Stagflation Money Flows, Fed Funds & Recession

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Stagflation Money Flows, Fed Funds & Recession

Three “Data” items today:

Topic #1: Another week of “stagflation playbook” mutual and exchange traded fund money flows. The data here is from the Investment Company Institute, through the week ending March 16th, 2021 (link below):

  • Fund investors added $15.5 billion to their US equity fund holdings last week, notable since those inflows coincide with the March 14th YTD lows on the S&P 500. During the market weakness the week before, inflows were also positive (+$12.5 bn).
  • Not to sound like a broken record, but the fixed income buyers’ strike continues. Bond fund outflows were $11.1 billion last week and $11.7 bn the week before. February’s outflows totaled $24.4 billion.
  • Fund flows into commodity funds (mostly physical gold) totaled $1.6 billion last week. The prior week saw $3.6 billion of inflows and for the month of February the total was +$6.8 billion.

Looking at the fund flow data for the year-to-date, the most dramatic trend we see is that fund investors have gone from adding significant net capital to simply shifting their holdings from bonds to stocks and commodities.

  • Total fund flows for 2022 thus far are only $17.9 billion, or $1.8 billion/week. The average in 2021 was $76.3 billion/week.
  • Year to date, fund investors have sold a net $47.2 billion in bond funds, bought a net $60.0 billion in stock funds (90 percent of that US equities), and added a net $12 billion in commodity funds. They also sold $6.9 billion in hybrid products, presumably because of their fixed income exposure.

Takeaway: we always say “money has to go somewhere”, and the US fund flow data says inflation fears are pushing retail investors to swap bonds for stocks. We certainly understand their logic. They see their employers making strong profits, and their own job security and wage growth is excellent. At the same time, they also see how inflation and Fed policy will hit bond prices. When US equities sell off, they sell bonds and buy the dip. Importantly, fund investors are not so bullish that they’re really adding financial asset exposure; they are simply tweaking existing portfolios.

Topic #2: Used cars are getting a tiny bit cheaper. The data here comes from auction company Manheim, which tracks the prices of late model used vehicles bought and sold by dealers. Used car prices were among the first to reveal that high inflation was structural rather than transitory. They remain a problem even now. The last CPI report pegged annual used vehicle inflation at 41 percent, even more than gasoline (+38 pct). This contributed 1.7 points of inflation to the CPI’s headline reading of 7.9 pct.

The chart below of Manheim’s Used Vehicle Value Index shows prices have declined 6 percent from their January 2022 all time highs. Even still, they are 64 percent above March 2019’s pre-pandemic reading. For what it’s worth, the S&P 500 is only up 55 percent since March 2019.

Manheim’s color on the data does not support the idea that we’re about to see a rapid decline in used vehicle prices, however:

  • “The latest trends in the key indicators suggest wholesale used-vehicle values will likely see increases in the second half of the month.”
  • “Used retail days’ supply declined 6 days from the 51 days measured at the end of February.” (Note: dealers like to have closer to 60 days’ supply, to assure adequate customer choice.)
  • “Wholesale supply was at 26 days, down 2 days from the end of February.”

On the plus side of things, the index’s year over year comps are beginning to be “less bad” in terms of their contribution to overall inflation:

  • October 2021: +38 percent
  • November 2021: +44 pct
  • December 2021: +47 pct
  • January 2022: +45 pct
  • February 2022: +37 pct
  • March 2022: +29 pct if the second half of March reverts to February levels

Takeaway: while used cars are a tiny slice of the US economy, this market perfectly captures both why inflation has remained so sticky and how difficult it will be to tame. The US economy is at full employment, so demand for personal transportation is very high. Supply chain issues have curtailed new vehicle production, and the supply of late model used cars and trucks is limited to trade-ins, lease expirations, and rental car company fleet sales. The only thing that significantly reduces new/used vehicle demand is a recession, and those also hit used vehicle prices (see chart above, 2001 – 2003 and 2008 – 2009).

Anniversary effects will help the CPI’s used car inflation math in coming months, true. Other categories – gas, food, and housing, for example – got a later start in terms of registering higher inflation than used cars did, however. Those will be the areas to watch in upcoming CPI reports.

Topic #3: A quick update on Fed Funds Futures odds for upcoming FOMC meetings (prices as of 3:30 pm East Coast time):

  • May: Odds of a 50 basis point hike are now up to 66 percent from 51 pct a week ago (right after the last meeting and Chair press conference)
  • June: Odds of another 50 basis point hike at this meeting sit at 61 percent, up from 34 pct a week ago.
  • December: there is a combined 63 percent probability that Fed Funds will be 2.25 – 2.75 percent by year end, up from a combined 22 pct a week ago. With 10-year Treasury yields at 2.32 percent today, that implies either a flat or inverted curve by year end.

Takeaway: Fed Funds Futures see a much more hawkish Fed than when Chair Powell wrapped up his press conference a week ago. Two 50 basis point rate increases at the next 2 meetings has become this market’s baseline expectation, as has a flat 2-10 year spread by year end – the traditional warning sign for an upcoming recession. On the (sort of) bright side, we continue to believe 10-year yields will rise, so that signal should wane. Even still, it is hard to see US equities staging a sustainable rally into multiple 50 basis point rate hikes. Things could change. The Russia-Ukraine crisis could have a deus ex machina moment, for example, or oil prices could drop on their own. Barring those outcomes, however, we remain cautious on US/global equities.

Sources:

Investment Company Institute weekly money flows: https://www.ici.org/research/stats/weekly-combined

Manheim Used Vehicle Value Index: https://publish.manheim.com/en/services/consulting/used-vehicle-value-index.html

CME FedWatch: https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html