The vicious cycle of inflation.
Last week, we learned that pay increases at central banks in many parts of the world won’t keep pace with inflation. As a result, their employees may not be able to maintain the standards of living they had before inflation began rising. For example, at the United States Federal Reserve (Fed) the maximum pay increase was 5.1 percent for 2022. That’s significantly below inflation which averaged 8 percent last year, reported Jana Randow and Enda Curran of Bloomberg.
It’s a similar story elsewhere in the world. Inflation in the Eurozone averaged 10.6 percent in 2022, yet the average salary increase at the European Central Bank (ECB) and Bank of France was 4.0 percent. Germany’s Bundesbank offered a 1.8 percent raise. In the United Kingdom, where inflation was 9.1 percent on average last year the Bank of England offered a 4.5 percent annual pay increase.
Central banks have a reason for not raising pay enough to cover price increases. It’s called the wage-price spiral. The Richmond Federal Reserve explained it like this:
“In a wage-price spiral, inflation is fed by a vicious cycle where, as the cost of living rises, workers demand higher wages to pay their bills, leading firms to increase prices even further to cover labor costs.”
Since central banks are trying to reduce inflation, they want to avoid a wage-price spiral. Consequently, giving employees raises that don’t keep pace with inflation means that central banks are practicing what they preach.
Understandably, central bank employees are not happy about it. In January, a spokesperson for the ECB’s trade union told Bloomberg’s Alexander Weber, “‘With inflation in Germany and the euro area likely around 8.5% this year, it means a substantial loss in purchasing power.’”
Last week, data suggested that central banks’ efforts to push inflation lower are working. The Bureau of Economic Analysis reported the Personal Consumption Expenditures Index, which is one of the Fed’s preferred measures for inflation, dropped from 5.5 percent in November 2022 to 5.0 percent in December. The core PCE index, which excludes food and energy prices, fell from 4.7 percent year-over-year to 4.4 percent over the same period.
Investors were enthusiastic about the progress on inflation and major U.S. stock indices finished the week higher. The yield on the one-year U.S. Treasury ended the week at 4.68 percent.
“It’s hard to be a contrarian for very long these days because the consensus seems to change so quickly,” opined Ed Yardeni via LinkedIn last week.
We’ve certainly seen a shift in investors’ preferences during the first few weeks of this year. Despite widespread expectations that markets would move lower early in 2023, major U.S. stock indices have trended higher. Year-to-date through January 20, 2023:
The year-to-date gains reflected stock investors’ optimism about where the economy may be headed, reported Nicholas Jasinski of Barron’s.
“Stocks have embraced the concept of a soft landing so far in 2023…The communication-services and consumer-discretionary sectors of the S&P 500 are trouncing the market, each up at least 5% year to date. Defensive consumer-staples, utilities, and healthcare stocks, on the other hand, have declined more than 2%. If stock investors were worried about a recession, shares of companies that sell electricity, toilet paper, and [cereal] should be doing better than riskier firms in more discretionary areas. They’re not.”
That’s a significant change from last year when the communication services and consumer discretionary sectors were the worst performers in the S&P 500, and energy and utilities were the top performers.
It’s quite possible we will see another shift in investors’ expectations so be prepared for a bumpy ride.
Major U.S. stock indices delivered mixed performance last week. The S&P 500 and Dow moved lower over the five-day period, while the Nasdaq moved higher. Yields on most longer-dated U.S. Treasuries finished the week lower.
Bullish or bearish?
After last year’s geopolitical turmoil, economic malaise, and tumultuous stock market decline, many financial professionals – from investors to asset managers – have strong opinions about what will happen in 2023.
Some are bullish. While individual opinions are quite nuanced, in broad terms, bulls tend to think the Federal Reserve (Fed)’s rate hikes will slow soon since headline inflation has been trending lower. Some bulls anticipate an economic recession in the United States and expect the Fed to reverse course and begin lowering rates to pull the country out of recession. Lower rates, in turn, may reinvigorate the economy and corporate earnings, and the stock market will move higher. Some expect the market to move lower before it moves higher.
Barron’s Roundtable member and stock asset manager Todd Ahlsten told Lauren R. Rublin of Barron’s, “The S&P 500…is trading for 17 times forward earnings, down from 21 times, which looks attractive. We see 60/40 odds that inflation is defeated and the economy has a soft landing or mild recession, as opposed to a hard landing. This is the year the Fed pivots. Rates probably peak in March…You’ve got to fasten your seatbelt for the next three to six months, but the S&P 500 could end the year above 4300.”
Some are bearish. Again, individual views are nuanced but, in broad terms, bears tend to think inflation will remain elevated. They see economic strength, particularly in the labor market, as a sign that the Federal Reserve will need to continue to pursue its current course and sustain interest rates at a higher level over a longer period time. Economic growth and corporate earnings may slow, and markets might finish the year flat or lower.
Barron’s Roundtable member and bond asset manager Sonal Desai told Barron’s, “I am not an equity person, but based on my macro[economic] outlook, I expect the S&P 500, and equity markets generally, to be flat this year. The current market volatility is less about the data and more about everyone trying to second-guess what the Fed’s reaction will be. An unemployment rate of 5% isn’t massively recessionary. Interest rates of 5% aren’t massively contractionary. We just happened to have a 15-year period in which interest rates were close to zero. That isn’t normal.”
Whether they were bullish or bearish, many financial professionals (Barron’s Roundtable members included) agree on one thing – there are attractive opportunities for investment, regardless of what 2023 brings.
Last week, the Consumer Price Index showed headline inflation slowing for the sixth consecutive month, although core inflation, which excludes food and energy prices, moved higher. Investors focused on the headline numbers and major U.S. stock indices gained last week. Yields on longer-term U.S. Treasuries finished the week lower.