The Cases for 'Uh-Oh' and 'OK'

Parsing the government's latest inflation report... The cases for 'uh-oh' and 'OK'... Inflation is not a 'black and white' story... The China effect... Scott Garliss on the U.S. jobs market... Why it might not be as strong as people think...

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On first glance, you might say 'uh-oh'...

It appears that the markets did, anyway. This morning, the S&P 500 Index was down roughly 1% before rallying to around breakeven by closing time.

Before the markets opened, we got the latest official read on inflation with the January consumer price index ("CPI"). It showed a 0.5% month-over-month gain, a big jump from the 0.1% rise in December and 0.2% gain in November.

In short, that means the pace of inflation – at least as measured by the U.S. Bureau of Labor Statistics ("BLS") – accelerated last month versus the months prior... That's the "uh-oh" part of the report.

The better news is the headline annual CPI gain continued to decline, to 6.4%. That marks the seventh straight month of slowing inflation versus the same period a year earlier... That's the "OK" part of the story...

Parsing these data isn't a black-and-white analysis... There's a substantial gray area that gets lumped into the headline numbers. For example, gas prices increased about 2% in January, and natural gas services rose more than 6%. That hurts a lot of people's budgets.

Yet some sectors of the economy – like medical-care services and used cars – showed deflation. And other parts, like food, showed modest 0.5% monthly gains... a pace slower than it has been for most of the past 12 months.

So, in all, inflation is slowing down compared with a year ago, but it's still not falling like a stone off a cliff. Instead, I (Corey McLaughlin) see inflation today as more like a pebble knocking around in a lazy river, heading downstream but not going out of view fast enough.

This inflation report wasn't the worst or the best...

It reflects "sticky inflation," which stinks for us as everyday people buying things like food and energy. In the longer run, though, when it comes to analyzing what these numbers mean for the stock market, the news might not all be bad...

One big reason is that today's inflation report reflects pretty much what folks at the Federal Reserve have been expecting. This could mean more of the status quo with monetary policy, and a lower likelihood for significantly higher interest rates than the market currently expects.

The gray areas of this latest CPI data largely match the expectations Fed Chair Jerome Powell talked about during an interview at an uppity economics conference in Washington, D.C. last week...

There, Powell described what he was seeing in the personal consumption expenditures ("PCE") index, a CPI-like gauge of inflation that the Fed favors for its policymaking. As we wrote in the February 7 Digest...

Powell noted that "goods" inflation in the PCE measure has started to slow down, in part because the PCE includes such products as cars and furniture, which are sensitive to interest rates because many are purchased on credit. And he expects the numbers linked to housing to come down in the second half of this year.

However, he explained that there's still one more big part of the economy that hasn't started slowing down yet.

That's the "services" sector outside of housing – which makes up 56% of PCE and includes things like food, health care, and hotel and travel costs. This area of the U.S. economy has shown no signs of disinflation yet, he said.

Those statements jibed with today's CPI report – mostly...

There was one concerning outlier...

Americans paid nearly 1% more for apparel in January, an unusually high increase and higher than it had been in at least six months.

Can you guess who supplies most of the apparel bought in the U.S.? China, whose economy is "reopening" after a bout with COVID-19. This dynamic could possibly stoke worldwide inflation... It's something to keep a close eye on.

And, please, don't think that the economic picture in the U.S. is all rosy. On balance, high inflation is still sticking around probably longer than anyone wants.

That includes U.S. government leaders, the folks who helped cause it with trillions of dollars of stimulus and a much-too-long run of near-zero benchmark interest rates for the economy.

Today, bond yields rose across the "curve" while stocks fell. This reflects an expectation for higher Fed interest rates for longer... And it continues the divergence we've seen at nearly every key juncture over the past year.

And nobody knows for certain where things go from here.

The other big question is the jobs market...

According to its congressional mandate, the Fed is supposed to ensure "stable prices" and guide the economy to "maximum employment" – a level the economy can sustain without generating high inflation.

With the latest unemployment number falling to 3.4%, a new 53-year-low, employment is historically at a high. And as we saw in today's CPI report, inflation is coming down, generally speaking.

Put these two big things together and the Fed's policy path ahead may be straightforward. That's especially true if you look below the surface at what's really going on with the jobs market – like our Stansberry NewsWire editor C. Scott Garliss has recently...

Over the past few weeks, Scott has taken an in-depth look at the U.S. labor market. He found that, first, it might not be as strong as it may appear on the surface... second, that fact has caused the Fed to change its tune recently about potential policy moving ahead... and third, this change in view from the central bank could be bullish for stocks.

Scott takes the rest of today's Digest from here with more...

As we've been discussing throughout the past 12 months, the Fed is pulling every economic lever it has to try to bring down inflation growth. But there have been two main items on which the central bank has focused in its attempt to kill economic demand... housing and labor.

Housing is a big focus because it's the largest component in the CPI. It accounted for a third of the December result. And owners' equivalent rent, or what you would pay to rent your own home, has an almost 25% weighting.

Economic activity typically slows before home prices start to fall. And recent data from the Federal Housing Finance Agency's ("FHFA") Home Price Index and S&P CoreLogic Case-Shiller 20-City Composite Home Price Index show prices are starting to decline.

The FHFA values have contracted in three out of the past five months, while S&P's home price index has been falling for five straight. Powell has said recently the central bank expects housing costs to become an inflation drag later this year. That should add to disinflationary momentum.

But boosting the labor supply hasn't been easy. While the pace of job gains has slowed, it hasn't cratered like the Fed hoped. And, importantly, recent Fed commentary indicates the central bank may be waving the white flag in the fight to cool the labor market.

The change would mean the Fed is willing to accept steady employment gains without jacking interest rates up even more aggressively. This would support steady economic growth and possibly help a rally in U.S. stocks.

The labor market is structurally challenged...

And the Fed doesn't think this is going to change anytime soon.

Here's why...

To better understand the structural labor-force problems, the first place we should start is the available job openings. Every month, the BLS releases the Job Openings and Labor Turnover Survey ("JOLTS"). It's an estimate of the available number of employment opportunities. Take a look at the most recent result...

As we can see in the above chart, job openings were soaring as the economy strengthened in 2021. Several waves of COVID-related stimulus and funds saved from working remotely meant more money for households to spend. The need for workers shot up. As you can see, it wasn't until the Fed began raising rates in March of last year that there was a change.

However, the falloff in job openings hasn't been as dramatic as the central bank had hoped. Again, looking at the above chart, we can see the number initially fell from 11.9 million in March to the recent low of 10.3 million in August. But since, it has rebounded back to 11 million in December.

Now, when the Fed first started raising interest rates back in March, Powell specifically cited the ratio of job openings to the number of unemployed. He said that prior to the pandemic, there was approximately one job opening for every unemployed person. But by March, that number had doubled...

The Fed's concern was wages... When there's less than one job opening per available employee, employers can be choosy. They can likely pick from multiple applicants for a single role. More importantly, if they have multiple people asking for the same job, they can go with the cheapest option. It also means little incentive to leave your current job.

But it's a far different story when there are two job openings for every available worker. In that instance, the tide has shifted. Folks seeking the job can be pickier in which opportunity they're willing to take. The change means employers have to offer better pay, more benefits, or both to attract a new worker. And the opportunity to switch jobs for higher pay is greater.

Look at the following chart from payroll processor ADP showing the median annual pay change for job changers compared with job stayers. We can see that the gap widened as openings jumped...

In June, the gap peaked when the job changers increase was 16.4% and the job stayers bump was 7.7%. For a relative comparison, back in October 2020, the pay rise for job changers was 5.8% versus the 2.8% jump for stayers. But since this summer, the gap has declined from its peak to 15.4% and 7.3%, respectively. The change has coincided with a slide in CPI.

And the Fed is starting to recognize the issue...

Back in December, Powell was the first to say something. During a speech at the Brookings Institution, he discussed the structural changes to the labor force. He noted that COVID-19 had changed labor dynamics. He said that roughly 3.5 million workers left the workforce... many retiring early and others dying. The Fed chair expects few of the retirees to come back. Fed Vice Chair Lael Brainard echoed this concern in a speech last month.

To put this in perspective, the current labor force stands at 165.8 million. And 5.7 million individuals are unemployed.

If the economy had not lost 3.5 million since the start of the pandemic, mostly from people voluntarily leaving the workforce, that would have kicked the unemployment rate from 3.4% to 5.5% today. That's a massive change. At the same time, the dynamic would drop the ratio of job openings per number of unemployed down to 1.2, close to the pre-pandemic level of 1. Both of these numbers would be acceptable to the central bank.

What that January jobs report was really about...

At the end of the day, a lot of noise is going to be made about changes to employment data. More increases like we saw in the recent employment report for January and the stock market naysayers will be out in full force, calling for more rate hikes.

First, on that point, I did some digging into those January payroll numbers and found end-of-year adjustments from the U.S. Census Bureau that identified a higher U.S. population, larger labor force, and greater number of unemployed Americans. Those adjustments mean the U.S. had even more jobs than everyone had been reporting all year.

On the other hand, there's another factor to consider: the quality of the jobs being created.

As I wrote in one of my daily NewsWire commentaries last week, from March 2022 through last month, the U.S. economy added roughly 1.4 million part-time jobs and lost 10,000 full-time jobs.

While the headline job gains seem great, it's a different story underneath the surface. If businesses were confident about economic potential, they'd be hiring more full-time workers, not letting them go.

Still, before getting worked up about the central bank kicking off a new round of aggressive rate hikes, we need to consider the entire picture. The Fed is looking at the same numbers. Its policymakers understand how annual adjustments can periodically disorient things.

We'll want to see if this is a sustainable trend or a one-time aberration.

That's because if job gains keep accelerating, the Fed may need to get more aggressive with rate hikes. But based on the type of employment taking place, one would expect the surge to be short-lived. That would mean the central bank can stick to its plans to end its rate hikes this spring.

Here's where I'm going with this...

More important than any one piece of jobs data, two of the most influential members at the Fed are telling us they recognize the broader structural change in the labor market. And as much as the central bank wants to loosen a "tight" market, it also realizes rate hikes can't go on in perpetuity.

Otherwise, we'll have rates at 10% that have totally crushed the American economy.

But as American households and businesses have done so well throughout their history, they will adapt. Companies will find solutions like technology that can make workers more efficient. Workers will realize massive pay hikes can't go on forever. And as the two forces find equilibrium, so will inflation growth.

We can see it already happening, as the CPI has been in a steady decline since June. And as prices stabilize, the central bank will have room to stop raising rates and eventually start cutting once more... And this change will underpin a steady rally in the S&P 500.

New 52-week highs (as of 2/13/23): BorgWarner (BWA), CBOE Global Markets (CBOE), iShares U.S. Aerospace & Defense Fund (ITA), Madison Square Garden Sports (MSGS), Novo Nordisk (NVO), VanEck Oil Services Fund (OIH), Parker-Hannifin (PH), Shell (SHEL), TFI International (TFII), and Trane Technologies (TT).

In today's mailbag, feedback on Dan's Monday Digest... A housekeeping note: Since we're through with our Report Card, Dan will be back in his regular slot on Friday... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"Dan, I agree with your assessment of the meme stock crowd. I can't wait to see them lose their ass. What is amazing to me is how anyone could get this many young people to do anything together. But then again there was Bernie Madoff. Who basically did the same thing with older investors. Thanks for your viewpoint on the markets. It goes totally against some of the other stock gurus. It kind of balances out things." – Paid-up subscriber John M.

"Dan and Corey, Obviously anything can happen and it all might turn into a huge bull market but also I wanted to comment that as Dan said in a recent Investor Hour and again in Monday's Digest this primarily looks like the perfect bear market rally. It makes sense the rally would be impressive because the bubble is/was impressive and the speed and magnitude of this rally was also a perfect bear market rally for a huge bubble.

"The novices have come out to play in their favorite meme stocks, how perfect. In 1929 the rally was 48% for the DJI index and it started in late December 1929 and went strong for 4 months and subsequently slowed into June 1930 when the whole market fell apart through to December 1930, according to Barrie Wigmore in The Crash and Its Aftermath. The Dow was up 48% in the first 4 months of 1930. [President Herbert] Hoover was organizing rejuvenation efforts and the industries themselves committed to capital expansions. But as the economy began to slow into June 1930 a rapid decline in the market ensued.

"My impression is that what we are experiencing right now is the perfect bear market rally, strong in the face of incredible debt, still seeing absurd dumping of money into really non-investible assets, incredible optimism despite obvious flaws to the experienced investors, like inflation and government corruption and influence on data gathering systems such as unemployment stats. In 1930 even the smart money was drawn in for the slaughter, according to Wigmore.

"This playbook couldn't be a more perfect model of a bear market rally coming from the biggest bubble ever. I suspect the timeline will be drawn out longer than the 1930s because the bubble is bigger and has lasted longer. I guess we shall see but it sure doesn't appear to be different than what Barrie Wigmore describes in The Crash and Its Aftermath.

"I'm fully aware I could be completely wrong but I just wanted to reinforce that the signs are so perfect. We'll see." – Paid-up subscriber Al M.

All the best,

Corey McLaughlin and C. Scott Garliss
Baltimore, Maryland
February 14, 2023