COM - Setbacks On The Inflation Front

2023-09-28 12:38:41 ET

Summary

• After falling at an impressive pace for a year through June, inflation has pricked back up again in recent months.
• Oil has surged to its highest levels since late last year and we have seen upticks in price levels within the last two monthly CPI reports.
• Why inflation, like interest rates, is likely to be "higher for longer" than investors would like and with negative impacts to the market is discussed in the paragraphs below.

Inflation is taxation without representation .”? James Thomas Kesterson Jr.

Stocks were propelled in the first half of 2023 in large part due to huge fall in inflation levels. From June 2022 to June of this year, the monthly CPI fell from 9.1% to 3.0%. However, July saw a 3.2% print which was followed by 3.7% in August . This has been a key factor in the weakness we have seen in equities since the start of August.

Then we have the surging price of oil (CL1:COM). WTI Crude is at $93 a barrel, up from $70 a barrel just three months ago. Production cutbacks from Saudi Arabia and Russia, the continued conflict in Ukraine, as well as solid global demand have pushed Black Gold to its highest levels since November of last year. And storage Crude inventories in Cushing (a key energy hub) have just hit their lowest levels since July of last year.

Flexibility to cushion the blow from rising oil prices has also lessened considerably in the United States. The current administration has drained the Strategic Petroleum Reserve or SPR by some 240 million barrels of oil. The SPR has approximately 350 million barrels remaining , and the SPR now stands at its lowest inventory levels since August of 1983.

If the recent backtracking of CPI and the 30% rise in crude were not enough headwinds on the inflation front, we now have the return of a phrase from the late 70s and early 80s from the last era the United States faced these sorts of inflationary pressures. That is the " Wage-Price Spiral ." This is defined as:

The wage-price spiral is a macroeconomic theory used to explain the cause-and-effect relationship between rising wages and rising prices, or inflation. The wage-price spiral suggests that rising wages increase disposable income raising the demand for goods and causing prices to rise. Rising prices increase demand for higher wages, which leads to higher production costs and further upward pressure on prices creating a conceptual spiral ."

Thanks to the over 17% increase in the inflation rate since the beginning of 2021, the tight labor market and falling buying power; workers are demanding and getting large wage increases in many parts of the economy. The 15,000 pilots at American Airlines ( AAL ) recently agreed to a four-year-contract that will contain 46% wage increases over the life of the contract, including 21% in the first year. This and the other benefits within the contract will cost American an additional $9.6 billion over four years. Pilots at other major airlines have reached similar contract terms.

The Teamsters Union agreed to a historic five-year contract with United Parcel Service, Inc ( UPS ) last month that will make the teamsters at the company the highest paid delivery drivers in the nation, improving their average top rate to $49 per hour.

We also have an ongoing labor situation with the UAW and the Big Three around approximately their 138,000 employees, which are negotiating a new four-year contract. The UAW's initial demands were for a 46% wage increase over four years, a 32-hour work week and a return to traditional pension plans. While the UAW has come down from that opening bid, the two sides are still far apart. So far, this has resulted in limited strikes, but that might escalate this Friday if negotiations don't make substantial progress.

Finally, the Culinary and Bartenders Unions both just authorized possible strike actions as they start to negotiate new contracts that cover some 60,000 workers in Las Vegas and Reno.

The 10-Year Treasury yield (US10Y) just touched a 15-year-high as the narrative that interest rates will remain "higher for longer" gets cemented in the market. Unfortunately, inflation also seems like it will be higher for longer as well.

Unfortunately, the Federal Reserve has put itself being a rock and a hard place. This is largely of its own making. Believing inflation was " transitionary" and " temporary" throughout 2021, the institution has let the inflation genie out of her lamp. As I have been saying since the central bank started to raise rates in March of last year both on Seeking Alpha and my perch at Real Money Pro, this ends in one of two ways.

The first is the inflation battle proves too long and costly, and the Federal Reserve accepts a higher " official" inflation target of three percent from its longstanding two percent target. I don't think this happens for two reasons. First, this would erode the Federal Reserve's creditability even further. Second, with a national debt that just went through the $33 trillion mark, this would make servicing that debt at current rates untenable over the longer term.

Their second path is to raise rates until the economy goes into a recession, which will depress demand and slam the lid on inflation once and for all. As I detailed in my recent article " Shades of 2007 ," I view that as the most likely scenario in the quarters ahead. The yield curve remains significantly inverted and Monthly Leading Economic Indicators have declined for 17 straight months, the first time this has happened since 2007/2008.

In summary, the two most likely outcomes as a result of this recently flailing war against inflation is either Stagflation or economic contraction. Neither scenario seems priced into the markets at current trading levels. Investors should position their portfolios accordingly.

Inflation is always and everywhere a monetary phenomenon .”? Milton Friedman.

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