Eating Your Vegetables

By Paul Broughton, Portfolio Manager

This equity market is the equivalent of having to eat your vegetables when you were a kid before you were finished with your dinner. Maybe you liked eating lightly steamed broccoli when you were seven. I didn’t. My idea of gourmet dining at that age was McDonalds. This is the dichotomy right now, for me at least – the benevolent Fed with ZIRP and massive QE morphing into the tough cop Fed with the aggressive rate hikes and QT.

This summer we’ve seen equities twice attempt to rally in early anticipation of a potential Fed pivot. Both attempts failed. Inflation is directionally moving lower, but at a pace that is looking like it may take longer than market participants were hoping for. Chair Powell couldn’t have been clearer in his speech given at the Jackson Hole Fed conference – the Fed will stay the course on raising rates and stopping inflation now before expectations become entrenched. Equities want to rally, but the reality is that it takes time for the rate hikes to affect the economy and in turn bring inflation lower. There are signs though that this starting to happen.

The oft mentioned supply chain backup is starting to ease on both coasts and this is reflected in the cost of shipping a container from China to the West Coast, which is now down over 70% y/y. However, the cost is still 2.5x its average for the five years before COVID. So, it is directionally moving lower but still very high.

Food prices remain high as we’re all experiencing daily. However, global food prices, as measured by the United Nations FAO Food Price Index, fell for a fifth month in a row in August after demand for some products weakened, and there was a seasonal uptick in supplies – namely better than expected wheat harvests in the northern hemisphere are helping ease supply constraints. At least for now, this index peaked in March (chart below) and is at its lowest level since January. The move lower over the last five months is 14%, but the index is still 45% above its five-year average before COVID. So, it is also moving in the right direction, but still elevated.

Gasoline prices are noticeably lower. The national average is now at $3.69 compared to the high in mid-June at $5.02 – a decline of over 26%. The decline in prices is likely due in part to the Strategic Petroleum Reserve release and lower vehicle miles driven over the last few months due to high summer gas prices. The average gasoline price in the five years before COVID was $2.45. So, at $3.69 we’re paying over 50% more per gallon, yet another example of prices moving in the right direction, but still very high.

Somewhat concerning for me is the level of the Goldman Sachs US Financial Conditions Index. This index is defined as a weighted average of riskless interest rates, the exchange rate, equity valuations, and credit spreads, with weights that correspond to the direct impact of each variable on GDP. Financial conditions, as measured by this index, were at their all-time most accommodative (lower is better) in November, 2021 at 96.92 (the index started in Sept 1982). At present the index is at 99.99, which is almost exactly the five-year average before COVID. In other words, financial conditions have tightened since November of last year, but they haven’t really tightened that much relative to the five years before COVID, which likely affords the Fed more latitude in raising rates further.

On a more positive note, regarding inflation expectations becoming entrenched, we can see for now that they look to be in check and aren’t moving noticeably higher. The US 5yr5yr Forward Breakeven rate stands at 2.22%, which compares to the average rate of 1.96% in the five years before COVID. As well, the price of gold has gone lower since August, 2020, down by 18%, and is just weak. Copper and iron ore prices are down by 27% and 20%, respectively. So, we see inflation expectations in forward rates, gold, and industrial metals are looking somewhat orderly.

The Fed’s current mission of stopping inflation before it becomes entrenched means that we’re likely going to need to see unemployment increase and the still very elevated job openings will surely need to decline meaningfully. This, in turn, should to lead to wage inflation slowing, which is certainly the Fed’s biggest underlying concern around the current elevated level of inflation that we’re experiencing.

The 2yr Treasury yield is moving up and to the right on what seems like a daily basis. It’s only reflecting what the market is pricing in with regards to further rate hikes. And for now, the Fed’s intent is to see the job through in stopping inflation now. At present, inflation is moving lower, but just not at a fast enough pace.

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