When VC Brainard Speaks, People Listen
Growth scare, 25 and done, rolling recession, debt ceiling, equal weighting equities
“BRAINARD SAYS FED POLICY NOW IN RESTRICTIVE TERRITORY”
Another Growth Scare
Data this week underscores the complex economic environment. December retail sales, though likely distorted by pandemic effects on seasonal adjustment factors, were much weaker than expected. Also released Wednesday morning was December industrial production and led by even weaker manufacturing output, only added to recession concerns. Housing, manufacturing surveys and initial claims for the payroll establishment survey week muddied the picture somewhat, and even on the big downdraft day following retail sales and industrial production, the worst performing sectors were the defensive consumer staples and utilities sectors.
Meanwhile, December inflation reports over the last two weeks were unequivocally favorable, and this week we learned that December final demand, core, goods and services producer prices all slowed to below 2% in 4Q22 annualized. Even as FOMC participants continue to fight the 2s, with the notable exception of Vice Chair for Monetary Affairs Brainard, with a concession from Governor Waller, breakeven inflation dragged nominal Treasury yields lower following a brief bear steepening move ahead of the BOJ meeting. Over the last three months, since peak hawkishness at the September FOMC meeting, 2-year breakeven inflation is 45bp lower and real rates are 3 lower. In other words, interpreting the drop in 2s below the Fed’s current policy rate as discounting recession risk is dubious. As when the yield curve initially inverted in April 2022, it is all about falling inflation.
Our inflation discussions with clients tend to focus on the 2H23 outlook, and our call that the path to 3-4% is clear appears to be widely accepted, with some clients expecting a significant overshoot of our now 3% target that may prove problematic for corporate margins. As we discussed last week, there are signs that import prices are starting to bottom out, even as the debt ceiling debate begins (more on this later) we suspect that fiscal policy will contribute to higher than Fed target inflation. It is early to position for higher inflation in 2H, but breakeven inflation trades look attractive. Additionally, though concerns about growth are likely to intensify in coming weeks, we are getting tempted to short Treasuries following the February FOMC meeting.
Throughout 2022 we maintained that growth was slowing but wasn’t slow. Our characterization, while inconsistent with the expenditure method of guesstimating output (GDP) largely due to the most extreme inventory cycle since the ‘40s, is best illustrated by nominal gross domestic income that peaked in 2Q21 at 16% annualized and slowed to 9.1% in 3Q22. Though next week brings the advanced guesstimate of 4Q22 GDP, it’ll be another month before we get GDI. A monthly proxy for ~60% of total domestic income is labor income, hours worked times nonsupervisory average hourly earnings, that peaked at 15.1% in May ‘21, was 13.3% in February ‘22, 10.4% in 3Q22 before slowing sharply to 6.8% in 4Q22. Within this context, the strong labor market narrative looks dubious, since even with record government transfer payments, labor income slowed to trend growth in 2022.