Moribund Business Optimism Will Surge When CPI Falls

Nobel economist Milton Friedman famously said “Inflation is always and everywhere a monetary phenomenon …  produced only by a more rapid increase in the quantity of money than in output”. While Copernicus was the mathematician who fathered Monetary Theory, Friedman popularized today’s current perspective. Many focus upon the supply growth of currency or money in ciruclation to forecast inflation trends, but they often forget Friedman’s key insight that money Velocity (unit of money turnover frequency) is unstable and critical to forecast inflation.  As the stock of money in ciruclation exploded since 1980, inflation rates conflounded consensus and fell steadily lower over the past 40 years due to the low velocity of money. It’s confusing to the public but logical that the use of a single Dollar over the course of a year would decline as the supply rose exponentially. As we witnessed during the multi-trillion dolar addition of currency during the era quantitative easing (QE) since 2008, the velocity of money fell sharply as money supply went parabolic. Each dollar added had a proportionately lower effect on the economy and thus inflation. When Covid hit, the Federal Reserve Bank and Treasury effectively printed dollars at unheard of annual rates of 20 to almost 30% to stimulate a partially locked down economy. This had no impact on inflation initially as Covid kept people from transacting in 2020. In 2021, restictive mandates and mobility improved which allowed money velocity and inflation to zoom higher, despite sa lowing growth in the supply of money throughout the year.  The good news is that  money growth is down to a 6% rate, approaching the rates of the past deacde when inflation was under 2%. New more deadly Covid variants, rising mandates, new monetary and fiscal stimulus can of course change the inflation outlook, but year over year (YoY) inflation comps in March will likely stop inflation from rising further in Q2 and begin to tame excessive rate hike fears. 

The media and professional pundits criticizing the Fed’s inflationary policies prefer to quote the popular Consumer Price Index (CPI)  that includes food and energy  to portray more alarm over inflation. The CPI currently sits at 7% , although without the volatile food and energy components it would be 5.5%.  Food and energy are typically not included in the inflation numbers as they can be very volatile, turning deeply negative or positive. A more consistent and pertinent model is the core Personal Consumption Index (PCE), excluding food and energy that the Fed uses for its monetary policy. This PCE measure is currently at 4.7%. This is well above the Fed’s 2 to 2.5% long term goal and thus a reason for markets to be concerned that the Fed is shifting rapidly from QE to QT (quantitative tightening). When draining bank reserves through QT was first foreshadowed by the Fed, they planned a gradual reduction of stimulus with some potential rate hikes in the 2nd half of 2022. However, market consensus has jumped the shark and assumes the Fed must make a double rate hike as early as March with potentially 6 rate hikes by early 2023 that will crush market multiples and trigger a Bear market drop in major stock indices of 20%. Assuming there are no more serious strains of Covid and accompanying mandates restricting travel and services, we expect inflation measures to peak in Q1 and work lower by year end. This could reduce the urgency of rate hikes and lower the volume of alarm that is now building. 

despite the record corporate profits on the back of a very strong 2021 GDP growth rate of 5%, small business optimism as measured by the NFIB survey remains moribund. With the never ending expectation of Covid and accompanying mandates that have exacerbated labor costs and supply chain inflation, its understandable why pessimism reigns. Many small cap companies, especially service oriented, have failed to benefit from the recovery. Assuming there are no more destructive Covid variants such as Delta, we would expect mandates to ease along with supply chain inflation, which should boost business optimism by the Summer.

A major factor beyond the uncertainty of Covid restrictions are the major supply shortages and accompanying inflationary cost pressures. The 40 year highs in the CPI are hurting small business margins and elevating budget uncertainties. As YoY inflation plateaus over the next couple of months and Goods demand slows, replaced by service sector spend, inflation should ease and buoy small business expectations. 

Meanwhile, inflation and rate hike hype are reaching a crescendo that is tanking stock prices as we have warned about for January. Readers will notice that our annotated chart below is essentially unchanged over the past couple of weeks when we highlighted an initial time and price target window in late January between the 200 day moving average (dma) and 10% correction levels as shown. Today, another failed rally attempt reversed quickly towards the magnetic attraction of the SP 500 Index 200 dma at 4427 today.  The 200 dma and 10% correction levels are actually just popular metrics that managers focus upon more as they are approached. Normally prices bounce from such levels, but frequently plunge below these obvious buying zones in order to wash out weak hands to clear the way for a more sustainable bottom. We still expect an initial momentum low around the last week of January and  the first Bullish indications have started appear beginning January 21st. It appears we are close to a bottoming process beginning next week, yet no fundamental impetus for a sustainable run to record highs is likley until the Sell the Rumor of rate hikes becomes the News in March. Long term investors should now start looking for bargains in US stock laggards and emerging markets. Stocks in the service sector, travel, cyclical, energy and financials should replace the a significant portion of personal portfolios. SP 3850 to 4250 is the ideal major zone to expect an initial climax low and robust short term rally for a few weeks. Watch for a brief capitulation wash-out drop in the SP 500 Index under its 10% correction lows into the lower 4200’s during the January 24th – 28th time frame to be a buyer.

 

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