TSLA - UAW Strike And Saudi Oil Cuts Are The Fed's New Inflation Nightmare

2023-09-17 09:00:00 ET

Summary

• Labor negotiations with key labor unions in the U.S. are leading to huge pay increases, which are both a symptom of and a cause of inflation.
• The recent United Auto Workers strike and Saudi Arabia's efforts to raise oil prices are further fueling inflation.
• The Fed is trapped and may need to tighten monetary policy further to control inflation, shocking traders betting on a quick return to easy money.

August CPI and retail sales numbers surprised to the upside this week, signaling a new phase in the Fed's battle to bring down inflation. Adding fuel to the inflationary fire, United Auto Workers president Shawn Fain has declared a simultaneous strike at the Big 3 automakers, demanding a roughly 40% increase to UAW union workers' pay. The strike could last a while. Before calling the strike, Fain had live-streamed himself throwing the automakers' offers in the trash. Nearly 7,000 miles away, Saudi Crown Prince Mohammed bin Salman has raised the stakes on his clash with the Biden Administration, extending cuts on oil production in an effort to squeeze the price of oil to well over $100 per barrel. Beijing has primed the pump with a new stimulus package to keep the Chinese economy moving, which is seen as further supporting commodity prices and keeping inflation burning worldwide. Most pundits think inflation will easily go away on its own, but these events have clear parallels to the 1970s that suggest that we're going to be in for a long haul. Without an imminent recession, we're now setting up for a fresh inflation surge. The Fed will have to deal with it either way. That's bad news for the S&P 500 ( SPY ) and NASDAQ ( QQQ ), trading at nosebleed P/E valuations as leading economic indicators continue to slide .

The UAW Throws Down The Gauntlet

Honor, trust, and respect are key in some aspects of life. Labor negotiations with Corporate America are not one of them. All that matters with union negotiations is leverage! Enter Shawn Fain, bulldog leader for the United Auto Workers union. Negotiations over the past year show that labor unions in key bottlenecks of the economy have been able to demand eye-popping deals with companies. Airline pilots demanded and got a 40% raise , the Teamsters grabbed a deal to push UPS ( UPS ) driver pay to $170,000 annually in five years, and dockworkers and rail workers have threatened strikes as well to renegotiate pay packages. This ramps up the pressure on the UAW to go big or go home in its own negotiations.

So what's going on here with these huge pay increases?

1. When money is printed, it benefits those to whom it's given, at the expense of those to whom it's not given. Trillions of dollars were printed during COVID, and everyone who got the money benefitted by getting relatively richer, while those who didn't get it got relatively poorer. This isn't rocket science. It also means that salaries can't buy as much, since those who are working for their money have to compete with those who are getting it for free. This is the case until they can renegotiate salaries. COVID took some of the union workers' purchasing power away. Now they're renegotiating.
2. Printing money increased demand, which actually increased the power of unions in the transportation sector because they control key bottlenecks in the economy. For this reason, you're not seeing huge pay increases for the teacher's unions like you are for dockworkers or pilots.
3. Many companies are earning record-high profits, which is causing unions to take a harder line than they would otherwise. This is particularly the case with the UAW, which suffered greatly after 2008 (although auto shareholders got crushed as well).

The fact that major unions are demanding and getting large pay increases speaks to the amount of damage that has already been done to the purchasing power of workers. In the 1970s in particular, these kinds of wage demands led to inflation by creating what's known as a wage-price spiral. Now it's interesting to see these coming back in a big way, including the UAW's demand to tie wages to price increases.

The UAW chose to begin by striking roughly 13,000 workers here, with the implicit threat that they can double down a couple of more times without depleting their strike fund. Their tactics are sharp here because they can virtually guarantee that they'll cost General Motors ( GM ), Ford ( F ), and Stellantis ( STLA ) billions of dollars in lost profits either way. It's quite possible that the UAW could win the battle but lose the war, as the Big 3 auto manufacturers are not the most competitive globally and have a poor track record of handling change.

Key parts of the American manufacturing economy are not competitive with Mexico, China, and Eastern Europe. As such, unemployment should naturally be a good amount higher than it is now. To keep this from happening in the post-2008 world, industry in the US and parts of Western Europe has been propped up by tax cuts, subsidies, and rock-bottom interest rates. Now inflation is taking this option away, which is likely to lead to a more difficult process of reeducating and retraining workers to be competitive in the 21st century. Elon Musk's Tesla ( TSLA ) is competitive globally, but they pay about 25% less than the union workers make, and the unions are demanding a 40% raise.

The UAW striking here will directly increase inflation because they're walking off the job when they would be making cars. In the short run, this means consumers are likely to have fewer choices of cars and will face higher prices. This directly complicates the Fed's inflation fight, which has relied partly on used cars dropping to bring overall consumer prices back towards target. Also notable is how poorly stocks have performed after getting crushed by unions in negotiations. UPS stock is lagging the market by roughly 30 percentage points this year, while American Airlines ( AAL ) is lagging by more than 10% with the flight attendant union looking for a new deal as well. My guess with the automakers is that the union will get a surprisingly good deal, or will strike long enough to punish the stocks anyway. I'm less certain that the UAW is prepared for the shift to electric cars, many of which will be made overseas or in more employer-friendly jurisdictions like Texas.

Another 1970s Stagflation Throwback, Courtesy of Saudi Arabia

The Saudis are ramping up the pressure with supply cuts, and it's working. Oil fell from its highs of around $120-$130 per barrel when the economy slowed last fall and stocks entered a bear market. Now, supply cuts have WTI oil back into the $90s. One way to think about this is that the Biden administration wants oil as low as possible for the 2024 election and that the Saudis want it as high as possible. The Saudis won the first round in 2021 and 2022, but the Biden administration won the second with a warm winter in the US and Europe and the Inflation Reduction Act bringing optimism about the supply chain. The results of the third round remain to be seen, but it's going to be very difficult to escape higher oil prices in the short run if Saudi Arabia doesn't play ball.

This is a huge challenge for the Fed. Though the Fed targets core inflation with its policies, the August CPI report showed that transportation services rose 2% for the month, the biggest rise of any category outside of energy! Transportation services are part of core inflation, underscoring the risks of another inflation surge happening under our noses. Does the increase in transportation services have anything to do with the Saudis driving oil up and labor unions in the transportation sector dropping the hammer? You bet it does. Oil has been higher in the past, especially when adjusted for inflation. The current surge in inflation has occurred without out-of-control oil prices. Imagine how bad prices for all kinds of goods and services would be with oil at $150. This isn't my current base case, but history shows that it's possible with war or supply cuts. If you believe the latest forecasts showing continued growth in oil demand over the next few years, this is going to be a structural problem.

The Fed Is In A Pickle

Due to the base effects from last year and higher energy and transportation costs, inflation is increasing and getting further from the Fed's 2% annual target. Adding a prolonged strike at the automakers is not helping the cause, calling into question the market's belief that the Fed is most likely done hiking interest rates.

The Fed has more or less boxed itself in from hiking in September by public comments various Fed speakers have made in recent days. For year-end, CME FedWatch is showing that the Fed has roughly a 60% chance of staying put, vs. a 40% chance of hiking more. The Fed had already said they would hike, so traders will get more information about this from this week's meeting. Economic modeling suggests the Fed is still behind the curve by trying to do the minimum. The 30/30 Taylor Rule model runs in my latest calculations are calling for at least one more hike. What should the Fed do at this week's FOMC meeting? My guess is that they'll hold interest rates steady, but signal a hike in November and a higher level of interest rates and inflation for 2024 in their Summary of Economic Projections .

The European Central Bank (the ECB) indicated that they're likely pausing hikes this week, and markets reacted mechanically by dumping the euro and panic-buying US stocks. However, what the ECB is really saying with their actions is that they're concerned about how deep the coming recession will be and are trying to limit the damage. This is likely why the panic buying completely reversed itself on Friday, while yields continued to grind higher. Over in Japan, they're struggling with inflation as well, and recent moves to relax their interest rate controls are putting pressure on the rest of the world . If the BOJ hikes interest rates and abandons yield curve control, that cuts off another key source of money that's helped hold interest rates low.

The Fed is in the same quandary as the ECB. Union negotiations at home and oil prices shooting up mean that the economic models are probably right and that the Fed can't simply pause and pray. They'll need to hike one or two more times to avoid losing control of prices, even into early signs of a moderate to severe recession. 30-year mortgage rates are creeping towards 8% in the US, while car loans are moving towards 7%. It's hard for interest rates to go down with stubborn inflation and deficits as big as they are, and there doesn't seem to be any appetite to raise taxes or cut spending. I don't think the economy is going to handle this very well at all.

Bottom Line

Inflation was supposed to be gone by now, but recent data shows that inflation is accelerating back to the upside. With labor trouble at home and the Saudis cutting oil production abroad, the Fed likely will have to tighten a bit more to balance supply and demand. This comes as leading economic indicators continue to worsen amidst rates for mortgage and auto loans hitting fresh post-2008 highs. That's bad news for traders expecting a Fed pivot and a corporate profit boom. The stock market remains overvalued. Therefore, I'm still firmly in the camp of holding money in cash paying 5.5% and waiting for a steep correction or crash in stocks before doing any significant buying. While there are always a few good deals in any market, the broad market indices look increasingly overvalued. What do you think? Share your thoughts in the comments!

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