Inflation is Deeper and Broader Than Many Believe

A close look at last week’s report on the Consumer Price Index (CPI) indicates inflation is well-embedded in the economy and will take some time and effort to reduce.

Market prices, especially the breakeven inflation rate on Treasury bonds, indicate most investors believe inflation will be tamed in short order. Federal Reserve officials also indicate they’ll have inflation under control soon.

It is hard to have confidence in the projections from either the Federal Reserve or the markets because they’ve been well off the mark the last few years.

Though energy prices have declined quite a bit since early June, they still are much higher than a year ago. Also, lower energy prices free up cash to be spent on other items, supporting higher prices for them.

A major impediment to lower inflation is the labor market. Because of the shortage of workers, employers must pay higher wages to attract and keep quality workers.

While the labor market has cooled a bit, it still is historically positive for workers. That means compensation for workers is rising (though not as fast as inflation). Workers can continue to spend and pay higher prices for the goods and services they really want.

Higher labor costs significantly affect the prices of services, and services make up the bulk of consumer spending. Inflation for services was much higher than for goods before the pandemic.

The spending mix shifted to more goods and fewer services in the first two years of the pandemic, because so many service businesses were closed.

With more spending shifting back to services, inflation for services is rising.

We’re probably at or near the peak for the CPI in this cycle. Commodity prices are below their peaks and won’t rise as rapidly as they did in the past year. But shortages of labor and many goods will continue.

That means annual inflation isn’t going to shrink back to the Fed’s 2% target under current conditions. Unfortunately, the Fed fell so far behind the inflation curve that it will take a meaningful recession to reduce demand enough to bring inflation down near the target.

More than likely, the Fed will have to accept inflation above its target (probably in the 3% to 5% range) so that it can ease again to avoid a significant recession.

Pandemic Retirees Express Retirement Regrets

The pandemic period became known as the Great Resignation to some, because millions of Americans left the work force earlier than they planned.

The exodus continued in the first half of 2022. The number of people quitting their jobs was about twice the level of a decade ago, according to the monthly JOLTS report from the Federal Reserve.

But many people now regret the decision to leave the work force early. More than 25% of those who left the work force recently are reconsidering their decisions, according to a recent study by job-search platform Joblist.

Some of the respondents point to the weakening job market as a concern. The job market was strong when they quit, and they had confidence they could return any time they wanted to or needed money. Now, they may worry about if the window to return and find a good-paying job is closing.

Others report they miss the social connections of the workplace. They didn’t realize how important the relationships and social interaction were.

Of course, inflation was low and asset prices were soaring when many decided to stop working. Now, they worry about the impact of inflation and declining asset prices on their retirement security.

How Some Stocks and Funds Cause Their Own Gains and Losses

Investors are learning or re-learning an important lesson in this investment cycle. It’s important to consider liquidity and cash flows when making investment decisions.

Though there are many recent examples, let’s consider the ARK Innovation ETF (ARKK).

The fund invests in a relatively small number of stocks (35 recently with 59% of the fund in the 10 largest positions) and buys only stocks of companies that manager Cathie Wood believes are innovators.

ARKK soared after the bottom of the pandemic bear market as the stocks it held became popular. From its low point early in the pandemic to its peak in February 2021, ARKK rose about 400%.

A lot of the excess performance was due to cash flows. As the fund’s returns generated more attention, investor dollars flowed into the fund. The fund’s assets went from $2 billion to just short of $28 billion. The fund invested most of that cash by buying more of the same stocks it already owned.

That might not be a big deal when a fund is buying stocks that have large daily trading volume. But when the stocks have lower daily trading volume, significant new purchases by the fund push prices higher.

In this case, the cash flows caused prices of stocks owned by the fund to rise, increasing the fund’s returns and attracting more money to the fund to be invested in the same stocks.

But once the Fed made clear it was going to turn off the money spigot, the money flows into ARKK and its stocks also stopped. With fewer and fewer people buying the stocks, their prices declined.

Many of the stocks in the portfolio are down 50% or more from their peaks, and ARKK’s share price is back near its pandemic low. Most of the cash that flowed into the fund arrived when it was near its peak. Investors who bought then have lost about 70% of their capital.

Sometimes investment cash flows, not business performance, are the main influence on a stock’s price. ARKK and its holdings are examples. So are Bitcoin and the other digital currencies.

All of this was a repeat of the tech stock boom and bust of the late 1990s, though the recent cycle was much shorter.

It is why I always recommend that investors be sure their holdings have margins of safety, that they pay attention to valuations, and be sure portfolios are balanced and diversified.

The Data

Housing starts in June were 2.0% lower than in May and 6.3% lower than 12 months earlier.

Single-family home starts in June were 8.1% lower than in May. Building permits also declined in June.

Despite the declines in starts and permits, there are a high number of homes under construction. The number of single-family homes under construction in June was slightly lower than each of the two previous months. Other than those two months, the number of single-family homes under construction in June was the most since November 2006.

The number of multi-family homes under construction in June was the most since March 1974.

There are so many homes under construction because it takes longer to complete construction due to shortages of supplies and labor.

The Housing Market Index from the National Association of Home Builders (NAHB) declined in July to 55 from 67 in June.

That’s the second-largest one-month decline in the index, topped only by the pandemic-induced decrease of April 2020. It also is the lowest level for the index since May 2020 and the seventh straight monthly decline.

Builders said sales and buyer traffic slowed dramatically in June because of higher interest rates and rising costs.

The survey found many builders halted construction because the cost of construction exceeded the market value of the homes.

Existing home sales declined 3.4% in June from May’s level, and sales in June were 8.6% lower than 12 months earlier.

I don’t usually cover the weekly mortgage application data, but this week’s report was noteworthy. Applications for mortgages declined by 6% from the previous week, and that brought the number of applications for the week to the lowest level since 2000.

Mortgage applications for home purchases declined 7% from the previous week and were 19% lower than 12 months earlier. The Mortgage Bankers Association said that fewer people can afford to buy homes because of rising interest rates and home prices.

In addition, general consumer price inflation leaves potential home buyers with less of their monthly income to spend on housing.

The Producer Price Index (PPI) increased by 1.0% in June, following a 0.8% increase in May.

Over 12 months the PPI increased 11.3%, following a 10.8% increase through May.

Excluding food and energy, the core PPI increased 0.4% in June after increasing 0.7% in May.

Over 12 months the core PPI increased 8.2%. It had increased 9.7% through May.

New unemployment claims increased by 9,000 to 244,000 in the latest week. That’s the highest level in 2022.

Continuing claims declined by 41,000 to 1.3 million.

Retail sales increased by 1.0% in June, a big jump from the revised 0.1% decline in May. Excluding vehicles and gas, retail sales increased 0.7% in June, up from the revised 0.1% decline in May.

Keep in mind the retail sales data isn’t adjusted for inflation, so all or most of the increase is the result of higher prices. People are spending more dollars but receiving less for them.

The Empire State Manufacturing Index was reported at 11.1 in July, up from negative 1.2 in June. The official report said the June level indicates there was a modest increase in manufacturing activity from the previous month. New orders increased marginally while shipments rose significantly.

Industrial production declined 0.2% in June, and May’s data was revised down to no change from April. Manufacturing output in June declined by 0.5%, and May’s number was revised down to a 0.5% decline from April.

Consumer sentiment, as measured by the University of Michigan, improved a bit in the first half of July. The Consumer Sentiment Index was 51.1, up from the record low of 50.0 at the end of June.

The index was 81.2 a year ago.

In the first half of July, consumers’ assessments of their personal finances reached their lowest level since 2011.

The Markets

The S&P 500 rose 3.00% for the week ended with Tuesday’s close. The Dow Jones Industrial Average gained 2.67%. The Russell 2000 increased 4.21%. The All-Country World Index (excluding U.S. stocks) added 2.68%. Emerging market equities is 1.72% higher.

Long-term treasuries lost 0.70% for the week. Investment-grade bonds increased 0.49%. Treasury Inflation-Protected Securities (TIPS) added 0.62%. High-yield bonds gained 1.32%.

In the currency arena, the U.S. dollar declined 1.28%.

Energy-based commodities increased 4.73%. Broader-based commodities rose 4.50%. However, gold declined 0.79%.

Bob’s News & Updates

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