Three items for “Data” today:
Topic #1: Today’s US Producer Price Index inflation report, and whether PPI inflation really leads Consumer Price Index inflation.
We’ll start with the question of how much today’s 11.2 percent PPI inflation deserves to be called a “record”. Strictly speaking, yes, it is the highest reading in the history of the data. But … This data series only started in November 2010, when the Bureau of Labor Statistics reformatted the PPI report to capture services inflation more accurately. There hasn’t been much inflation since 2010 until recently, and this time frame obviously misses the inflationary 1970s.
The following chart shows PPI inflation for Final Goods back to 1970 (black line), and it puts today’s reading into a more useful historical framework. Today’s 15.2 percent reading is not an absolute record, but it is higher than the June 1980 peak of 14.0 pct. The only higher readings were in 1974, where PPI Final Goods inflation topped out at 19.5 pct.
The chart also provides the answer to the age-old question “does PPI lead CPI?” The short answer is “No”. As we’ve noted, every peak in Final Goods PPI since 1970 coincides with a peak in headline CPI (1974, 1980, 1990, 2001, and 2008). The twists and turns of each inflation measure also track closely across economic cycles.
Takeaway: on the plus side, we need not fear that this month’s “record” 11 percent PPI inflation print means CPI inflation is mathematically predestined to rise in coming months. The two measures will almost certainly move together, as they have for decades. The downside is the one we all know: inflation is extremely high. It should not take +15 percent Fed Funds to reduce it, as it did in the late 1970s/early 1980s. The chart above shows how deeply imbedded inflation had become by then. As for exactly what level of Fed Funds will do the trick in 2022 – 2023, and whether a recession will be a necessary precondition to lower inflation, investors and the Federal Reserve are in the same boat. No one knows for sure. Yet, anyway.
Topic #2: The S&P 500 is down 6.7 percent year to date, so let’s put that into a long run historical perspective with respect to annual returns. There’s still +8 months left in the year, after all – plenty of time for the S&P to either recover or head lower.
This is the mental model we use when considering annual S&P returns:
- At the end of every year, the index closes at some level. Last year, for example, that was 4,766.
- That price is always “wrong”. It only reflects everything markets think they know on New Year’s Eve about future interest rates and corporate earnings for the year to come, as well as how much conviction investors have in their estimates for those valuation inputs.
- Over the course of the following year, markets correct that error, incorporating fresh information on rates, earnings, and how convinced investors are that these reflect sustainable reality.
- When the news on earnings and rates are better than expected on December 31st, the next year shows positive S&P returns consistent with the level of the positive surprise. When the news is worse than expected, equity values decline in proportion to the size of the miss versus expectations.
Since the S&P 500 is down YTD, we know that over the last 3 ½ months the news on earnings and/or rates is worse than the expectations imbedded in stock prices on December 31. No prizes as to what’s gone wrong: inflation has proved higher and more entrenched, and Fed policy/interest rates must adjust accordingly. The Russia-Ukraine war has played a role as well, by pushing oil prices higher and feeding inflation and European recession concerns.
Here’s the thing, though: stock prices don’t usually overestimate 12-month future earnings and/or the deleterious effect of higher interest rates at the end of a given year:
- The S&P has posted a negative total return in only 25 of the last 94 years (27 percent).
- In those losing years, the index was more likely to be down 0 – 10 percent (14 instances, 56 pct of down years) than down more than 10 percent (11 times, 44 pct of down years). Truly awful 1-year returns (down +20 pct) are thankfully rare: just 6 since 1928.
- Multi-year sequential periods where markets get it wrong are also very uncommon. The worst stretch of annual negative S&P returns was during the Great Depression (1929 – 1932, -65 pct in total). The 3 other times the index registered consecutive losses were in 1940 – 1941 (-23 pct), 1973 – 1974 (-37 pct) and 2000 – 2002 (also -37 pct).
Takeaway: the S&P’s December 31st, 2021 closing price is, thus far, 7 percent “wrong”, and the only relevant question for returns over the rest of the year is if that is “wrong enough”. It is hard, but not impossible, to argue that it is. The reason comes down to how much certainty investors can put in current interest rates holding steady, Fed policy being predictable, and corporate earnings growth remaining strong. The picture for all 3 is much cloudier than yearend 2021.
Topic #3: US mutual fund/ETF investors took a pause from their recent equity buying spree but are still buying commodity funds and selling fixed income products. The latest data for the week ending April 6th, courtesy of the Investment Company Institute (link below):
- Fund investors (mostly retail and small institutions) sold $7.6 billion in US equity products last week. The prior 4-week average inflows were $10.4 billion. They did, however, step up their purchases of non-US equities, with $8.8 billion of inflows. The prior 4-week average there was $991 million.
- Outflows from fixed income funds totaled $4.0 billion. That’s slightly more than the prior week (-$2.5 billion) and less than the 4-week average of -$6.7 bn.
- Commodity funds saw another week of inflows (+$575 million), but this was slower than the prior 4-week average of +$2.0 bn.
- Total fund flows were negative $3.4 billion, a notable reversal from the prior 4-week average of +$5.3 billion.
Takeaway: we warned last week that US equity fund inflows could weaken as affluent investors squared up their final 2021 tax payments ahead of the April 18th IRS deadline, and that appears to be happening. We have another week to go before that effect washes through the data. In the meantime, the fixed income buyers’ strike continues, and fund investors continue to buy commodity products (mostly physical gold) as a hedge against inflation.
Annual S&P returns: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html
Investment Company Institute weekly money flow data: https://www.ici.org/research/stats/weekly-combined