The difference between inflation in the US and Europe is noteworthy, see chart below.
Europe is experiencing stagflation with high inflation and the economy in a recession.
The US is seeing falling inflation and still solid growth.
Our set of daily and weekly indicators is available here.
The decline in inflation is good news for the Fed and markets, and there are good reasons to believe this is the beginning of a downtrend. How long will it take before we return to the Fed’s 2% inflation target? The pattern seen in the early 1970s suggests that it will take another two years, see chart below. The bottom line is that inflation is starting to come down without a sharp increase in the unemployment rate, which all points to a higher probability that we will get a soft landing, which should be bullish for credit and equities.
Hiring for the holiday season is generally done in October, and adding up new jobs created in the BLS-defined holiday season retail sectors in the latest employment report shows that retailers expect a significantly weaker holiday season than in 2020 and 2021, see chart below. This soft outlook is consistent with growing inventories at many retailers. The BLS defines holiday sectors as furniture, electronics, personal care, clothing, sporting goods, general merchandise stores, miscellaneous store retailers (e.g., florists, office supply stores, gift shops, and pet shops), and non-store retailers (e.g., online shopping and mail-order houses, vending machine operators, and direct store establishments).
Passive investors only see the overall movements in the index, but many things are going on inside the S&P500, IG, and HY indexes, which active investors are paying attention to. With inflation being a multi-year problem and the Fed raising rates, the tech sector continues to underperform, and the continued divergence in performance between growth and value in the S&P500 and credit indexes is very significant. In fact, the spread between the best and the worst performing sector of the S&P500 is currently at the highest level on record, see chart below.
Layoffs in tech are being offset by hiring in Health care, Leisure and hospitality, Manufacturing, and the Government, see the first chart below.
The second chart shows that job cut announcements have increased recently but remain at pre-pandemic levels.
The bottom line is that the Fed wants to slow down hiring, and they will eventually succeed, but the labor market is not slowing down fast enough.
Once the labor market starts slowing, then the Fed will pivot. But the slowdown in the economy could be so fast that the pivot would be associated with a sell-off in credit and equities.
In other words, the pre-condition for a Fed pivot is a weaker economy. But a weaker economy means lower corporate earnings. Which means that a Fed pivot could result in a stock market sell-off and wider credit spreads.
Manufacturers of electronics and computers are building factories in the US at the fastest pace on record, see chart below. Onshoring is in full swing and will likely continue for the next decade.
From last week’s employment report, we learned that the U.S. economy created 261,000 jobs. We also had an upward revision to the September employment report with 315,000 jobs created. Wage growth came in at 4.7%, which is above the typical levels of 2.5% to 3%. The key conclusion is that the labor market remains tight and overheated, despite rising interest rates. This week we will get Consumer Price Index (CPI) inflation data for October. The consensus expects headline inflation to come in at 7.9% and core inflation at 6.5%—still far above the Fed’s 2% target. If wage inflation is too high, and overall inflation is too high, what does that mean for corporate profit margins?
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The chart below shows the US CLO investor base by tranche. Our updated outlook for credit markets is available here.
The Fed is trying to slow down hiring to slow down inflation.
But Fed hikes are so far not having a negative impact on the labor market. The employment report for October showed job growth even in the housing sector. And also in manufacturing, despite the rising dollar. In addition, October data for startups shows that layoffs at startups are beginning to slow down, see the first chart below.
The bottom line is that the economy is not slowing down as quickly as the Fed would like it to. That is why the Fed has no other option than to continue to be hawkish. As a result, there is more downside risk to the 60/40 portfolio, see the second chart.
Our daily and weekly economic indicators for the US economy are attached.
The chart below shows that we will end up with higher peak yields in the US and UK than in Europe and Japan.
The chart also shows that the Fed is closer to done than the BoE and the ECB.
The bottom line is that current market pricing says that for the Fed and the BoE, most of the work is done with raising rates.
The ECB is only halfway there. And with core inflation in Japan at 0.9%, the inflation problem in Japan is much smaller than in other OECD countries, which gives the BoJ plenty of room to continue with YCC.
