leading indicators within the retail sales report
00:10:10: Real retail sales of durable goods well below trend
00:10:39: Right size their business
00:11:01: Expectation of a recession in the first half of next year
00:11:33: Short term bill investments
00:12:22: Impact of quantitative tightening
00:13:09: Waiting for the signs of a recession before buying long duration government securities
00:13:22: Exposure to the stock market
00:15:06: Defensive posture on the stock market and short term Treasuries,
00:15:36: Disadvantage of having equity exposure
00:16:19: Products by Invictus Research
00:17:33: Contact and feedback information
Transcript:
Cris Sheridan: Inflation is likely to accelerate into year end with ongoing wage pressures and now rising oil and gas prices. What does that mean for the market and economic outlook? Well, that's what we're going to discuss today. Mike Singleton at Invictus Research joins us and you can follow all of his reports at Invictus Research. Mike, thank you for joining us on the show again.
Mike Singleton: Thanks for having me Chris. Always a pleasure.
Cris Sheridan: So Mike, love your daily and weekly material. Follow all of your work extensively. You're recently discussing print that we got on inflation last week. This looks like inflation is starting to pick back up. Of course, there's some concerns over oil prices. Just to be clear, the headline number was at 3.7% on the CPI, so that is up from 3.3%. So at least on the official headline number, we do see an uptick in inflation that could be putting some pressure on the Fed, obviously to remain at higher rates for longer. So a lot of implications here for investors. But let's start off, what is your view on the inflation data?
Mike Singleton: So our view on the inflation data is that it's likely to accelerate through the end of this year before eventually we hit a recession and it declines again. That's to say, we think that there's going to be a short term uptick in inflation, but it won't be a new inflation cycle, so to speak. We don't think that the economy has the legs to support a durable upswing in inflation. So the primary consequence of faster inflation through perhaps call it December, will be the policy risk, the risk that the Fed keeps rates higher for longer than investors currently expect. Maybe that means one more rate hike, maybe it means they just hold the Fed funds rate where it is longer than investors expect. But in either case, when you look at what the fixed income markets are pricing in, that's still a risk that investors are not positioned for.
Cris Sheridan: We're speaking on Tuesday, September 19. So the Fed is expected to meet tomorrow and at present the futures market is putting in a 99% probability that they are not going to hike, even with this recent uptick that we've seen actually past two months uptick in inflation. So apparently the market doesn't believe that this is going to translate. This most recent data isn't going to translate to any tighter policy on the Fed side. So is this something you think is going to be put off till perhaps later this year if, like you say, we continue to see inflation turn up for the months ahead?
Mike Singleton: Right. So I think the real policy risk is probably in November and out. And the reason why I say it remains a risk is that when you think about the underlying drivers of inflation at this point in the cycle, they still haven't really been addressed. What do I mean by that? I mean that the labor market is still relatively tight. It's getting softer, but it's still tight. And as a result, wage growth is still inconsistent with 2% inflation. We track probably ten different data points on wage growth, and in aggregate, wage growth is comping at about a four and a half percent annualized when you look across all of them. And four and a half percent wage growth in a world where productivity growth is flat is just not consistent with four and a half percent inflation. It's not consistent with 2% inflation, especially over the long term. Right? You can sort of see fluctuations around that in the short term, but over the long term, it's multiples of the Fed's target. In addition, you're also seeing the price of oil move higher. The SPR has been refilling, OPEC has been tightening supply. Maybe we've seen a marginal uptick in industrial activity, which is to say demand for industrial inputs like oil. But regardless of what's happening, you have to acknowledge, look, oil is up some 30% off of its trough in May, right? And the price of oil has a very high leading correlation with headline inflation by about three months. So what you're seeing is the underlying drivers of wage inflation and services inflation have not been addressed in terms of the labor market. And on top of that, you're seeing oil, which is one of the best leading indicators that we have for the headline data reaccelerating. So it's hard for me to imagine that unless we start seeing imminent evidence of a recession, that the Fed is going to respond dovishly to this data either tomorrow or in November, but especially not November unless something changes rather dramatically. So right now our expectation is that the labor market data at least remains relatively strong at the headline level through year end. Call it a 4% unemployment rate or less, but that's up from here. So people will be talking about it. And then we really see the nonlinear increase in the unemployment rate in call it Q One and Q Two of 2024.
Cris Sheridan: Okay, yeah. I want to go back to some of these underlying trends that are driving inflation currently. Like you said, there's wages, oil prices, there's a number of different inputs. One thing I want to get your perspective on is gas prices. I live in San Diego and we've seen just a huge jump in gas prices. I was just looking at the gas station on the corner next to where I live. It jumped $0.30 overnight and is now at $6.40/gallon--that is ridiculous. And so gas prices in general in California are now around $6 a gallon. But I know nationwide gas prices are also up as well. How much of an influence is this having on inflation and how much is this cutting into consumers wallets?
Mike Singleton: So that's a good question, and I think that there is a lot of misinformation about the impact of gas prices on inflation. So gas prices are important in part because everyone sees them and they make deductions about how they're going to vote based on gas prices. And then you have Wall Street analysts who will say things like, well, gas prices really only represent 3% of consumer spending or so. Right. And I think that misses the point. The reason that gas prices are up is because oil prices are up. Right. Crude oil is the primary input into gasoline at the pump, which is a refined product. And if you just look at the correlation between the spot price of, say, Brent crude or West Texas Intermediate and the average gas price across the US. Which is published by the EIA, the correlation is about 98%. Right. So what you're really seeing when you see high gas prices most of the time is higher crude oil prices. And like I said earlier, crude oil is a leading indicator for headline inflation. And the reason for that is because crude oil is an input into almost everything in our economy. Right? It's an input into our utilities. It's an input into the tupperware in the grocery store. It's an input into pharmaceuticals, which is in the healthcare basket when crude oil inflates everything else follows suit. So gas prices get a lot of attention and a lot of headlines, and they simultaneously induce a lot of what I think are silly headlines from Wall Street analysts about how they really don't matter. The truth is, gas prices matter because the price of oil matters, and oil is an input into everything, hence why it's a leading indicator for inflation.
Cris Sheridan: And like you said, 90% correlation between oil and gas prices. And right now, oil is trading at $92.35 as of today, September 19. So that is obviously the lion's share of what's putting the upward pressure on gas prices. And you believe that inflation is likely to trend higher for the remainder of this year until we see some type of deflationary recession materialize in the first half of 2024.
Mike Singleton: Right. And I think that you're going to see some pretty visible warning signs before that. In fact, you're already seeing them. So what's going to break this upward drift in inflation that I'm referencing? Well, it'll be a higher unemployment rate. Are we seeing evidence that the unemployment rate could go higher? Yes, we're definitely seeing softening in the labor market on the margins. You can see it in the wage data. You can see it in hours worked. You can see it in the Kansas City Labor Conditions Index, which is a composite of all of these different things. And it's starting to turn lower, which usually corresponds to a higher unemployment rate if you look at the leading cyclical sectors of the economy. So think residential construction, trucking, temp services, manufacturing. Those sectors in aggregate have lost jobs for all of the last seven months and nine of the last ten months. So all of this is saying that there is going to be there's weakness on the come. It's just a question of when. And our models at Invictus suggest that the headline data will actually remain pretty strong through year end, although we will certainly remain nimble in the face of incoming data.
Cris Sheridan: Can you comment briefly on the retail sales number that we got last week? A lot of headlines saying that this was a very positive retail number that shows that consumers are still spending and healthy. What is your assessment?
Mike Singleton: So, I guess two points. First of all, a lot of the increase in retail sales was from gas prices, right? Gas stations count as retailers. Higher gas prices increase retail sales mechanically, but it's not really a reflection of a stronger economy. It's really just a reflection of higher inflation. That said, income growth for consumers across the US. Is still pretty strong, right? So income growth is driven by two variables growth in employment and growth in wages and salaries. Growth in employment is still comping about 2% year over year, and growth in wages and salaries is still comping about four and a half percent. So what that means is incomes, which is the sum, is growing at about six and a half percent for an economy that can only sustain real output growth of about a percent and a half. Six and a half percent income growth is not consistent with 2% inflation. It's going to get spent, most of it's getting spent in services, which we know Taylor Swift concerts and Oppenheimer and Barbie and whatnot, but some of it's going to end retail sales. It'll leak into it. That said, when you look at the leading indicators within the retail sales report so a number that we really like to look at at invictus is volumes of durable goods. Or you could say real retail sales of durable goods so that's items like furniture, home appliances, these are the items that drive the manufacturing sector in the US. Real retail sales of durable goods is well well below trend. And what that means is manufacturing companies have overinvested in terms of building inventory, in terms of factories, in terms of hiring new employees, because they expected essentially 2021 levels of demand to persist through 2022 and 2023. And so far that hasn't happened. We're about 10% or 11% below trend growth. So how do they respond to that? How do they right size their business? Traditionally, that means cutting investments. And usually what that means is cutting hemp count. And like I said earlier, we are starting to see evidence that that's happening. We're seeing layoffs in the manufacturing sector. I would still describe it as preliminary weakness. It's not recessionary weakness yet, but it is something that we're keeping an eye on.
Cris Sheridan: Okay, preliminary weakness. You are expecting a recession to materialize in the first half of next year. Fed is now dealing with not just wage pressures, but also higher oil and gas prices. And you do expect the trend to be higher for inflation throughout the remainder of this year. That is going to be putting pressure on the Fed to either raise rates or stay at the higher for longer position. That being said, we're in this window right now between now and when you expect this recession to materialize next year. What do investors do between now and then?
Mike Singleton: So I continue to like short term bills. I think a five to five and a half percent nominally risk free yield at this point in the cycle is attractive. Historically, the long bond, long term government bond, that's the ten year note, the 20 year bond or the 30 year bond, they've been the best performing assets through historical recessions. At Invictus, we're telling our clients, pump the brakes on that allocation decision. This is not the time to get long government bonds for a variety of reasons and I can go through a few of them because they have economic implications as well. But first of all, I'll use use the ten year note just as an example, but it holds true for the 20 year and 30 year yields as well. The ten year yield has about a 90% correlation with the Fed funds rate. So if the Fed is not cutting, it's going to be very hard for the ten year to go down. But so much in addition to that, you have quantitative tightening at about $95 billion a month. In our estimation, that puts about ten basis points of upward pressure per month on the ten year yield. So you could think of it as the equivalent of a ten basis point rate hike every month in terms of the impact on financial conditions and the impact on the ten year yield. And then on top of that, you have the treasury issuing $2 trillion in new securities in Q Three and Q Four of this year. A little under half a trillion of that is coupon issuance. So think notes and bonds, not bills. And what that does is it introduces duration into the market. So when there's more supply of coupon securities from the treasury, the way that demand meets supply is by increasing the yield. So at Invictus we estimate that'll be another 40 to 50 basis points of upward pressure on the ten year. And all of this translates into you really want to wait until you see the whites of the eyes of this recession before you start buying long duration government securities.
Cris Sheridan: And what about any exposure to the stock market?
Mike Singleton: Certainly cautious on the stock market, right? So you said earlier we expect a recession in Q One or Q Two. I think we could see the Nberx post date the recession as beginning in December of this year. Frequently the recession begins before the job losses really start to accelerate. And if you look historically at the stock market and when it begins to really price in a recession, historically it prices in a recession between two or three months in advance. That's when you really see the nonlinear decline and stock prices start to reflect the fact that essentially the labor market is going to break. So if that's our view for December or January of 2024, beginning on those dates, you really want to be careful about your equity exposure here. So, yeah, we would recommend or suggest being defensive, being conservatively positioned, holding lots of cash, holding large caps versus small caps. That's been a trade that's worked well for a while, holding strong balance sheets as opposed to highly levered names, defensive sectors as opposed to cyclical ones, particularly where trend and momentum look good defensives, have struggled in 2023 thus far. We're seeing some evidence that that might be reversing, but at invictus, we do have respect for the technicals as well. So the fact that defensives haven't looked quite as good in 2023 is an input into our process. We're hesitant to say just go long defensives or massively overweight defensives until technical start to improve a little bit. But that's where we're looking for new opportunities.
Cris Sheridan: Okay, so if we were to summarize some of what we discussed today, you believe inflation is likely to trend higher for the remainder of this year. This is going to be putting more pressure on the Fed in their tightening posture. And this is likely to materialize, given the underlying trends that you're looking at, the cyclical part of the economy, the leading economic indicators for a recession to materialize in the first or second quarter of next year, in which case you have a defensive posture on the stock market. You like short term Treasuries, which are giving you a decent yield and not ready to go long Treasuries. So like the ten year or greater yet, that's something that you want to do once you see really that deflationary, recession like event, perhaps the early part of next year. Does that about summarize your view at this stage?
Mike Singleton: Yes, that's a good summary. One thing I'll add really quickly is a lot of people want equity exposure all the time, which I certainly understand. But if you look at the yield on stocks so if you look at the earnings yield on the S and P 500 over the last twelve months, it's about 4.3%. And that represents a negative equity risk premium above and beyond or below, I should say, what treasury bills are offering you. Right. You're getting an extra 120 basis points of yield on treasury bills even though they have no credit risk, no duration risk. And in my mind, that's sort of a backdrop against which you should be significantly underweight stocks. Right. Why are you taking risk when there is no compensation for it? Which is just to say this is supporting evidence for our overweight position in bills.
Cris Sheridan: Well, Mike, as we close, would you mind telling our listeners a little bit more about some of the products that you feature at invictus research and the way that they can get their hands on your excellent work.
Mike Singleton: Of course. So we're at invictusresearch.com. Our flagship product is The Daily Edge, as five to ten minute video that covers all of the economic data from the day before, puts in the context of the business cycle, provides back tests. There's a lot of really useful charts and graphs to put everything into context and to make things really accessible. We try and cut back on the jargon as much as possible.
Mike Singleton: And like I said, it's delivered over video, so it's not another boring PDF in your inbox. And in addition to that, you can read our tweets at Invictus Macro on Twitter or X.com or whatever it's called now.
Cris Sheridan: All right, well, Mike, it was a pleasure to speak with you again on our show, and again, you can follow all of his work at Invictus Research, and as he mentioned, there's The Daily Edge, which he sends out via email. Videos that you can access on the website or through email, weekly trade ideas, monthly Outlook pieces. So lots of great information that you can gain access to. And I follow Mike's work religiously here at FS Insider. So Mike, it was a pleasure speaking with you.
Cris Sheridan: We definitely look forward to having you on another few months to see how things are tracking.
Mike Singleton: Of course. Thank you for having me, Chris.
Cris Sheridan: If you have any questions or feedback on what we discussed today, or if you'd like to get in touch with us about our asset management or financial planning services, you can do so by going to FinancialSense.com and clicking where it says Contact us. As always, don't forget to spread the word about FS Insider with your friends and family and share our podcast on all of your social media channels. For FS insider. I'm Chris Sheridan. Thanks for listening.
