Inflation, Rising Rates, And Rotation

Summary

• This is a weekly series focused on analyzing the previous week's economic data releases.
• The objective is to concentrate on leading indicators of economic activity to determine whether the economy is strengthening or weakening, and the rate of inflation is increasing or decreasing.
• This week, I will examine construction spending, the ISM and Markit manufacturing and services indices, weekly unemployment claims and the jobs report for February.
• This idea was discussed in more depth with members of my private investing community, The Portfolio Architect. Learn More »

Chairman Powell no longer appears to be the stock market whisperer he once was. It seems he thinks that he can maintain the ultra-easy monetary policy of the past decade to support financial markets, while also achieving the Fed's objective of full employment without realizing the higher long-term interest rates and inflation that come with it. Despite his assertion that he will not withdraw any of the continuing monetary policy accommodations, the bond market is tightening financial conditions for him. Inflation expectations have risen to a 12-year high, long-term bond yields are soaring as a result, and the stock market darlings of yesterday are no more.

Construction Spending

Construction spending rose 1.7% in January, led by the residential side again, where spending was up 2.5% for the month and 21.1% year over year. Non-residential spending rose 0.5% for the month but has declined 5% over the past year. The good news is that there was strength in January across the board.

ISM Manufacturing Index

The Institute for Supply Management's Manufacturing Index rose for the ninth consecutive month to a three-year high of 60.8% in February. New orders and production are showing particular strength, as well as the employment sub-index, which climbed for a third month in a row to 54.4%. Sixteen of the 18 industries surveyed by the ISM were expanding last month. The only concern comes with the shortage of raw materials, which is leading to a surge in prices. That could be a headwind to demand and growth if the price surge continues.

IHS Markit Manufacturing Index

IHS Markit's Manufacturing Index for February came in at 58.6 and tells the same story as ISM. It was the second fastest rate of growth since April 2010, led by output and new orders, but input costs are soaring due to supply chain disruptions and supplier shortages. Costs rose at the steepest rate since April 2011. Still, employment growth is strong, and confidence has improved markedly.

ISM Non-Manufacturing Index

The Institute for Supply Management's Non-Manufacturing Index fell from a two-year high of 58.7% in January to a nine-month low of 55.3% in February. This shows the service sector is still growing, but at a more moderate pace. The culprits in this slowdown were shortages of supplies and difficulties in obtaining them. This led to a surge in prices with the price sub-index rising to a 10-year high of 71.8%, as can be seen in the chart below. As a result, service providers are starting to pass on higher costs to their customers. Inflation is coming. The only weak spot in this report was in the employment sub-index, which fell from 55.2% to 52.7%.

IHS Markit Services Index

The Markit Services PMI did not see the softening in service sector activity that was seen by ISM. Markit's index rose to 59.8 in February, which was a six-and-a-half year high, led by new orders and output. Similarly, input cost inflation accelerated at a pace that was the fastest since October 2009. In response, businesses raised selling prices at the second-fastest monthly rate in the survey began 11 years ago. Again, inflation is on the rise. Employment is improving very modestly, but that should be expected, as the labor market is the caboose in the recovery cycle.

Unemployment Claims

Initial claims filed through state programs rose 9,000 to 745,000 for the week ending February 27. The number filing under federal pandemic-relief programs rose by 437,000, resulting in a total of 1.18 million. The day we can fall below one million total claims will be a psychological turning point. Continuing claims under all state and federal programs fell to 18 million through February 13, which is down by one million from the week before. These numbers should improve dramatically over the coming 2-3 month period as the majority of Americans are vaccinated this spring.

Source: MarketWatch

The Jobs Report

This was a blow out number! The Bureau of Labor Statistics estimates that the economy created 379,000 jobs last month, led by service sector positions in restaurants, hotels, bars, and retailers. Leisure and hospitality jobs accounted for 355,000 of the total figure. The prior month's number was revised up from 49,000 to 166,000. The unemployment rate fell from 6.3% to 6.2%, while the labor participation rate remained unchanged at 61.4%. We need that percentage to increase to pre-pandemic levels that were closer to 63%.

Source: MarketWatch

As the vaccination rollout accelerates, and the economy more fully reopens, expect jobs to be recovered at a much more rapid pace. I can a million-plus jobs or more recovered per month this summer.

Conclusion

As I mentioned in this report weeks ago, exceeding 1.5% on the 10-year Treasury yield would be a major headwind for the stock market, because that is the approximate yield for the S&P 500 index. Finally, there is an alternative.

More importantly, the reflex reaction to the bond yield spike is to sell the most expensive stocks in the marketplace with the fastest growth rates. This should come as no surprise, as I have been warning about it for months. Stock valuations that are more dependent on profits down the road (think Ark Invest) tend to have a much stronger inverse correlation with long-term interest rates. This is because those future profits are discounted to determine their present value based on rates. The higher the rate, the greater the discount to present value. As a result, the Nasdaq Composite has now corrected 10% from its high, which may be just the beginning of a revaluation of the entire technology sector. I do not envision a repeat of the bear-market decline from the 2000 through 2003, but I do see a revaluation of growth in a similar manner and a reemergence of value and more cyclically oriented sectors.

My target has been 2% for the 10-year Treasury yield this year, and that is gradually becoming the consensus call on Wall Street, which implies a lot of volatility ahead. It means an even stronger headwind for high-flying growth stocks, as well as the popular investment trends towards a number of high-yielding securities, especially the ones that use leverage. The deleveraging process after a decade of near-zero interest rate policy will be extremely painful.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The Portfolio Architect is published as an information service. Lawrence Fuller, the publisher, is also the Managing Director of Fuller Asset Management, a Registered Investment Advisor, which is unaffiliated with this Marketplace service. While this service includes opinions about buying, selling and holding a wide range of securities, the publisher is not acting as an investment adviser or providing advice or recommendations to any particular subscriber. Any investment recommended should be made only after consulting with your investment advisor or completing your own due diligence. There are risks involved with investing including loss of principal. Mr. Fuller makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals or the strategies discussed by will be met.

Comments

[Ponti_fication]

@Lawrence Fuller @kimbillro @GrahamBrecker

My magnus opus :) :) below of 5 March refers.

Inflation : Core Producer Price inflation in USA now 2.5%
twitter.com/...

PPI leads the headline CPI, so my belief that CPI = " 2.75 to 3.25% - easily - in about 9 months time " may be on-the-money.

Be careful out there - "prevention is better than cure"

[kimbillro]

@Ponti_fication , Thanks for bringing forth some interesting facts.

[Ponti_fication]

@kimbillro and @Lawrence Fuller

You Bill - my good mate - can thank me, again, for this:
10 year USA interest rates are at 12 month highs now, and 10 basis points up since the date of this article :

www.investing.com/...

They are going to 2.75% within the next 12 months, yes

[kimbillro]

@Ponti_fication , I can certainly see that happening.

[AllStreets]

What worries me about the economy is what happens when the mortgage forbearance and eviction moratoriums end and when will the bleeding of small businesses stop. Are we going to see an implosion of the mortgage bond market and millions of renters on the streets? Business bankruptcies are going at record pace, and I think I saw a number like 400,000 for the number of small business that have gone out of business in the last year. Most will not come back because those entrepreneurs who failed probably won't resume business, and there may not be enough who can acquire startup capital and want it. Small businesses provide about half of employment and about 44% of economic activity. I think the stock market has discounted to much rapid comeback in the economy.

[kimbillro]

@AllStreets , Don't worry, the Congress will outlaw everything like evictions and foreclosures.

[JHHAlpha]

Lawrence, your own ethical character has you overlooking what the fed may do next. So, you wrote:
" As I mentioned in this report weeks ago, exceeding 1.5% on the 10-year Treasury yield would be a major headwind for the stock market, because that is the approximate yield for the S&P 500 index. Finally, there is an alternative. "

After the 2008 debacle, the central banks, led by our own, have thrown newly minted fiat currencies to increase money circulation, lending, and monetize government debt, as it accelerates. Japan's just acted to squelch rising rates.
We have just passed a trillion dollar bill that does nothing really except to burden our government with more nonproductive debt that has to be financed. Do you imagine the fed will let the burden of our expanding debt face the additional hurdle of higher interest rates? Do you think that the fed will sit idly by as rising rates crater stock market based wealth? I expect the fed to soon be intervening to bring the ten year, and longer notes, down. Of course this will make the MInsky moment worse-- but who knows why or when it will happen.

I think it prudent to buy stock of companies that have some pricing power as inflation increases. especially as inflation is not being accurately measured and reported.

Bottom line is the fed is going to intervene soon if the long rates continue to move up.

[Lawrence Fuller]

@JHHAlpha Perhaps you will be right, but not now. I think the 10 year could rise to 2% without the Fed taking action, UNLESS the stock market tanks. At whatever point the rise in rates impairs the wealth effect, then I can see the FED acting, but that would take a lot of buying power to bring rates down, unless the rest of market participants followed suit.

[Robert Morie]

Rates going up is the explanation for the markets sell off. Every day there is an explanation for why the market goes up or down. None of it is true. The market goes up or down for it's own inexplicable reasons. Higher rates are a sign of a better main street economy. The market forecasts this months ahead. Now we are faced with a sell off in the higher growth, high valuation names. No surprise. A long tern investor is looking at 2023 earnings and beyond. The themes of digital transformation to the cloud, more E- commerce, AI and machine learning, robotics, continued healthcare innovation, EV expansion, and many other things are already in place. Those themes are very real and will continue to dominate the investment world. At the moment, the vaccine related recovery is also real. Travel will resume, vacations are a must, people want to go to movies, restaurants, sports events, Broadway shows, concerts, etc. These pent up desires are all real. The market had predicted it. Being bullish through 2020 was the right strategy. Now we are faced with the reality of the destruction of the small business world and the focus on the political effort to assist the maimed.

The optimist is still in control. Focussing on both the longer term investment themes mentioned above, coupled with a main stream recovery in the economy seems to me to be the best strategy. Never sell short the American dream.

[Lawrence Fuller]

@Robert Morie Just don't pay more than 10x revenues for one of these themes! That's my advice.

[reron]

@Lawrence Fuller 10x revenues, really. That's a recommendation?

[Lawrence Fuller]

@reron I think investors can avoid a lot of mistakes by avoiding that segment of the market which is extremely overpriced, and 10x plus revenue and UP is a good place to start. That was the case in 2000, as names like Cisco Systems still have not reached their 2000 highs 21 years later. Otherwise, I'm staying diversified in each assets class, holding a fair amount of cash, maintaining my core exposures as dictated by my all weather approach, and still up double-digits this year. At the same time, cheering this stock market lower so I can pick up more quality names on my watch list at bargain prices.

[benny_thejet]

Really appreciate this insight!

[kimbillro]

I can eventually see 2% long rates.

[Ponti_fication]

@kimbillro @Lawrence Fuller

Inflation and long rates:
I can see 2.75 to 3.25% - easily - in about 9 months time in both these variables, given pumping of economic growth, and sustained powerful cost-pressure stoking inflation, like the almost 90% increase in the price of oil over the past 12 months and the massive recent price increases in some commodity prices, steel, silver and lumber being stand-outs. Also, the Fed is 'looking' for 2% inflation.

.

Market re-evaluation of price earnings multiple in inflationary beginnings, and serious downward price correction coming:
Lawrence prints in his "Conclusion" paragraph: " I do not envision a repeat of the bear-market decline from the 2000 through 2003 ... "

Why not, Lawrence ?

When inflation ignites from initial low levels, accompanied by high price earnings multiples, the stock market crumbles:

John Hussman, Market Comment = Hypervaluation and the Option Value of Cash, December 2020; paragraph titled" Inflation will not bail out a hypervalued market",
www.hussmanfunds.com/...
"Put simply, U.S. stocks have actually earned their reputation as “inflation hedges” in periods when inflation is falling, starting valuations are depressed, or both. Once valuations have been crushed, stocks recover lost ground – particularly once the rate of inflation has peaked and begins to normalize. The combination of depressed starting valuations and falling inflation is exactly what contributed to the enormous stock market returns during the disinflationary period between the early 1980’s and the 2000 bubble peak."

A 20 - 30% downward price correction in the indices, would seem a good outcome; larger price declines, though, seems on the cards [the market leaders can reverse very sharply downwards = refer TSLA over past two months ; seekingalpha.com/... ]

All the best

[Lawrence Fuller]

@Ponti_fication It is certainly possible to see a 20% plus additional decline, but it probably doesn't last long with the FED continuing to pump 120B a month of liquidity into markets. Liquidity drives markets. 2000-2003 was the opposite, as the FED was withdrawing it.

[kimbillro]

@Ponti_fication , Wow, you really climbed up on your soap box and let us all here gathered around have it. Tesla has already corrected almost 40% like you pointed out. We used to talk about fun things like kangaroos and wombats back during the good old days when @GrahamBrecker would join in for the frolic. Whatever happened to @wekilishorts ?

[Long-Short Manager]

I think you're right about the pace of job growth, and more importantly, equity markets don't really seem to be looking ahead very well (just like last year, when they waited until the virus was actually circulating before tanking rather than figuring out it would get here once it was in Milan). How can rates still be at zero in 2023 and Powell hold off from tapering through all of this year if we're seeing 1m+ jobs return every month this summer? There are 12m under- and unemployed from the pandemic before we're back to a normal job market. Also 1m a month could easily be an underestimate - these people aren't unemployed because of financial problems with firms, lack of employers, or anything structural - its pure virus virus virus related closure. Restaurants, hotels, travel, concerts, parks and amusement, summer camps and so on will all open at the same time (they have not been all simultaneously closed for a common reason in 100 years) once we have an all-clear. Historical job growth numbers will be NO USE to estimating the monthly pace of job re-opening. Why couldn't it hit 2m a month or even 3 mil in a given month if we're talking about 500k shuttered/hibernating businesses suddenly calling people whose numbers they already have?