I thought we need to discuss this a little bit even if it's not the most pleasant topic. If we take a step back and look at the Yield Curve for just a second and how all of this has played out.
I wrote about the YC inversion works and how we could possibly see one, back in October 2021. I really didn’t think it would play out exactly so and for this long. But, here we are. The Yield Curve has been inverted for the better of the year. Where do we go from here?
By now, I think we all know how yields work. When yields go up, bond prices come down and that the short end is managed by the Fed while the long end is what the economy signals.
But, an important factor in all of this is also the expected inflation. Of course the short end is driven by monetary policy but we also have a situation where higher near-term inflation expectations is causing the short-end of the curve to move up.
Now, of course the aggressive tightening is working and we’re seeing overall goods inflation come down. Mostly in the durable space, particularly used cars. We’re also getting some relief in terms of health care and quite a bit on energy.
But, where inflation still remains sticky is obviously shelter. But, more importantly services. The chart below shows the PCE Price Index as a % off it's latest highs. Goods have come down by 83% while Services are down only 43%.
To me, it feels like this is the one thing that the Fed really fears.
We’re seeing evidence of wage increases and this is what is naturally meant to happen. Firstly, as Chair Powell eloquently puts it, the labor market has a supply and demand imbalance. There’s more demand than supply and that will naturally pull up the level of wages.
And then there’s inflation. Both current inflation and expected inflation in the short term. Given a a demand constraint you have a situation where workers can demand more. So you have wages going up in anticipation of inflation which will cause input costs go up and create further inflation.
US Real Average Hourly Earnings has turned positive and the Employment Cost Index is the highest it has been in 10 years.
The question is what can stop this? The only answer is unemployment.
The Fed therefore, is in a situation where they think that breaking the back of the labor market is the next step after breaking the housing market. The problem with that is always that once unemployment starts to increase, the rate of change tends to become rapid. In other words, we see unemployment spiral out of control.
Case in point the post-Volcker era of hikes, where employment just soared.
This is when demand really breaks and we have situation where where inflation starts to come down and normalize.
When inflation starts to decline, it also means demand starts to decline. Companies with pricing power will need to eventually reverse their stance. This will play out into margin compression - sales prices coming down and costs going up - both due to higher labor costs and higher cost of capital. This is likely to lead to a deeper earnings recession.
There’s no place to hide in a recession where stocks are concerned. But, we will still find corners of the market that will do less bad and that where we need to focus our efforts. We will also see some companies withstand the pressure and those will be the names to buy.
So the bottom in the stock market is coming, it’s just not yet.
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