The Labor Department reported that producer prices rose 0.8% in May, up 10.8% from a year earlier, up from a 0.4% advance in April. Excluding food and energy, the so-called core producer price index rose 0.5% last month, up 8.3% from May 2021. This follows last week’s consumer price data which accelerated to its highest level in four decades in May in a broad-based advance. Technically, peak wholesale prices were last month when the annual headline rate reached 10.9% and the annual core figure was 8.6%. Nevertheless, supply chain issues continue to provide strong headwinds to taming inflationary pressures with the war in Ukraine continuing and China re-imposing Covid-19 restrictions soon after loosening them in many cities in its quest to achieve zero-Covid purity. The expiration of labor contracts covering 22,000 West Coast dockworkers is another foreboding sign on the horizon. Goods prices rose 1.4% while services prices were up 0.4%.
The Fed also released its quarterly projections of the economy. The median projection would lift the fed-funds rate to around 3.375%, or by an additional 1.75 percentage point over the following four meetings this year. Most officials had projected in March that they would raise rates to at least 1.875% this year. By the end of 2023, projections show the rate around 3.75%. This would be above their long-term, so-called neutral rate, of 2.5% emphasizing that they are trying to reducing inflation as quickly as possible. The projections also show that Fed officials expect GDP to slow and unemployment to rise as a result of their rate policy. Most officials now see growth of around 1.7% this year and next, compared to projections in March that showed growth rising by 2.8% this year and 2.2% in 2023. The median projection showed the unemployment rate, which stood at 3.6% in May, ending at 3.7% this year before rising to 4.1% in 2024.
Powell added what might be the understatement of the year: “What is becoming more clear is that many factors that we don’t control are going to play a very significant role in deciding whether that’s (a soft landing) possible or not. It is not going to be easy.” Supply of many things are limited which is what is causing prices to spike. The Fed is trying to balance demand to the level of supply which will help reduce prices. However, by doing so, it increases the risk that they tighten too much and tip the economy into a recession. Not to be forgotten—the Fed is also reducing its balance sheet by not reinvesting proceeds from maturing instruments. This passive attrition to the tune of $95 billion per month in a few months acts as another form of tightening but does not get the same type of headlines as monetary policy. However, the effect is the same—less liquidity for the markets which means less spending.
The Fed’s job is made harder because the “guy or gal on the street” is not an economist. The best predictor of future price increases are core price changes—that is, housing prices, the cost for lawn care, how much for getting a cavity filled at the dentist, what a book costs on Amazon, etc. But what the “guy or gal” sees every single day is the price of a gallon of gas on huge signs by the road and the price of milk and butter in large font in supermarkets. Those repeated interactions at the gas station or grocery story are what mostly shape expectations because it happens so often to so many people. Ask someone how much to fill up their vehicle, they can rattle it off in a second probably accompanied by a gasp. Ask what they paid for their child’s lunchbox last year or air fryer bought during the holidays or most recent eye exam and it’s unlikely they will know.
What does this mean for investors? It means we are just at the beginning of a rate hike cycle that will last into next year and possibly beyond. The higher rates go, the slower the economy will grow. A slower economy means the likelihood of a recession increases but is still not guaranteed. If a recession occurred, it could be shallow and brief as a best case scenario or, conversely, long and deep like the recession of 2008-2009. However, the environment is quite different than that time period. The financial system is more stable and household debt more manageable. While the inflationary period reminds some of the 1970s and 1980s, today is different from then as well. Despite what consumers pay at the pump, the U.S. is more energy independent than the times of the oil embargo, productivity has culled many price increases across various industries and inflation would have to stay at double digit levels for over a decade to match that time period. Today’s situation is going to be reminiscent of many others from the past because economies move in cycles. Previous ups are going to look like prior booms and past downs are going to resemble earlier busts. The problem is not demand, for now that remains quite solid but there have been signs of weakness. Retail sales fell in May for the first time in five months though, excluding vehicles, sales actually rose 0.5% last month according to the Commerce Department. The National Association of Home Builders/Wells Fargo gauge fell two points in June to 67, the lowest level since June 2020 reflecting higher mortgage rates weighing on housing demand. Residential starts fell 14.4% last month to a 1.6 million annualized rate, the lowest in more than a year according to government data. While those data points are noteworthy, the primary issue right now is supply and that’s going to require patience to wrinkle out the issues. Our view is holding a diversified portfolio generating solid cash flows remains the best option for these volatile times which will help combat inflation as well as provide a real return. The market over the past week has reached metrics not seen since previous recessions such as technical indicators like stocks trading below their 50 day moving average, voluminous selling on down days and poor relative strength indicators. These are signs of a bottoming process suggesting that the bulk of the selling has already occurred. Many companies are using the pullbacks to buy more of their own shares. Even if there is more downside, an argument can be made that markets are tipping more into oversold territory as fundamentals show no signs of deteriorating as fast as prices have been falling. We abide by the principle that even though value investing isn’t superior for every period, finding value does not go out of style.