Morning Briefing Archive (2021)
January 20 (Thursday)
Technology: The World’s Piñata. The world is after Meta Platforms. Literally. Regulators and legislators at home and abroad are pushing and prodding to change the way the company—formerly known as “Facebook”—does business. A whistleblower has divulged documents showing how the company’s social platforms hurt some teenaged girls. And assorted lawsuits and shareholders have the company in their sights.
While the headlines have been ugly, Meta’s business and stock so far have escaped largely unscathed. While Meta shares have slightly underperformed the market over the past three months, they have outperformed over the past year—up 26.6% y/y through Tuesday’s close compared to 21.5% for the S&P 500 and 11.6% for Nasdaq.
But “unscathed” may not characterize the company for long. Lawmakers in Congress have proposed a number of bills targeting Meta, among other tech giants, and the Federal Trade Commission (FTC) is expected to become more aggressive now that it’s headed by Biden appointee Lina Khan, an academic who wrote about breaking up Amazon.com.
Among the biggest risks to Meta may be distraction. As Meta defends itself from various attacks, its leaders may take their eye off the business while Meta’s competition proceeds to innovate and grow. Case in point: Microsoft announced the acquisition of Activision Blizzard on Tuesday, a deal that could advance its ambition to lead the metaverse. (More on that below.)
Here’s a look at some of the many arrows heading Meta’s direction:
(1) FTC gets the green light to proceed. Earlier this month, a federal judge allowed the FTC to move forward with its antitrust lawsuit against Meta. The lawsuit alleges that Meta has monopoly power in the market for social-networking services. If the FTC is successful, Meta might have to divest Instagram, acquired in 2012, and WhatsApp, acquired in 2014. The revised case was allowed to proceed because it included more market-share statistics and evidence supporting the allegations that Meta controls prices and blocks competition in social networking, a January 11 Axios article reported.
“Although the agency may well face a tall task down the road in proving its allegations, the Court believes that it has now cleared the pleading bar and may proceed to discovery,” wrote Judge James Boasberg from the U.S. District Court for the District of Columbia. The discovery phase, which can take months or years, allows the government to search through Meta’s data and documents.
The FTC, along with several states’ attorneys general (AGs), is also investigating Meta’s Oculus virtual reality unit, according to a January 14 Bloomberg article. Meta bought Oculus in 2014 for $2 billion, and its headsets represented 75% of the new headsets sold globally in Q1-2021, according to Counterpoint Research. FTC officials reportedly are considering whether the company has broken antitrust laws, using its market power to stifle competition in the virtual reality (VR) space. Specifically, they’re looking into whether Meta discriminates against third-party sellers of apps and whether it underprices the Oculus Quest 2 headset to squeeze out competitors.
The FTC has also reportedly opened an antitrust probe into Meta’s planned acquisition of VR fitness app Supernatural. “While the FTC might eventually approve the Supernatural deal, its decision to investigate signals that Meta’s playbook of quickly buying the hottest VR startups on its platform may already be coming to an end,” a December 16 article in The Verge reported.
(2) Arrows out of Washington, DC. Various bills floating around the halls of Congress target Meta and other tech giants. But members of Congress will have to act fast, preferably by summer before the focus turns to midterm elections, to turn the bills into laws. If the Republicans regain control of the Senate after the midterms—as is expected—these bills would stand little chance of passing.
Among the highest-profile bills is the American Innovation and Choice Online Act. With the backing of Senators Amy Klobuchar (D-MN) and Lindsey Graham (R-SC), the bill would prohibit Big Tech companies from acting anticompetitively and favoring their own services, a January 10 Axios article reported. Klobuchar and Senator Tom Cotton (R-AR) also introduced the Platform Competition and Opportunity Act, a bill that would make it more difficult for Big Tech to make acquisitions.
The Children’s Online Privacy Protection Act, introduced by Senators Ed Markey (D-MA) and Bill Cassidy (R-LA), aims to update existing legislation by limiting social platforms’ collection of data from children under 15 years old, up from 13 today. The bill also gives children and their parents more legal resources regarding online harm, a January 19 FT article stated.
The Health Misinformation Act, co-sponsored by Klobuchar and Senator Ben Ray (D-NM), holds social media platforms responsible if their algorithms promote misinformation about vaccines, fake cures, and other harmful health-related claims during public health emergencies, a July 22 NPR article explains. Yet another bill would require tech companies to open up more data to outside researchers.
(3) Busy state AGs. Almost 50 states’ AGs have asked a federal appeals court judge to reconsider their antitrust lawsuit against Meta that was thrown out by a judge in June. Judge James E. Boasberg of the US District Court of the District of Columbia said the states waited too long after Meta’s deals closed to make the suit. The states countered that they have more timing latitude than private plaintiffs, a January 14 NYT article stated.
At least eight state AGs late last year launched an investigation into measures that Meta takes to increase young people’s Instagram use and whether any harm results, a November 18 WSJ article stated. The AGs will also consider whether Meta has violated consumer protection laws and put the public at risk. Perhaps in response, Meta has paused the development of an Instagram product that targets children as users.
In January 2020, Facebook settled for $550 million an Illinois class-action lawsuit alleging that it broke a 2008 state law prohibiting companies from collecting biometric data without users’ consent. Facebook allegedly created and stored face templates that powered an automatic photo-tagging feature. In November of last year, the company announced that it planned to shut down its facial recognition system. The system was part of a tool that allowed users to share photos on social media, a November 2 WSJ article reported.
(4) Pressure from regulators abroad too. In November, the UK’s competition regulator required Meta to sell Giphy, an online image platform it bought for $400 million in 2020. Relative to Meta’s size, the acquisition price and size are drops in the bucket. But the regulator’s decision should make it harder for Meta to acquire companies in the future, shutting down an important source of the company’s past growth. Meta has applied for a review of the ruling.
In the European Union (EU), the Digital Markets Act was proposed by EU antitrust head Margrethe Vestager and agreed to by a key committee of EU lawmakers. It would limit tech giants’ acquisitions and prohibit their targeting advertising to minors and others without consent. The legislation still needs to be “thrashed out” with the European Parliament and EU countries before it can be adopted, a November 23 CNBC article reported.
(5) Private entities also have Meta in their sights. In addition to being targeted by legislators and regulators, Meta finds itself the focus of lawsuits and shareholder actions. One of the more interesting lawsuits tries to pierce the protection Meta receives under Section 230 of the Communications Decency Act. That’s a 1996 federal law that shields Internet sites from legal liability for things users post online, contending that Internet companies are passive hosts of information, acting like a bulletin board. Newspapers and TV stations don’t enjoy such liability protection because they actively curate and create the information they disseminate.
In the Meta lawsuit, Facebook’s recommendations for joining pages are under scrutiny. It claims that Facebook’s algorithm recommended that Robert Alvin Justus Jr. join the Facebook page of the Boogaloo Bois, a movement of antigovernment extremists, where he “met” former Air Force Sergeant Steven Carrillo. The two men traveled to Oakland with the intent to kill federal agents. There, Carrillo shot and killed Dave Underwood, a federal security guard, and injured his partner. Carrillo has pled not guilty to separate murder and attempted murder charges, and Justus pled not guilty to aiding and abetting murder and attempted murder.
“[B]y making group recommendations based on users’ interests, Facebook did ‘something far different than simply facilitate a bulletin board.’ The act of recommending that people join groups that share inflammatory content makes Facebook more than a passive platform protected by Section 230,” said the plaintiff’s attorney in a January 6 WSJ article.
In a different case, roughly 30 companies publishing more than 200 newspapers in the US are suing Facebook and Google, alleging that the two companies unfairly manipulated the advertising market, siphoning away the newspaper companies’ revenue and crippling their business, a December 8 New York Post article reported. The papers are looking to recover damages equal to the revenue lost and establish a new system going forward in which newspapers can thrive. One attorney for the newspapers pointed to Australia’s new laws that force the tech firms to pay for newspapers’ content.
Large institutional shareholders have filed a shareholder proposal that calls for Meta’s board of directors to oversee “efforts to reduce harmful content, an assessment of the risk of the company’s metaverse efforts, and a review of the social media company’s audit and risk committee,” a December 13 WSJ article reported. Shareholders include the New York State Common Retirement Fund and Illinois State Treasurer. Because Meta CEO Mark Zuckerberg has super-voting shares that give him 58% of the vote, the proposals are likely to fail; but they send management a message nonetheless.
Disruptive Technologies: Microsoft Makes Its Move. Microsoft’s $68.7 billion acquisition of Activision Blizzard checks a lot of boxes. Owning Activision will help Microsoft boost its gaming subscription revenue. It increases Microsoft’s gaming content, on both consoles and mobile devices. And the purchase of Activision will eventually help Microsoft fill the metaverse’s rooms with content. Not bad for a deal paid for in cash. Let’s take a quick look at the deal and some of the other recent news about the metaverse:
(1) Boosting revenues today. Companies and investors love consistent, reoccurring subscription revenue. Microsoft’s Game Pass is an annual subscription that gives users access to a wide library of video games. Revenue from Game Pass grew almost 30% last year to hit 25 million subscribers.
The Activision deal brings popular games Call of Duty and Warcraft into the fold. It follows Microsoft’s $7.5 billion acquisition of ZeniMax Media in 2020 and the $2.5 billion acquisition of Mojang, maker of Minecraft, in 2014. While it’s not clear which Activision games will be available on Game Pass, more content gives Microsoft more options.
Microsoft also makes money when gamers make in-game purchases of virtual goods and services, like weapons and clothing. Compound annual growth in the global market for microtransactions is expected to accelerate from 3.6% in 2021 to 10% in 2025, bringing revenue up to $51.1 billion, according to an August 19 ResearchandMarkets.com report. Activision’s Candy Crush Saga, a popular mobile game, is estimated to generate more than $1 billion a year in in-app purchases, a January 19 CNBC article reported.
(2) Content for the metaverse. People will need a reason to put on VR headsets and visit the metaverse instead of streaming videos on TV or meeting friends in person. Video games are one of the first reasons people will have to visit this alternative reality. Gamers are used to working with others in alternative worlds. Doing that in the metaverse is just changing the label on what many gamers do currently.
The more content Microsoft has, the more likely it will be able to lure eyeballs to its metaverse. Content wars are nothing new. They are occurring now in the streaming wars, where Netflix and Amazon are spending billions to buy and create the best content. It happened online as websites battled it out for eyeballs. And it all started with ABC, NBC, and CBS duking it out during sweeps week.
In its press release for the deal, Microsoft stated that the acquisition will provide the “building blocks” for the metaverse. “Gaming is the most dynamic and exciting category in entertainment across all platforms today and will play a key role in the development of metaverse platforms,” said Microsoft CEO Satya Nadella.
(3) Everyone’s jumping into the metaverse. Microsoft’s deal for Activision turned the already loud buzz around the metaverse up a notch or two. In a quintessential land rush, the metaverse is attracting everyone from large corporations to small investors.
Prices for “plots of land” in the metaverse soared as much as 500% over the past few months, sparked by Facebook’s announcement that it was jumping into VR and changing its name, reported a January 12 CNBC article. And that was before this week’s Microsoft/Activision deal.
Tokens.com, which invests in metaverse real estate and digital assets, paid almost $2.5 billion on a parcel of land in Decentraland, a popular metaverse world, the article stated. Republic Realm, another virtual real estate development company spent a record $4.3 million on a parcel of virtual land. Republic sold virtual private islands for $15,000 each last year, and today they’re selling for about $300,000 each.
Walmart looks ready to jump into the metaverse. It filed new trademarks late last month implying plans to make and sell virtual goods in the metaverse and offer users a virtual currency and non-fungible tokens (NFTs), a January 16 CNBC article reported. Walmart’s moves follow news that Nike has partnered with Roblox to create Nikeland, an online world, and that Nike has bought virtual sneaker company RTFKT. Gap, UnderArmour, and Adidas have also sold NFTs.
Meta may be limited in what it can acquire due to the regulatory inquiries we outlined above. But the company is developing systems internally for the metaverse. Recent patent filings show the company had developed sensors that monitor a user’s body movements so that their avatars in the metaverse can mirror the user’s movements and expressions, a January 19 New York Post article reported. The data could also be used to deliver more specific ads.
The race for metaverse supremacy is on.
A Very Brief US History Of the Postwar 1940s
January 19 (Wednesday)
US Economy: History Rhymes. In a 1948 speech to the House of Commons, former British Prime Minister Winston Churchill warned that “those who fail to learn from history are condemned to repeat it.” On a related note, American humorist Mark Twain once quipped, “History does not repeat itself, but it often rhymes.”
Today, we hear lots of people claiming that the US has never been so divided between the Left and the Right. Both sides of the political spectrum seem to be dominated by extremists more so than ever, allowing for no room for compromise. Both sides are convinced that “our democracy” has never been more at risk of turning into totalitarianism. Race relations have never been worse, we are told. Hostile foreign powers are manipulating our elections. The basic message is: “Be afraid, be very afraid” (as Geena Davis somberly intoned in the 1986 horror film “The Fly”).
Many of the alarmists apparently haven’t read American history. Indeed, the Founding Fathers of our country anticipated that “factions” inevitably would fight one another to gain power. That’s why they designed a system of checks and balances to make it very hard for any one faction to permanently dominate our government. In The Federalist Papers, No. 10, James Madison explained why a democracy is incapable of controlling factions, which is why the US Constitution was written for a federal republic uniting America’s states.
In many ways, the system of checks and balances exacerbated partisanship by making compromise necessary but elusive. America’s various factions often have been unable to compromise. In other words, the system was designed by the Founders to frustrate the factions when they couldn’t agree on legislation. So the system works best when it doesn’t allow any one faction to impose its will on the other factions. It works best when it doesn’t work for any one faction to take control of the government for very long!
American history is a tale of ongoing and often bitter partisanship. Recall that one of the earliest armed insurrections was Shay’s Rebellion during 1786 and 1787. Obviously, the issue of slavery was very contentious and led to the Civil War. But the republic was reunited after the war, and the Constitution once again became the law of the land.
To those alarmists who believe that now is the most perilous time for the US since the end of the Civil War, I recommend reading A.J. Baime’s Dewey Defeats Truman: The 1948 Election and the Battle for America’s Soul (2020). Here are some highlights based on the book and Wikipedia:
(1) Economy. Harry S. Truman assumed the presidency on April 12, 1945, after President Franklin D. Roosevelt died in office. When World War II (WWII) ended later that year, there were widespread fears that the economy would slide back into a deflationary depression. Strikes crippled major industries as workers pushed for wage increases. In January 1946, a steel strike involving 800,000 laborers became the largest in the nation’s history. It was followed by a coal strike in April and a rail strike in May. Truman seized the railroads in an attempt to contain the issue, but two key railway unions struck anyway. The entire national railroad system was shut down for several days.
After the war, there was a severe shortage of housing. Consumer goods were hard to find, and their prices soared when wartime price controls were terminated. The elimination of price controls, supply shortages, and pent-up demand caused the CPI inflation rate to soar.
WWII ended on V-J (Victory over Japan) Day, August 15, 1945. The CPI inflation rate on a y/y basis jumped from 1.7% during February 1946 to peak at 19.7% during March 1947 (Fig. 1). It then plunged to zero in early 1949 and ended the decade in negative territory. Industrial production plummeted during 1945 and early 1946 as manufacturers scrambled to retool to produce consumer goods rather than armaments (Fig. 2). Then production rebounded dramatically in late 1946 and 1947, helping to bring down inflation by boosting supplies of consumer goods.
(2) Politics. President Truman’s approval rating dropped from 82% in January 1946 to 32% by the end of the year. ln the 1946 midterm elections, the Republicans took control of Congress for the first time since 1930.
(3) Civil rights. Truman proposed numerous liberal domestic reforms, but few were enacted by the conservatives who dominated the Congress. In 1948, he submitted the first comprehensive civil rights legislation. It didn’t pass, so he instead issued Executive Orders 9980 and 9981 to promote racial equality in federal agencies and the military. The southern states rejected civil rights and continued to enforce segregation.
(4) Soviet Union. After the war, the Soviet Union expanded its political control of Eastern Europe. Truman and his foreign policy advisors took a hard line against the USSR. The US public increasingly feared that the Soviet Union’s aggressions would trigger a World War III. Instead, the Truman administration adopted a policy of containment by rebuilding Western Europe with the Marshall Plan. The Cold War resulted.
(5) Red scare. At home, a “red scare” spread immediately after WWII. The widespread public perception was that national or foreign communists were infiltrating or subverting US society and the federal government. During the 1948 presidential campaign, Truman ran against New York’s Republican Governor Thomas Dewey. Truman had fired Secretary of Commerce Henry Wallace for urging conciliatory policies toward the Soviet Union. Wallace and his supporters then established the nationwide Progressive Party and launched a third-party campaign for president. Wallace lost badly, as he was dogged by accusations of being a communist. There were fears that the Soviets were trying to influence the election.
(6) Stocks. And what did the S&P 500 do in the midst of all the turmoil during the 1940s? After mostly falling during the second half of the 1930s, which included the second of the two recessions that composed the Great Depression, the index actually bottomed during April 1942, just before America’s victory over Japan in the Battle of Midway (Fig. 3). It then soared 157.7% through mid-1946. All the strikes and rapidly rising inflation caused the S&P 500 to fall 29.6% through June 1949. But then the bull market resumed during the 1950s.
(7) Now and then. As we have previously observed, there are similarities between the current bout of inflation and the Great Inflation of the 1970s. There are also similarities between today’s bout and the inflationary experience of the years immediately following the end of WWII.
Of the two former incidences of inflation, the postwar inflation is the more likely to be repeating now. While inflation exceeded that of the 1970s, it lasted only a couple of years as opposed to an entire decade.
The biggest difference between now and the past two episodes of inflation is that now there is a severe and chronic labor shortage, as we have often discussed. After WWII, soldiers returned home and boosted employment (Fig. 4). During the 1970s, the Baby Boomers poured into the labor markets. This time, we believe that employers will respond to labor shortages by spending more on capital equipment and technology to boost productivity. (Also see bonus Fig. 5 and Fig. 6.)
US Fiscal Policy: Senators’ Checks & Balances. Melissa and I first introduced Joe Manchin, the Democratic senator from West Virginia, as potentially the most important person in America in our November 16, 2020 Morning Briefing. He is viewed as a conservative Democrat and has championed bipartisanship. Larry Kudlow, former Trump economic advisor, has even called the man a hero. Indeed, Manchin is the last man standing in support of checks and balances in the Senate.
On November 9, 2020, he was interviewed by Fox News. He said: “50-50 [control] means that if one senator does not vote on the Democratic side, there is no tie and there is no bill.” That night, he committed to fight the far-left agenda, including ending the filibuster. Simply, he said: “I will not vote to do that.”
Manchin is a man who keeps his word. Despite recent pressure all the way from the top, Manchin has refused to support Democratic US President Joe Biden’s $2 trillion Build Back Better (BBB) human infrastructure and climate agenda. He also has refused to change Senate rules requiring a 60-40 vote to pass the bill through the upper chamber of Congress. Here’s more:
(1) Reconciliation refresher. Budget reconciliation is a special procedure of US Congress intended to expedite the passage of certain legislation in the Senate. It overrides the filibuster rules in the Senate, which otherwise could require a 60-vote supermajority for passage. Reconciliation bills can pass the Senate with a simple majority of 51 votes or 50 votes plus the vice president’s as the tiebreaker. Without a reconciliation bill, unanimous agreement is needed among Democratic senators plus support from 10 Republican senators.
(2) Manchin’s counteroffer. So far, Biden’s bill has failed to capture the required number of supporters. The Washington Post reported on January 8 that the West Virginian senator had pulled a proposed a counteroffer to the House bill passed last year on November 19. “There [are] no negotiations going on at this time, OK?,” he said.
In his compromise proposal, Manchin included funding for universal pre-K, an ObamaCare expansion, and a tax on billionaires, reported the January 10 New York Post. Reportedly, Manchin said he would support spending as much as $600 billion on climate change initiatives, despite representing a state that is a major producer of coal.
(3) Sinema too. Senator Kyrsten Sinema (D-AZ) has opposed parts of the bill too. In December, a spokesperson for Sinema told Politico that she “continues to support the Senate’s 60-vote threshold, to protect the country from repeated radical reversals in federal policy which would cement uncertainty, deepen divisions, and further erode Americans’ confidence in our government.”
As we wrote in our December 20, 2021 Morning Briefing, to get Sinema’s vote for BBB, she has demanded no corporate rate hike, no individual rate hike, no capital gains rate hike, and no broad based tax increase of any kind. The result would be a bill with $1.5 trillion in other revenue raisers.
(4) Deal breakers. Manchin and Sinema’s main sticking point against passing the bill as it stood relates to the expanded child tax credit (CTC). The two want to add a work requirement to collect the CTC. That would exclude families having no other income.
With the CTC, the Democrats also have attempted to utilize a gimmick routinely turned to for passing bills: enact a version of a proposal that is temporary but paves the way to become permanent. In the House version of the bill, the CTC expansion ends after just one year. But many say that so many Americans would grow dependent on the credit that Congress would be hard-pressed not to continue it. Manchin also has opposed some climate portions of the bill, specifically anti-fossil fuel provisions, arguing against a methane gas tax that could inflate gas prices and stating that “the bill will also risk the reliability of our electric grid and increase our dependence on foreign supply chains.”
(5) No holiday for Dems. On Monday, January 3, Senate Majority Leader Chuck Schumer (D-NY) asserted that he will force a vote on a measure to change the upper chamber’s rules by Martin Luther King Day on January 17. That day came and went without a vote. Schumer announced on January 13 that the Senate would not take up the rule change by the federal holiday.
Creating a carveout that would exempt specific legislation from the 60-vote obstacle but leave it in place for other matters also has been discussed among senators and rejected by Manchin. He has pointed out that there is no such thing as an exception, saying: “Any time there’s a carveout, you eat the whole turkey, there’s nothing left.”
A Fox News opinion piece this week discussed the reason that Manchin is so opposed to a change to the Senate rules: “[T]here is 2024 to consider. A Republican president with a Congress of his own party could check off their wish list of legislation like a rich kid on Christmas morning.”
(6) Mid-terms in jeopardy. Biden may have hoped that the bill could pass the Senate by his State of the Union address set for March 1 so that he could tout its success. Not passing the plan in the Senate could cost the Democrats the 2022 mid-term elections, as the Washington Post recently discussed. If only Democrats had a few extra seats, “Manchin and Sinema would no longer hold the balance of power; the party could reform the filibuster, pass voting rights legislation, pass the BBB bill and do a bunch more besides. It’s as simple as that.” It added: “But it’s hard to say to your supporters, ‘I know we didn’t give you what we said we would, but if you just turn out for one more election, I promise we’ll deliver next time!’”
(7) Alternative scenarios. E&E News, a publication owned by Politico, painted four alternate scenarios on January 3 for the outcome of the bill: 1) Schumer and House Speaker Nancy Pelosi (D-CA) could negotiate a smaller package with Manchin—not an impossibility given that “Democratic leaders and the White House have already twice scaled back their ambitions.” 2) If Manchin’s opposition is too hard to overcome, a no-deal scenario could occur and compromise the Democrats’ chances of succeeding during the mid-terms. 3) The situation could be salvaged by breaking the BBB into chunks (e.g., separating out climate spending from the rest of the package). 4) If all else fails, Democratic lawmakers might have to rely on annual spending bills to advance their agenda.
James Lucier of Capital Alpha Partners in a December 20, 2021 note set out three equally weighted scenarios: “a one-third chance that nothing passes, a one-third chance that a successor bill with less than $1 trillion pay-fors passes, and a one-third chance that a bill with up to $1.5 trillion in pay-fors passes.” The note was titled “Triple-B: Not Dead Yet.” But since Manchin’s latest refusal to negotiate, the chances that nothing passes have risen.
(8) Manchin’s power. It’s too bad for the Democrats, who could have better managed Manchin’s counteroffer. Jim reckons that “Manchin didn’t say he was a no on everything, for Pete’s sake. He just said that he was a no on the bill as it stood.” An element of “Manchin’s power,” Jim says, is that he is “willing to walk away and let nothing pass. … Another element of Manchin’s power is that he and Sinema are not alone. We can count at least six other Democratic senators who would have similar preferences for a small bill or no bill at all.”
January 18 (Tuesday)
YRI Webinar. Join Dr. Ed’s live Q&A webinar on Tuesday at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays are available here. Dr. Ed’s presentation lasts about 15 minutes with another 15 minutes for Q&A.
Strategy I: The Valuation Question. Joe and I have been receiving lots of follow-up questions about our ongoing analysis of the MegaCap-8, i.e., the eight stocks in the S&P 500 with the highest market capitalization. We are frequently asked about the impact of their elevated valuation multiples on the S&P 500. They certainly have had a significant impact. The question is whether their high valuations are reminiscent of the tech bubble of 1999 or not. The answer is yes and no. There are similarities, but there are important differences too. Consider the following:
(1) Quarterly Buffett Ratio. One of the most alarming valuation metrics is the Buffett Ratio showing the market cap of all US equities (excluding foreign issues) divided by nominal GNP (Fig. 1). Another similar ratio is the market cap of the S&P 500 divided by S&P 500 revenues. Both are quarterly series and track each other very closely. They both peaked just below 2.0% during 2000 just before the tech bubble burst, triggering significant bear markets in the S&P 500 and the Nasdaq, led by plunging tech stock prices.
During Q3-2021, both ratios were in record-high territory at 2.9 and 2.7, respectively. Both most likely rose close to 3.0% during Q4. We will know the exact numbers when Q4 nominal GDP is released on January 27.
(2) Weekly Buffett Ratio. Joe and I found that the weekly price-to-sales ratio (P/S)—i.e., the S&P 500’s stock price index divided by its forward revenues—tracks the quarterly P/S ratio very closely. (“Forward revenues” is the time-weighted average of analysts’ consensus revenues estimates for this year and next.) The weekly P/S series was at 2.8 during the January 14 week, well above the 2.0 peak on the quarterly P/S ratio hit during Q4-1999.
(3) Weekly P/S versus P/E. Not surprisingly, the weekly forward P/E of the S&P 500 has been highly correlated with the comparable P/S ratio since the start of the latter series in 2004. However, they’ve increasingly diverged since mid-2020. The forward P/E rose to a post-pandemic high of 23.6 during the September 2, 2020 week. It was down to 20.9 last week. Both readings are below the record high of 24.5 set during July 1999. Nevertheless, the recent readings remain high on a historical basis, instilling fears of a bubble that could be followed by a bear market.
By the way, the reason that the weekly forward P/E and forward P/S have diverged is that the forward profit margin (i.e., the imputed margin we derive from forward earnings and revenues) has been rising to record highs since the start of the pandemic, so earnings have been rising faster than revenues (Fig. 2). That should ease some concern about the record highs in the P/S ratio.
(4) MegaCap-8 valuation. I asked Joe to construct weekly MegaCap-8 forward P/S and forward P/E ratios. The available data since 2013, after Facebook went public on May 18, 2012, show that their P/S ratio rose from about 2.7 at the start of the period to 6.6 during the January 14 week of this year (Fig. 3). During that week, the P/S of the S&P 500 was 2.8 with the MegaCap-8 and 2.3 without them.
During the January 14 week, the forward P/E of the MegaCap-8 was 32.3, and the forward P/E of the S&P 500 was 21.1 with them and 18.7 without them (Fig. 4).
(5) Forward profit margin comparisons. Again, the rapidly rising forward profit margin of the MegaCap-8 explains why their forward P/S has trended higher since mid-2020, while their forward P/E has trended lower. Here are the relevant forward profit margins during the January 14 week: MegaCap-8 (20.4%), S&P 500 (13.3), and S&P 500 ex-MegaCap-8 (12.5). By the way, the margin of the MegaCap-8 excluding Amazon is 27.8 (Fig. 5).
Here are the latest forward profit margins for each of the MegaCap-8 stocks: Nvidia (41.2%), Microsoft (35.7), Meta (Facebook) (29.3), Alphabet (Google) (27.8), Apple (25.6), Netflix (17.6), Tesla (13.1), and Amazon (4.8).
Strategy II: The Case for Tech. Only three of the MegaCap-8 stocks actually are in the S&P 500 Information Technology sector—Apple, Microsoft, and Nvidia. They currently account for 52% of the sector’s market cap. Accounting for 46% of the Communication Services sector are Alphabet, Meta, and Netflix. Amazon and Tesla account for 47% of the Consumer Discretionary sector currently. This sector dispersion makes it hard to compare the magnitude of the current MegaCap-8 bubble (if that’s what it is) to the all-tech bubble during the late 1990s. Recognizing that we are comparing apples and oranges, consider the following:
(1) Tech’s market cap and earnings shares. During the tech bubble of the late 1990s, the market-cap share of the S&P 500 Information Technology sector rose from 12.1% during March 1998 to a record high of 33.7% during March 2000 (Fig. 6). Back then, the sector’s earnings share peaked at 18.2% during September 2000.
During the first week of the current year, the sector’s market-cap share was 28.6%, and its earnings share was 22.4%. In other words, the difference between the two shares isn’t as inflated as it was during the 1990s tech bubble.
(2) Semiconductors are in demand. Meanwhile, worldwide semiconductor sales rose to another record high during November (Fig. 7). This series is highly correlated with the forward earnings of the S&P 500 Semiconductor industry, which also rose to a record high during the November 29 week. That’s a good omen for the overall fundamentals of the IT sector.
Of course, just before the 1990s tech bubble burst, both series also achieved record highs. However, the bubble burst in 2000 as Y2K-led demand for technology hardware and software plunged at the start of the new millennium. This time, it’s hard to see what might cause demand for technology to drop. It’s easier to see more demand, arising from the need to increase productivity in response to chronic labor shortages. And of course, the transition to electric vehicles also bodes well for technology spending.
(3) Computer output at record high. By the way, the 1990s bubble was led by inflated demand for communications equipment, which led the subsequent tech wreck (Fig. 8). The current tech boom has been led by industrial production of computers and peripheral equipment, which increased 1.8% m/m and 7.8% y/y during December to a new record high. Output of semiconductors and other electronic components edged up last month to a new record high as well. Output of communications equipment declined during December but remains on a solid uptrend.
US Economy: A Whiff of Stagflation. There was a strong whiff of stagflation in last week’s economic reports. December’s CPI was up 7.0% y/y, the highest since June 1982, and the month’s PPI for final demand was up 9.7% y/y. Meanwhile, December’s retail sales and industrial production fell 1.9% and 0.1%, respectively, on a m/m basis.
Contributing to this downbeat scenario is the Omicron phase of the pandemic. While it is less deadly than the Delta variant, it has been spreading much more quickly, resulting in more and more workers calling in sick to work. This development may prolong the period of supply-chain disruptions, which could depress economic growth while further boosting inflation. Let’s have a closer look at the relevant data:
(1) Pandemic. The number of new Covid cases in the US hit a record-high 673,735 on January 10, using the 10-day moving average (Fig. 9). New cases may have peaked, as they since have edged down. Meanwhile, the number of Covid hospital patients rose to a new record high of 134,281 on January 14, also using a 10-day moving average.
Over in Europe, the sum of new cases in France, Germany, Italy, Spain, and the UK rose to a record of 843,623 on January 14, on a 10-day basis. The number of hospital patients in just France, Italy, and the UK rose to 56,000 on January 13. On Thursday, Jackie and I reviewed the extreme quarantine measures that the Chinese government is taking to achieve their zero-Covid policy—including shutting down factories, which could seriously disrupt global supply chains and boost prices further.
(2) Economic indicators. December’s drop in retail sales was from a record high during November (Fig. 10). Rapidly spreading Omicron and rapidly rising inflation undoubtedly explain some of the weakness in retail sales at the end of last year. In addition, thanks to three rounds of government stimulus checks, consumers have more than satisfied their pent-up demand for goods, with the exception of autos, which remain in scarce supply as a result of parts shortages.
Eyeballing the chart, the retail sales level seems to be about $1 trillion (saar) above its pre-pandemic trend. The gap is less so on an inflation-adjusted basis. On the other hand, there isn’t much of a gap anymore on an inflation-adjusted basis—real retail sales are back down to the pre-pandemic trend.
A slowdown in consumer demand for goods would be a very good opportunity for businesses to restock their depleted inventories. If that’s what happens, then weakness in consumer spending would be offset by inventory accumulation in the GDP accounts. In October, the real business inventories-to-sales ratio remained at its recent low of 1.38, which was the lowest since May 2013 (Fig. 11).
December’s drop in industrial production reflected 0.3% and 1.5% m/m drops in manufacturing and utilities output. A 1.3% decline in auto manufacturing reflected the industry’s supply-chain problems, especially shortages of crucial computer chips. Nevertheless, industrial production rose at a 4.0% annual rate during Q4-2021.
(3) Inflation indicators. There are a few signs that inflation may be peaking, but numerous other ones suggesting that it remains a persistent problem. Debbie and I are still targeting a core PCED inflation rate of 4.0%-5.0% through mid-year, then 3.0%-4.0% during H2-2022 and into 2023. We may have to raise the first target range depending on how December’s PCED plays out when it is released on January 28.
We are still expecting that consumer durables prices will either stop going up or even fall in coming months. They’ve led the CPI’s jump with one-year and two-year gains of 16.8% and 21.3% through December (Fig. 12). Here are the two-year price gains for specific durable goods categories: used cars (51.1%), new cars (13.9), motor vehicle parts (11.8), furniture & bedding (16.3), and appliances (12.5). Prior to the pandemic and since 1995, these prices tended to fall.
On the other hand, rent inflation is likely to move persistently higher during 2022. That’s because the median price of an existing single-family home is up a whopping 32.3% over the past 24 months through November (Fig. 13). As a result, many would-be first-time homebuyers have been priced out of the market, boosting the demand for rental units. Rising mortgage rates will only reduce the affordability of housing. That will push rents higher too.
In the CPI, rent of shelter rose 4.2% y/y, the highest pace since February 2007 (Fig. 14). Here are the increases in its three components over the same period: owners’ equivalent rent (3.8%, highest since April 2007), tenant-occupied rent (3.3%, highest since May 2020), and lodging away from home (24.2%, highest on record).
Movie. “Ray Donovan: The Movie” (+ + +) (link) is the final installment of the American crime drama series Ray Donovan, with a great performance by Liev Schreiber as Donovan. In February 2020, Showtime canceled the series after seven seasons. The movie does a great job of answering open questions left by the series, much more so than the “Many Saints of Newark” did for the TV series The Sopranos. Donavan is a professional “fixer.” He uses bribes, payoffs, threats, and other illegal activities to protect his Hollywood celebrity clients. He has had a very challenging relationship with his father since he was a teenager, which helps to explain his chosen profession as well as his brooding and often violent personality. Like that of the Tony Soprano character, Donovan’s family life is full of drama.
Financials, China, and Wireless Charging
January 13 (Thursday)
Financials: In the Lead Out of the Gate. The S&P 500 Financials sector has had a strong start to 2022 thanks to the robust economy, higher interest rates, and a steeper yield curve. Here’s the performance derby for the S&P 500 and its sectors ytd through Tuesday’s close: Energy (14.1%), Financials (5.9), Industrials (0.1), Consumer Staples (-0.5), S&P 500 (-1.1), Materials (-1.4), Communication Services (-1.7), Consumer Discretionary (-2.2), Health Care (-2.9), Utilities (-3.1), Information Technology (-3.4), and Real Estate (-5.7) (Fig. 1).
Q4 earnings for many of the largest players in the industry hit the tape on Friday. Financials shares rallying prior to earnings can often be a sign of “buying the rumor” and may result in “selling the news” as occurred Wednesday when Jefferies Financial Group’s earnings report missed expectations and its shares tumbled. More on that below. That said, let’s examine what investors have been excited about:
(1) Steeper yield curve. Federal Reserve officials haven’t been shy signaling their intention to raise interest rates and reduce the Fed’s Treasury bond holdings. The need to act was reinforced Wednesday after the Labor Department reported that the Consumer Price Index (CPI) jumped 7.0% in December and the core CPI rose 5.5%.
The new direction hasn’t been lost on investors, who sent the yield on the 10-year Treasury up to 1.75% as of Tuesday’s close even as the fed funds target rate remained at 0.13% (Fig. 2). As a result, the yield-curve spread has widened to 163bps, up from its 2021 low of 81bps at the start of the year, and a 2020 low of -60bps (Fig. 3).
(2) Strong economy. Banks stand to profit as the US economy continues to recover from Covid. The economy got strong marks from JP Morgan CEO Jamie Dimon in a January 10 CNBC interview. “The consumer balance sheet has never been in better shape,” said the banking industry giant. Stock prices, home prices, and wages are up. Debt balances are down, savings are up, and job openings are plentiful. Business confidence is high, and balance sheets are solid. The market may be volatile, he noted, but the underlying economy is strong, and if we’re lucky the Fed will engineer a soft landing.
As for banks, commercial and industrial (C&I) loans have started to increase again. Recall that C&I loans spiked when Covid-19 first came on the scene in early 2020 and companies borrowed against their lines of credit in anticipation of problems. C&I loans slowly fell over the course of 2020 and 2021 and bottomed during the week of September 22; now they appear to be heading up once again (Fig. 4). Banks are flush with inexpensive deposits that have flooded in over the past two years as consumers have found themselves with excess cash (Fig. 5).
(3) Optimistic analysts. The y/y stock price index gains logged by S&P 500 Investment Banking and Brokerage (44.3%), Regional Banks (38.1), and Diversified Banks (32.1) have placed each of these indexes at or near their highest levels of the past decade (Fig. 6, Fig. 7, and Fig. 8). On their face, 2022 earnings for the three industries look terrible, each in negative territory. However, Joe notes that the industries are up against banner results in 2021, when the capital markets were red hot and earnings received a boost from the reversal of 2020’s loan-loss reserves.
(4) Jefferies disappoints. For its quarter ended November 30, Jefferies reported strong results in investment banking, but weakness in both equity and fixed-income trading dragged down results. Advisory revenue climbed 64.7% y/y; debt and equity underwriting rose 8.0%. The declines came in equity capital markets revenue, which fell 11.3% to $290.4 million, and revenue from fixed-income capital markets, which dropped 49.5% to $132.8 million.
The company attributed the drop in capital markets results to “challenging market conditions for fixed income trading leading to lower volumes as compared with the prior year quarter, which benefitted from high levels of client level activity due to more favorable market conditions.” Jefferies shares fell 9.3% on Wednesday.
The company reported adjusted profits of $1.36 per share, below analysts’ consensus forecast of $1.40 a share, according to Zacks Equity Research data. The miss also could be tied to Jefferies’ involvement in the blank-check market, which was hot in 2020 but has cooled of late. Jefferies underwrote 72 of the 1,120 blank-check companies that came to market in 2020 and 2021, reported a January 11 Reuters article. Of those brought to market, 17 of the Jefferies offerings trade below the $10-a-share offering price.
China: Covid & the Olympics. China’s list of problems is lengthening. The government is locking down entire cities with populations in the millions as part of its “Covid Zero” strategy to stem the spread of Covid-19. It’s also shutting down—or sharply reducing the production at—factories in northern China in an effort to clear its skies of smog prior to the start of the 2022 Winter Olympics. These challenges come on top of the financial woes of China’s huge property development companies and the erratic proclamations by President Xi affecting tutoring companies, gaming companies, delivery companies, and others.
We’ve expected the country’s economic growth to continue to slow from its already sluggish rates. The tougher question is whether the ripple effects will reach US shores. Here’s a look at some of the more recent developments with implications for the answer:
(1) The Covid shutdowns. Last spring, the number of new Covid-19 cases reported daily in China was routinely below 50. But the daily new case count started ticking up in December, and in recent weeks has run north of 150 a day. That may seem ridiculously low relative to the US’s 1.4 million new cases reported on Monday. But in China, where there’s a zero-tolerance Covid policy, the recent increase in cases is causing shutdowns and renewed supply-chain concerns.
The uptick in new cases comes at an unfortunate time, with the Chinese New Year—when many people travel to their hometowns—on February 1 and the start of the Winter Olympics on February 4 rapidly approaching.
In various Chinese cities, the Covid shutdowns are imposing punishing conditions on residents and businesses alike. In Xi’an, citizens are angry and chip manufacturers are reporting staffing difficulties. In Tianjin, mass testing halted operations at a Toyota factor for two days. In Hong Kong, inbound cargo capacity has dropped to 20% of pre-pandemic levels, which is expected to cause shortages of everything from lobsters to flowers. Covid-related restrictions have also disrupted life and business operations in Ningbo-Zhoushan, the world’s third-busiest container port; Shenzhen, a southern technology hub; Zhengzhou; and Yuzhou. Those are just some of the examples we’ve seen in recent days’ reporting from Reuters (here), the WSJ (here), and Bloomberg (here).
(2) Looking up. Presumably in an effort to turn the skies blue for the 2022 Winter Olympics, Chinese officials have reduced or stopped production at factories in 64 cities located in five provinces in addition to Beijing and Tianjin, a December 14 article in the South China Morning Post reported. Expected to remain in place until the 2022 Winter Paralympics ends on March 13, the directive impacts the world’s biggest steel-producing city, the largest coal-mining province, and major producers of aluminum.
The move was expected to reduce crude steel production in H2-2021 by 13% compared to H1-2021. Three urea plants in northern Shanxi province were asked to operate at 50% capacity, a January 11 Bloomberg article reported. And the article speculated that as the Olympics draw closer, more plants could be asked to reduce production.
China has been working toward bluer skies since establishing air-quality standards in 2013 and winning the election to host the Olympic games two years later. China has planted trees, installed more renewable energy sources, required filters at industrial facilities, and imposed higher fuel standards for cars. The average concentration of fine particulate pollution has fallen by 13% y/y and 63% since 2013. But it’s still three to four times higher than in western capitals like Washington, DC and London, a January 5 WSJ article reported.
(3) Chinese property saga continues. The unwinding of the Chinese property development sector proceeds, with more debt repayments due this week and an increasing number of properties hitting the market.
China Evergrande Group, which is buckling under $300 billion of liabilities, is negotiating with holders of its yuan-denominated bonds to extend the coupon payments for six months to July. The company has already defaulted on offshore, dollar-denominated bonds.
Shimao Group Holdings defaulted on a trust loan last week, and one of its subsidiaries is in negotiations to extend the maturities on two asset-backed securities due this month, a January 10 Reuters article reported. The company has 34.2 billion yuan of asset-backed securities and $5.7 billion of dollar bonds outstanding.
Shimao Group has put its residential and commercial properties up for sale. It has one agreement to sell a Shanghai commercial property for more than 10 billion yuan to a Chinese state-owned company. The country reportedly plans to make it easier for state-backed property developers to buy the distressed assets of troubled property developers. The loans used to fund building purchases won’t be counted under restrictive borrowing caps or included when banks calculate their debt ratios.
Meanwhile, Guangzhou R&F Properties averted default by agreeing to pay $104 million for a tender offer and fees to offshore bondholders who agreed to extend the maturity of a bond due on Thursday to July.
(4) More saber-rattling. While China’s military is expected to behave in the weeks prior to the Olympics, there’s concern that the country has developed missiles that can evade US defenses. China has developed a heat-seeking hypersonic missile that’s reportedly more advanced than anything the US possesses and can target almost anything, including stealth aircraft like the F-22. It can “penetrate missile defense systems and hit fixed targets on the ground at five times the speed of sound or faster,” a December 31 SCMP article reported.
In the past, a hypersonic missile’s surface became so hot that it interfered with the detection of heat signals from a targeted object. Chinese scientists solved that problem by creating an “air-blowing device” that cools the missile with cold air. It’s expected to take the US four years to design comparable missiles.
Last summer, China tested a hypersonic glide vehicle, a maneuverable spacecraft that travels at more than five times the speed of sound, reported a December 2 FT article. The vehicle launched a missile while in flight, implying that the country now has the ability to launch a nuclear missile that can evade US missile defense systems and hit any part of the US. If true, this new capability could put the US at a serious military and negotiating disadvantage. North Korea also claimed this week to have launched a hypersonic missile, though it only flew for 434 miles before landing in the waters off North Korea.
(5) Slower growth ahead? Goldman Sachs on Tuesday cut its forecast for China’s 2022 GDP growth to 4.3% from 4.8% due to the latest shutdowns. The country reported 4.9% annualized GDP growth in Q3 (Fig. 12). The China MSCI share price index has been signaling problems, falling 35.4% since peaking on February 7, 2021 (Fig. 13).
Analysts have been cutting their 2022 estimates for companies in the China MSCI index in recent months. Their consensus estimates imply revenue growth of 9.1% this year, down from an estimated 18.1% last year, and earnings growth of 14.7% versus earlier projections of nearly 19% last June and compared to a projected 13.4% for 2021 (Fig. 14 and Fig. 15).
Disruptive Technology: Pulling the Plug. Companies are working on delivering electricity wirelessly. If they’re successful, wireless devices truly will be wireless. You’ll never need to charge your phone or change the batteries in your fire detector. Drones will be able to fly indefinitely, and electric vehicles (EVs) will charge on the run.
Wireless electricity delivery is something Nikola Tesla dreamed of 100 years ago. Let’s look at how his vision might become our reality in the not-too-distant future.
(1) Wireless power at home. Ossia’s product, Cota Real Wireless Power, claims to deliver power through the air at any distance, and it doesn’t require a line of sight between the transmitter and the receiver to do so. The company also offers software and cloud services that allow customers to monitor and analyze the electricity used and the data generated by connected devices. Its sensors can be retrofitted into existing into devices.
The company talks about using wireless electricity delivery in personal health care devices, which would make the devices smaller, more reliable, and eliminate the need for batteries. Wireless electricity could be used to run all the Internet of Things devices in homes. French company Archos plans to put Cota in a wireless security camera, an air-monitoring sensor, and a pet tracker, an Ossia press release stated. The company is also working with a large furniture company to develop its Cota Power Table, where electricity will beam from the ceiling to conventional phone charging pads on the table.
Energous is another company working on the same technology. Its product is being used inside EarTechnic hearing aids, Williot smart tracking tags, and Posture Tracker that’s being used with the Gokhale Method, a system of postures and exercises to relieve back pain by changing the way one stands, sits, and moves.
(2) Wireless electric from space. Caltech has a Space Solar Power Project that plans to launch a satellite that captures solar energy, converts it to electrical energy, then transmits it to Earth using radio frequency electrical power. Last summer, the school announced the project had received a $100 million donation from Donald Bren, chairman of the Irvine Company and member of the Caltech Board of Trustees.
(3) Wireless EV charging. Resonant Link is developing wireless chargers embedded in streets that can charge EV fleets while they operate. For example, buses would get quick hits of electricity when they stop for riders instead of having to return to terminals for recharging.
(4) Wireless electric in the office. Aeterlink set up an office to demonstrate its wireless electricity product. The office’s chairs’ sensors receive electricity from transmitters in the ceiling. The chairs can then report to building management whether or not they are occupied so that air conditioning can be set precisely, a January 12 article in Market Research Telecast reported. (Or perhaps the technology could be used to tell bosses when employees take extended lunch breaks!) The company also sees its product being used to wirelessly power contact lenses that project images to the retina or robotic hands in factories.
(5) Wireless electric on the front lines. The US military is exploring how it can use the wireless transmission of electricity on the front lines of military conflict. One area of interest: wirelessly charging drones. DARPA is working with Electric Sky, which has developed Whisper Beam to wirelessly charge small drones, according to a December 16 article in Task & Purpose. The current range is a meter or two, but in the future it could be hundreds of meters.
The article noted that if Whisper Beam takes off, it should be renamed “Scotty.” “Then at long last, the old Star Trek command ‘beam me up, Scotty’ can finally become a legitimate military order.”
Earnings Season Starting
January 12 (Wednesday)
Strategy I: Looking Forward. The Q4 earnings season has started. We are expecting another strong season, with actual results once again beating expectations. After all, the Atlanta Federal Reserve Bank’s GDPNow model showed Q4’s real GDP tracking at 6.8% (saar) as of January 10. Real consumer spending is showing a solid gain of 4.5%, and real gross private domestic investment growth is tracking at 17.8%. Inflation is also likely to boost Q4’s results given that the CPI is up 6.8% y/y through November. Of course, costs are also going up, but profit margins seem to be holding up remarkably well. Consider the following:
(1) Q4 earnings growth. The analysts’ consensus estimate for S&P 500 earnings per share has been hovering around $51 for Q4 since mid-2021 (Fig. 1). That means that Q3’s better-than-expected results didn’t change Q4 expectations much. The expected y/y growth rate for Q4 has been hovering around 20.0% since mid-2021 (Fig. 2).
(2) Another earnings hook. Following the recession of 2020, the y/y growth rate of S&P 500 earnings per share peaked at 88.6% during Q2 (Fig. 3). It eased to 39.3% during Q3. Joe and I expect yet another “earnings hook” during the current earnings season, with Q4 results beating estimates. That’s a frequent phenomenon; it occurred during the previous three quarters and in fact during most earnings seasons in the past.
(3) Forward earnings. Indeed, the y/y growth rate in S&P 500 forward earnings on a monthly basis is highly correlated with the comparable growth rate in the actual quarterly results (Fig. 4). (“Forward earnings” is the time-weighted average of analysts’ consensus estimates for this year and next.) The former was up 32.9% during December. That’s more than 10 percentage points above analysts’ current consensus outlook. The level of forward earnings tends to be a good year-ahead leading indicator of actual earnings (Fig. 5 and Fig. 6).
During the January 6 week, S&P 500 forward earnings rose to yet another record high of $223.78 per share (Fig. 7). This series has been rising in record-high territory since March 4, 2021, and it remains on the steep uptrend that started during the spring of 2020. Industry analysts currently expect that earnings per share will be $223.35 in 2022 (up 8.5% y/y), and $245.71 in 2023 (up 10.0%).
(4) Our annual earnings forecasts. We are forecasting S&P 500 earnings per share will be $220.00 this year (up 4.8%), $235.00 next year (up 6.8%), and $250.00 in 2024 (up 6.4%) (Fig. 8).
(5) Our forward earnings forecast. Our forecasts for the S&P 500 stock price index are based on our forecasts of forward earnings. We are currently projecting that by the end of this year, forward earnings will rise to $235.00 from $223.78 during the January 6 week, and we project $250.00 by the end of 2023 (Fig. 9).
(6) Our S&P 500 forecasts. Assuming as we do currently that the S&P 500 forward P/E will remain around 22.0, our projection is that the S&P 500 stock price index will be 5200 by the end of this year and 5500 by the end of 2023 (Fig. 10).
Strategy II: On the Margin. Joe and I derive the profit margin of the S&P 500 by dividing S&P 500 operating earnings per share by the composite’s revenues per share. Consider the following:
(1) Revenues. Revenues growth peaked at a record high of 21.8% y/y during Q2-2021 (Fig. 11). It slowed to a still-robust growth rate of 13.9% during Q3. We are expecting to see revenues grow 3.1% this year and 3.0% next year (Fig. 12).
(2) Quarterly profit margin. The S&P 500 operating profit margin averaged a record 13.1% during the four quarters through Q3-2021 (Fig. 13). That’s also our forecast for all of 2021. For this year and next year, we are predicting 13.2% and 13.8%, just about the same as the analysts’ consensus currently.
(3) Weekly margin proxy. By the way, we also derive a weekly operating profit margin by dividing forward earnings by forward revenues (Fig. 14). It is a very good weekly coincident indicator of the actual quarterly profit margin. It suggests that the profit margin is currently peaking around 13.0%.
Strategy III: Sector Stories. Where among the 11 sectors of the S&P 500 might the Q4 revenues and earnings surprises be concentrated? Lots of macroeconomic variables seem to be providing hints. Here’s what they tell us about the Q4 surprise prospects of several of the sectors:
(1) Consumer Discretionary. Omicron may have depressed retail sales. However, total retail sales rose to a new record high during November. The same can be said excluding motor vehicles and gasoline. Auto sales have been depressed by a shortage of dealer inventories. Gasoline sales have been boosted by price increases.
Also at or near record highs were retail sales of furniture & home furnishings stores, clothing & accessory stores, health & personal care stores, sporting goods stores, and general merchandise stores. Restaurants and bars had record sales too, though some of that strength undoubtedly reflected higher prices to offset rapidly rising costs.
By the way, consumers are using their credit cards again. Revolving credit jumped $20 billion during November, the biggest monthly gain on record (Fig. 15), excluding the $50 billion outlier during January 2006.
Homebuilders still report plenty of prospective-buyer traffic. That’s even though both median and average new home prices are up around 15% y/y through November. Of course, those increases reflect not only demand for new homes but also rapidly rising construction costs.
(2) Energy. At the end of last year, petroleum products usage rose to a new record high for that time of year. It exceeded December 2019 usage (Fig. 16). The average price of a barrel of Brent crude oil was around $80 during Q4-2021, up almost 100% from the Q4-2020 average.
(3) Financials. Commercial banks reduced their loan-loss provisions by $52.7 billion from $221.7 billion at the end of 2020 to $169.0 billion at the end of 2021 (Fig. 17). As discussed in the next section, 2021 was a banner year for the M&A business of investment banks.
(4) Industrials. The transportation subsector of the S&P 500 Industrials sector faced lots of challenges as employees had to stay home if they were hit with Omicron. However, the airports were packed during the holiday season. It’s not clear whether airfares were up or down. November’s CPI and PCED for airfares were down 3.7% and up 13.5%, respectively, on a y/y basis.
There’s no ambiguity about durable goods orders. They were up 14.8% y/y through November. Over the same period, nondefense capital goods orders excluding aircraft rose 11.7% to yet another record high. Orders were particularly strong for primary metals, fabricated metal products, electrical equipment, and industrial machinery. (See our Durable Goods Orders & Shipments.)
(5) Q4 consensus sectors earnings growth. Here are analysts’ consensus forecasts for y/y revenues and earnings growth during Q4 for the S&P 500 and its 11 sectors: S&P 500 (12.1%, 20.1%), Communication Services (8.9, 9.6), Consumer Discretionary (11.3, 8.1), Consumer Staples (7.4, 3.3), Energy (72.7, -/+), Financials (-5.0, 2.2), Health Care (11.2, 19.4), Industrials (12.6, 51.5), Information Technology (10.8, 15.9), Materials (24.2, 64.2), Real Estate (14.9, 13.9), and Utilities (4.3, 0.8).
Global M&A: New Records. Global M&A activity well exceeded the $5 trillion mark during 2021 for the first time ever. It was fueled by corporates’ access to unprecedented levels of cash and cheap capital during the pandemic. Dealmakers expect activity to increase to new records in 2022. However, several challenging factors on the horizon could either slow M&A activity or further support it. For example, companies facing supply-chain disruptions and ESG (environmental, social, and governmental) pressures could turn to M&A to solve their problems. Consider the following:
(1) Setting global records in 2021. Reuters reported that the total value of global M&A transactions through December 31 was $5.8 trillion, a record since the start of the data, up 64% from the same period a year before, according to Refinitiv. Over 63,000 M&A deals were announced during 2021, another record, according to Refinitiv.
Completed global deals valued above $100 million reached 1,047 in 2021, up significantly from 674 in 2020, reports Willis Towers Watson (WTW). That’s the highest volume for any year since the company began counting in 2008.
(2) Companies have amassed cash. Companies have put cash they’ve amassed during the pandemic to work on deals. Cash and equivalents at S&P 500 firms increased 11% y/y during Q3 to about $3.8 trillion, according to S&P Global Market Intelligence, reported MSN. Indeed, US corporate cash flow hit a new record high that quarter of $3.2 trillion, according to the Bureau of Economic Analysis’ data (Fig. 18).
(3) Issuances remain on a high. With all that cash on hand, companies haven’t issued as many new securities; new issues fell in both the bond and stock markets toward the end of 2021.
Businesses raised $1.4 trillion during December 21 from US investment-grade bond sales, down 22% from a year earlier when pandemic activity peaked, Refinitiv said, according to MSN. Federal Reserve Financial Accounts data also show that new corporate issues in both the bond and stock markets slowed in recent months through November (Fig. 19). However, new issues remained elevated from a historical viewpoint, buoyed by historically low interest rates.
(4) Big money in certain sectors. Reuters recounted the following blockbuster transactions: AT&T Inc. and Discovery Inc.’s $43 billion media asset merger; the $34 billion leveraged buyout of Medline Industries Inc; Canadian Pacific Railway's $31 billion takeover of Kansas City Southern; and the breakups of General Electric Co and Johnson & Johnson.
Other recent big deals include Block Inc.’s (formerly Square) $29 billion acquisition of Afterpay Ltd. and Oracle Corp.’s $28.3 billion acquisition of medical records company Cerner Corp., MSN has reported.
Most M&A volume has been concentrated in the Technology, Financials, Industrials, and Energy sectors. Many deals were pursued despite high valuations. Bain & Co said that multiples for transactions (i.e., the ratio of median enterprise value to earnings before interest, taxes, depreciation, and amortization) increased across industries in 2021 over 2020. The Technology and Health Care sectors’ multiples were the highest, at 28 times and 24 times, respectively, reported MSN.
(5) Across-the-border volume up. Deal volume was up across all regions that WTW evaluated, including the US, Europe, and Asia. “While China cross-border activity has been modest, corporates from other Asian countries have stepped up to buy global assets,” Goldman Sachs’s Global Vice Chair of Investment Banking told Reuters.
(6) Alternative deals abound. Last year’s heightened interest in SPACs (special purpose acquisition companies—essentially, publicly traded cash pools) is likely to generate additional deal-making in 2022 because these entities usually have about two years to close a deal. SPAC deals accounted for about 10% of the global M&A volumes, reported Reuters.
Bain also said that private-equity and venture-capital firms increased their share of total M&A transaction values in 2021 by about 2ppts over 2020 levels, to 19% and 8%, respectively. As we discussed in our December 1 Morning Briefing, private-equity and venture-capital funding recently reached record highs.
(7) Turning challenges into opportunities. Datasite surveyed 600 dealmakers in the US, UK, and EU to understand what kinds of opportunities and challenges are ahead for global M&A, reported Business Wire. More than 70% of global dealmakers said rising inflation affected a deal they had worked on in 2021, by changing company operating assumptions or affecting deal valuations, found Datasite.
For 2022, according to the Datasite survey, dealmakers say that the biggest challenges to getting deals done are supply-chain issues, labor shortages, and ESG risks. ESG trends could also promote dealmaking, however, as companies search for ESG-friendly targets to climatize their business, WTW pointed out. WTW also expects that supply-chain challenges could drive many companies to look for more self-sufficiency in their products and services through deal activity.
(8) Policy could slow M&A. Fiscal and monetary policy could, however, dampen the pace of deals. The Fed’s anticipated interest-rate increases and balance-sheet wind-down certainly could curb enthusiasm in deal markets. So could antitrust regulators’ increased scrutiny, especially of technology companies.
Is the Party Ending Or Just Moving?
January 11 (Tuesday)
Strategy I: The Punch Bowl. Fed Chair Jerome Powell has been a party animal since the start of the pandemic, continually filling the Fed’s punch bowl with lots of high-octane liquidity. During 2020, all that rum punch fueled a V-shaped economic recovery, i.e., a fast rebound from a severe but short recession. It lasted only two months, i.e., March and April, according to the Index of Coincident Indicators (Fig. 1).
On a quarterly basis, the recession spanned two quarters, i.e., Q1-2020 and Q2-2020 (Fig. 2). Real GDP fully recovered and rose to a new record high during Q2-2021. The party started to get out of hand last March, when the CPI inflation rate breached the Fed’s 2.0% target, rising to 2.6% y/y (Fig. 3). It got as high as 6.8% y/y during November. December’s number—to be released on Wednesday—is expected to exceed 7.0% y/y.
The Fed kept filling the punch bowl nonetheless, because Powell and other Fed officials believed that the spike in inflation was transitory notwithstanding the spiked punch. They changed their minds late last year. Consider the following:
(1) During the November 2-3 FOMC meeting, members voted to start tapering their bond purchases of $120 billion per month by $15 billion per month so that they would stop by July. (See the November FOMC statement.) During their December 14-15 meeting, the committee decided to taper by $30 billion per month starting in January, thus ending their bond purchases by April.
At his post-meeting press conference at the end of last year. Powell suggested that the Fed could start raising the federal funds rate soon after tapering was done. He mentioned that there was a discussion about reducing the Fed’s balance sheet without “the need for another long delay” after the first rate hike. However, he also said, “we’ll make this decision in coming meetings, and it’s not—it’s not a decision that the Committee has really focused on yet.”
(2) But then the actual minutes of the December meeting was released on January 5 and investors were shocked to learn that there was a new section titled “Discussion of Policy Normalization Considerations.” It turns out that there was significant discussion about reducing the Fed’s balance sheet.
As Melissa and I observed in yesterday’s Morning Briefing, “The big surprise that unnerved investors is that the minutes noted that participants discussed ‘the appropriate conditions and timing for starting balance sheet runoff relative to raising the federal funds rate.’ Furthermore, ‘[a]lmost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate.’ The word ‘runoff’ was mentioned 10 times in the minutes. It wasn’t mentioned at all in the previous minutes.”
(3) So the FOMC is set to stop filling the punch bowl. However, we aren’t convinced that doing so would end the party for the stock market. Through Monday’s close, the S&P 500 is down only 2.6% from its record high of 4796.56 on January 3. On the other hand, the party has already ended for some stocks, such as those in Cathie Wood’s ARK funds. Lots of Nasdaq stocks are in bear markets. The Nasdaq is down 6.9% from its record high on November 19, with the Nasdaq 100 down 5.8%, also from its November 19 record high.
Meanwhile, as we’ve discussed often recently, there is plenty of liquidity left in the punch bowl as a result of the excessively stimulative fiscal and monetary policies of the past two years. We reckon that M2 currently exceeds its pre-pandemic uptrend by $3 trillion to $4 trillion (Fig. 4). It is up $6.0 trillion from February 2020 through November 2021, led by a $3.1 trillion increase in demand deposits.
Strategy II: Bond Vigilantes Sobering Up. The 10-year US Treasury bond yield jumped from 1.514% at the end of last year to 1.63% on January 3, the first trading day of the new year (Fig. 5). It did so on expectations of a faster pace of Fed tapering and an earlier start to Fed rate-hiking this year. The “run-off” minutes released on January 5 pushed the yield higher. It closed at 1.767% yesterday.
The 2-year US Treasury note yield tends to be a good year-ahead leading indicator for the federal funds rate. It started the year at 0.774%, implying three 25bps rate hikes this year. Yesterday, it closed at 0.902%, implying possibly four rate hikes (Fig. 6).
In the January 4 Morning Briefing, we discussed whether the bond market might act more normally in 2022 than it did in 2021. We observed that despite the surge in inflation last year, the bond yield mostly hovered around 1.50%. Around mid-year, we moved our 2.00% target for the yield from the end of last year to the end of this year. Now it appears we will get to 2.00% soon, so we are raising our year-end target to 2.75%. It could go still higher in 2023, but for now we are predicting that inflation will moderate by the second half of this year. Consider the following related developments:
(1) The most bearish indicators for the bond market have been all the uniformly ugly inflation statistics since last March, noted above. As a result, the median one-year-ahead expected inflation rate was 6.0% during November according to a survey of consumers conducted by the NY Fed (Fig. 7). The only bit of good news, so far, was that the prices-paid index in December’s M-PMI survey fell to 68.2 from the cyclical-high reading of 92.1 during June (Fig. 8).
(2) The copper-to-gold price ratio has been hovering around a level consistent with a bond yield of 2.50% since late April of last year (Fig. 9). This ratio has been closely tracking the yield since 2004, but they diverged last year. The V-shaped recovery in the M-PMI since summer 2020 should have been more bearish for bonds as well last year (Fig. 10).
Strategy III: Is the Party Moving from Growth to Value? Computer trading algorithms and portfolio managers seem to have something in common these days: They rotate out of Growth and into Value stocks when bond yields are rising. They’ve certainly been doing that so far this year. Since the end of last year through Friday’s close, the S&P 500 Growth index is down 4.5%, while the Value index is up 1.0%. Much of the rotation seems to be out of the S&P 500 Information Technology sector and into Energy and Financials. Let’s have a closer look at the dynamics of this rotation:
(1) Bond-yield correlations. There has been some correlation between the 10-year bond yield and the ratio of the S&P 500 Financials to the S&P 500 Information Technology stock market indexes (Fig. 11). Both variables have been in downward trends since the early 1990s. On a short-term basis over several weeks and even months, they have diverged. Eyeballing the two, we are convinced that even a computer algorithm could not make money trading the relationship of the two.
A better correlation is between the bond yield and the ratio of the S&P 500 Financials to the market capitalization of the S&P 500. The fit between the two has been especially tight since the start of the pandemic (Fig. 12).
(2) Growth and Mag-8 market cap. Growth tends to account for about 50%-55% of the market cap of the S&P 500 (Fig. 13). The Magnificent Eight (the eight biggest-cap stocks in the index) currently account for almost 50% of the market cap of Growth, up from around 13% during 2013 (Fig. 14). The Mag-8 account for about 25% of the market cap of the S&P 500 (Fig. 15).
(3) Market cap winners and losers. Last year, the S&P 500 rose 26.9%. The Mag-8’s market cap rose 37.5%. Excluding them, the S&P 500 was up 23.7% (Fig. 16).
Last year, the S&P 500 Growth index increased 31.0%. Excluding the Mag-8, S&P 500 Growth increased 20.9% (Fig. 17).
(4) Relative forward earnings. The forward earnings of the S&P 500 Growth has been outpacing the forward earnings of the S&P 500 Value for many years (Fig. 18). (“Forward earnings” is the time-weighted average of analysts’ consensus earnings estimates for this year and next.) The outperformance was accelerated by the pandemic, as the former rose 39.8% and the latter rose 6.3% from the last week of 2019 through the last week of 2020.
(5) Mag-8 earnings growth rates. I asked Joe to calculate STRG and STEG for the Mag-8. The former is analysts’ consensus expectation for forward revenues growth over the short term (i.e., one year ahead), while the latter is their consensus expectation for short-term forward earnings growth (Fig. 19).
During the January 6 week, STRG was 14.9%, while STEG was 9.7%. Here are the STRG and STEG readings as of January 7 for each of the Mag-8 stocks: Alphabet (16.6%, 4.7%), Amazon (17.7, 27.5), Apple (4.5, 4.3), Meta (18.9, 3.6), Microsoft (15.8, 15.9), Netflix (14.6, 22.4), Nvidia (19.0, 19.9), and Tesla (39.7, 38.4). (See our The Magnificent Eight chart book.)
(6) Valuation. Investors certainly aren’t worrying about the Mag-8’s growth potential. What has them on edge is the group’s high forward P/E. It was 32.2 during the January 7 week. That’s why the forward P/E of the S&P 500 Growth is at 27.0 (Fig. 20).
While the ratio of the S&P 500 Financials sector’s stock price index to the S&P 500 Information Technology sector’s stock price index displays some correlation with the bond yield, the same cannot be said about the ratio of Growth’s to Value’s stock price indexes.
(7) Don’t sell Growth short. Our conclusion is that the bond yield is just one of many variables involved in the valuation of Growth. The most important variable is probably earnings growth itself, which still looks solid for the Mag-8. Another valuation booster is all the liquidity that remains in the Fed’s punch bowl.
So we would stick with the Mag-8. Of course, it’s hard to market-weight them, let alone to overweight them, since most portfolio managers are limited in the percentage of their portfolio that can be in any individual stock. Own them, and own stocks in the S&P 500 Energy and Financials sectors too.
The Markets, the Fed, and Jobs
January 10 (Monday)
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Strategy: The Great Rotation, Again? Investors are starting the new year by chanting the following mantra: “Don’t fight the Fed.” That’s because the latest FOMC minutes released on Wednesday indicated that the Fed will start reducing its balance sheet sooner than expected in addition to ending its bond purchasing by March, after which it will start to raise the federal funds rate. The 10-year US Treasury bond yield rose to 1.76% by the end of last week, the highest reading since early last year (Fig. 1).
The S&P 500 took the news badly too, but its sell-off was only 2.4% below its record high of 4793.54 on January 4. However, there was some significant rotation within the index. Since the end of last year through Friday, S&P 500 Growth is down 4.5%, while Value is up 1.0% (Fig. 2). Growth’s forward P/E fell to 27.0 (from 28.3 a week ago), while Value’s forward P/E rose to 17.3 (from 17.1 a week ago) (Fig. 3). The overall forward P/E of the S&P 500 remained relatively subdued at 21.0. The Nasdaq and the Magnificent Eight (the eight highest-capitalization stocks in the S&P 500) also fell 4.5% last week.
There has been lots of talk about a great rotation out of Growth and into Value over the past few years as the former continued to outperform the latter (Fig. 4). This might be the year that finally happens. Nevertheless, Joe and I aren’t big fans of the Growth-vs-Value paradigm. We prefer focusing on sectors, and we recommend overweighting Energy, Financials, and Information Technology companies, especially those with earnings. We would stay away from tech stocks that were overvalued as a result of the pandemic or because of their projected hyped-up disruptive effects on established businesses. This should be the year that widely undervalued SMidCaps outperform LargeCaps, in our opinion.
We will have more to say about this in coming Morning Briefings. For now, let’s review the highlights of the latest FOMC minutes that rattled the markets last week:
(1) Persistent inflation. The minutes of the December 14-15 FOMC meeting were released on January 5. The word “transitory,” which had previously described the Fed’s outlook for inflation, was mentioned once: “As elevated inflation had persisted for longer than they had previously anticipated, members agreed that it was appropriate to remove the reference to ‘transitory’ factors affecting inflation in the post-meeting statement and instead note that supply and demand imbalances have continued to contribute to elevated inflation.” The word was mentioned five times in the minutes of the previous meeting, on November 2-3.
The word “persistent” appeared five times in the latest minutes in the context of describing supply-chain disruptions and inflationary pressures.
(2) Policy normalization. The latest minutes included a new section titled “Discussion of Policy Normalization Considerations.” The participants observed that “the current economic outlook was much stronger, with higher inflation and a tighter labor market than at the beginning of the previous normalization episode.” The minutes confirmed that the widely expected policy response would be to end the Fed’s bond-purchasing program by March and then commence with hiking the federal funds rate.
(3) Balance sheet run-off. The big surprise that unnerved investors is that the minutes noted that participants discussed “the appropriate conditions and timing for starting balance sheet runoff relative to raising the federal funds rate.” Furthermore, “[a]lmost all participants agreed that it would likely be appropriate to initiate balance sheet runoff at some point after the first increase in the target range for the federal funds rate.” The word “runoff” was mentioned 10 times in the minutes. It wasn’t mentioned at all in the previous minutes.
However, the fact that the FOMC discussed when to start reducing the Fed’s balance sheet shouldn’t have come as such a market-roiling surprise. During his post-meeting press conference on December 15, Fed Chair Jerome Powell said outright that the FOMC had discussed it during the meeting. He added, “I was here at the Fed when we lifted off the last time” and noted that “the economy is so much stronger now” and “so much closer to full employment.” He also stated that “inflation is running well above target.” He concluded that there’d be no need for “a long delay in starting the runoff.”
US Labor Market I: More Full-Time Jobs. The Wizard of Oz said, “Pay no attention to that man behind the curtain.” I say, “Pay no attention to Friday’s weak 199,000 payroll employment gain for December (Fig. 5). Any statistic that doesn’t support my outlook is either a faulty one or it will be revised to confirm I was right after all.” Indeed, October and November payrolls were revised upward by 141,000. The 12-month sum of payroll revisions rose to a cyclical high of 936,000 through November (Fig. 6). Just about every other relevant indicator shows that the labor market is booming. For example:
(1) Household employment. The household measure of employment (which measures job holders rather than the number of jobs) rose 651,000, led by an 803,000 jump in full-time employment (Fig. 7). Some of the weakness in the number of payroll jobs may reflect the fact that more people are getting full-time jobs, replacing two or more part-time jobs.
(2) Earned Income Proxy. Our Earned Income Proxy (EIP) for wages and salaries in the private sector rose 0.8% m/m and 9.9% y/y in December (Fig. 8). Our EIP reflects the 0.6% m/m increase in hourly wages and the 0.2% increase in aggregate hours worked. The EIP is outpacing the PCED inflation rate, which was 5.7% y/y in November.
(3) Unemployment. The unemployment rate fell to 3.9% in December (Fig. 9). That was a fresh pandemic-era low and near the 50-year low of 3.5% in January and February 2020. The short-term unemployment rate for those without a job for less than 27 weeks was 2.7%, matching its record low recorded during September 2019, while the long-term jobless rate was only 1.2%.
(4) Quits. Job quits jumped to 4.53 million during November, according to the Job Openings and Labor Turnover Survey (Fig. 10). That was an 8.9% increase from October and broke September’s high-water mark of 4.36 million. The number of job openings totaled 10.56 million, a small decline from 11.09 million in October. There are 1.5 jobs open for every unemployed worker.
(5) ADP payrolls. The ADP measure of private-sector employment rose 807,000 during December. Service-producing jobs rose 669,000, while goods-producing ones rose 138,000.
(6) Jobless claims. In recent weeks, the number of initial unemployment claims has been hovering around 200,000 (Fig. 11). Just before the pandemic, jobless claims was fluctuating around 215,000.
(7) Job survey. According to the Conference Board’s December survey of consumer confidence, the labor market remains strong, as 55.1% of consumers said jobs were “plentiful,” down from 55.5% but still a strong reading historically. In addition, 25.1% of consumers expect more jobs to be available in the months ahead, up from 22.8%.
(8) Purchasing managers. December’s PMI surveys showed solid employment indexes, with manufacturing at 54.2 and nonmanufacturing at 54.9 (Fig. 12).
(9) Small businesses. In November, a near-record 49% of small business owners had job openings (Fig. 13).
US Labor Market II: Wage-Price Spiral? Over the past 12 months through December, average hourly earnings (AHE) of production and nonsupervisory workers rose 5.8%, while the PCED rose 5.7% though November. That’s a wage-price spiral. However, it isn’t as bad as what happened from the early 1970s through the mid-1990s when prices rose faster than wages, depressing the purchasing power of workers (Fig. 14). Productivity growth collapsed during the 1970s.
Since 1995, the real hourly wage for production and nonsupervisory workers has been on an upward trendline tracking a compounded annual growth rate of 1.2%. Over the past year, real wage growth has stalled but remains on the uptrend and in record-high territory. Debbie and I attribute the ups and downs in the rate of real wage growth mostly to the ups and downs in the rate of productivity growth (Fig. 15).
We are bullish on the outlook for productivity. We believe that demographic factors are behind the chronic shortage of labor. During December, the working-age population and the labor force rose just 0.4% and 0.3%, respectively, on a y/y basis using the 12-month average of each series (Fig. 16).
US Labor Market III: High and Low Wages. There is no shortage of stories about labor shortages. There are also plenty of stories about employers raising the wages they pay to keep their employees and to attract new ones. Nevertheless, as in all matters related to the US labor market, there are lots of shades of gray. Consider the following:
(1) Wage measures. The most widely followed measure of hourly wages is average hourly earnings for all workers. The series is released every month in the Employment Report prepared by the Bureau of Labor Statistics (BLS). Economists typically monitor it on a y/y basis. It has been extremely volatile during the pandemic because it is very sensitive to the composition of employment (Fig. 17). So when lots of lower-wage workers lost their jobs during the 2020 pandemic lockdown, AHE for all workers showed a misleadingly large 8.2% increase during April because there were fewer workers reflected in AHE.
A less volatile series that has been highly correlated with AHE on a y/y basis is the wage growth tracker (WGT) compiled monthly by the Atlanta Fed. The latter isn’t as sensitive to the composition of employment. It is provided as a three-month and a 12-month moving average.
During December, the AHE measure for production and nonsupervisory workers was up 5.8% y/y, while the WGT measure (on a three-month basis, yearly percent change) was 4.3%.
(2) AHE. When the employment report is released, Debbie and I calculate our Earned Income Proxy, as discussed above. Since the start of the pandemic, we have also been closely tracking the AHEs of lower-wage and higher-wage workers (Fig. 18). The BLS provides AHE series for all workers and for production and nonsupervisory workers, who account for about 80% of payroll employment. We derive a series for higher-wage workers using the two.
During December, the AHEs for lower- and higher-wage workers rose 5.8% y/y and 2.4% y/y, respectively. The PCED inflation rate during November was 5.7%. So the former were just barley keeping up with inflation, while the latter were falling behind.
Here are the December y/y percentage changes in AHEs for all workers and for production and nonsupervisory workers by major industries sorted by highest to lowest for all workers: leisure & hospitality (14.1%, 15.8%), professional & business services (6.2, 7.3), transportation & warehousing (5.6, 8.4), retail trade (5.4, 6.9), financial activities (4.9, 4.1), wholesale trade (4.8, 5.6), education & health services (4.7, 6.6), construction (4.6, 5.3), utilities (4.6, 5.0), manufacturing (4.4, 5.2), natural resources (3.3, 5.8), and information services (2.4 & 2.3). (See our Average Hourly Earnings By Industry chart book.)
(3) WGT. According to the WGT measure of wages, only the 16-24 age cohort has been beating the rate of inflation over the past year (Fig. 19). Their WGT rose to 10.1%. The other age groups aren’t benefitting from the shortage of labor, with wages up 3.8% for the 25- to 54-year-old group and 2.2% for the 55 and older group.
The 12-month WGT rates by industries were all under 4.0% through November (Fig. 20). The industries with the most widely recognized labor shortages—namely, leisure and hospitality (3.8%) and trade and transportation (3.8%)—showed no signs of wage pressures in the WGT, but that’s because they are 12-month moving averages. By the way, it’s obvious why quits are at a record high: The three-month WGT for job switchers was 5.2% in November, but 3.8% for job stayers (Fig. 21).
Movie. “King Richard” (+) (link) is a biopic about Richard Williams, the father of tennis superstars Venus and Serena Williams. He recognized his daughters’ potential for tennis greatness when they were in their teens. He trained them and mapped out a plan for their success. That included moving the family from Compton, California, where the girls trained on a public tennis court, to Florida to train with a top coach to sharpen their skills. Along the way, Williams defied convention, insisting that his daughters skip playing in the juniors and go straight to the pros, once they were old enough and ready to do so. He wanted them to enjoy their childhood. In many ways, the Williams’ family story is the classic tale of the American Dream. Venus and Serena served as executive producers of the film, which stars Will Smith in the title role.
All Things Tech
January 6 (Thursday)
Technology I: A Smaller CES Kicks Off. Though a day shorter this year amid Omicron’s rampage, CES—the Consumer Technology Association’s annual trade show being held on January 5-7 in Las Vegas—is still full of product introductions large and small, silly and substantial. Here are a few that caught our attention:
(1) Autos dominate. One of the bigger surprises came from Sony, which introduced Sony Mobility, a company that it’s starting to develop electric vehicles. Last year, Sony introduced the Vision-S, an electric sedan, and this year it revealed an electric SUV.
Mercedes Vision EQXX theoretically has won the mileage wars—so far. The concept car can travel 620 miles on a charge according to computer simulations. The car doesn’t yet exist in the real world nor does it have a theoretical price tag. But if the simulations prove correct, the car’s mileage would top that of Tesla Model S (402 miles on a charge) and the Lucid Air Dream (520 miles). But for right now, the Vision EQXX is only in our dreams.
John Deere doesn’t make cars, but it did introduce an autonomous tractor at CES that’s controlled by an app on a cell phone. The company has sold self-driving tractors in the past, but these new tractors are fully autonomous. They don’t require a farmer to sit in the cab as the tractor tills the fields.
The productivity gains could be substantial. One farmer explained that Deere’s autonomous tractor can operate all night long, allowing him to do more and get ahead of bad weather, a January 4 CNET article reported. Autonomous tractors also solve the labor shortage most farms are facing.
(2) Lots of semi news. AMD CEO Dr. Lisa Su kicked off CES, which has seen a flood of new chip introductions. AMD launched Ryzen 6000 laptop processors, the first to include Microsoft’s new Pluton security processor. The company also rolled out new chips for thin gaming laptops, competing with Nvidia chips.
The chip companies are elbowing into each other’s territories, a January 4 Los Angeles Times article observed. Intel offered Arc graphics chips that also targeted AMD’s and Nvidia’s market. Qualcomm has developed chips for autos and PCs, expanding beyond its mobile phone domain. Nvidia introduced high-end gaming graphics chips for laptops.
CES once again highlighted the growing need for semiconductor chips as more everyday items get “smarter.” Global semiconductor sales were $49.7 billion in November using the three-month moving average, up 23.5% y/y and up 1.5% m/m, the Semiconductor Industry Association reported on January 3 (Fig. 1). Sales growth slowed modestly from its peak of 30.4% growth in June.
Semiconductor chip sales were strong in November all around the world: Americas (28.7% y/y), Europe (26.3), Asia Pacific/All Other (22.2), China (21.4), and Japan (19.5). Month-to-month sales were strong as well: Americas (4.2% m/m), Europe (3.1), Japan (1.1), Asia Pacific/All Other (0.9), and China (-0.2).
Global semiconductor sales and S&P 500 Semiconductor industry earnings have risen in lockstep over the past two years (Fig. 2). Analysts are slightly more conservative in their 2022 forecasts, targeting a revenue increase of 11.1% but an earnings increase of only 7.4%, down from the projected 37.8% surge enjoyed in 2021 (Fig. 3 and Fig. 4). With the industry’s forward P/E higher than it has been over the last decade, at 24.5, semi stocks might be ready to take a breather over the coming year.
(3) Peering into the metaverse. If the metaverse stands a chance of going mainstream, someone needs to invent a better headset than the clunky ones currently available. Kura’s Gallium AR headset may be the answer. Though pricey at $1,199, the Gallium looks more like glasses than a bulky head device. TechRadar called Gallium AR “the most promising AR headset yet,” in a December 23 article.
(4) Harnessing the sun. GAF Energy, a division of roofing materials company GAF, introduced Timberline Solar, solar panels that it says can be installed by any roofer with a nail gun, a January 3 TechCruch article reported, dramatically reducing installation costs. From pictures, they appear to lie flush against the roof—an aesthetic improvement over older solar panels, which stick up above the roof shingles around them, but not as aesthetically pleasing as Tesla’s solar panels, which actually are the roof shingles.
On a much smaller scale, Samsung introduced the Eco Remote, a remote that charges by harvesting “the RF signals from your router” or via solar energy from the sun or the end-table lamp.
(5) Silly but useful. Petnow has an app that identifies a dog by its nose print. Like human fingerprints, dogs’ nose prints are unique to each individual. The app can be used to identify lost dogs, eliminating the need to implant a chip.
Sengled is offering a smart lightbulb that monitors a person’s health by tracking sleep, heart rate, body temperature, and other vital signs using a radar sensor, a January 4 Tom’s Guide article explains. It may even sense whether someone has fallen and can’t get up.
Atomic Form is offering the Wave, which looks like a digital picture frame in which one’s NFTs, or non-fungible tokens, can be displayed. The Wave displays NFTs in various ways that users control (e.g., multiple NFTs might rotate), and it connects to the Atomic Form Hub, where NFTs can be stored and organized.
Technology II: A Look at the Data. Since late last year, technology shares have underperformed the shares of more traditional companies. From the start of 2022 through Wednesday’s close, the tech-heavy Nasdaq has fallen 3.5%, while the Dow Jones Industrial Average has gained 1.9% and the S&P 500 has eased 1.4%. Wednesday’s selloff gained speed after the Federal Reserve’s minutes from its December meeting indicated that the Fed is ready to raise interest rates and reduce its bond holdings this year. Treasury yields rose, and stock markets sold off on the news, with the Nasdaq falling the most.
Last year, the S&P 500 led for most of the year and the Nasdaq and the Dow duked it out for second place, trading positions a number of times during the year. By the time the New Year’s Eve ball dropped, the S&P 500 was up 26.9% for 2021, the Nasdaq was in second place with a 21.4% gain, and the Dow came in last, up 18.7%.
The S&P 500 Technology sector index was near the top of the sector leader board last year, rising 33.4% (Fig. 5). It was the third best-performing S&P 500 sector, trailing only Energy (47.7%) and Real Estate (42.5%). The sector enjoyed a trifecta of revenue growth, margin expansion, and earnings growth, while its forward P/E remained mostly unchanged on the year (“forward P/E” is the valuation multiple based on “forward earnings,” or the time-weighted average of industry analysts’ consensus estimates). Let’s dive into the numbers:
(1) A banner bottom line. The S&P 500 Technology sector’s revenue climbed a projected 18.0% in 2021, and analysts forecast another strong year in 2022, with 9.3% revenue growth (Fig. 6). The sector’s margins—which Joe calculates from analysts’ estimates for revenues and earnings—widened throughout much of last year, hitting an implied 24.9% at year-end, up from 22.4% at the start of January 2021 (Fig. 7). Margin improvement and revenue growth combined to deliver an estimated 37.1% earnings growth last year, and analysts are optimistic that earnings will improve again this year by 10.2% (Fig. 8).
As the Tech sector’s earnings improved, however, its forward P/E barely budged, ending the year at 28.5, up modestly from 27.5 at the start of the year (Fig. 9).
(2) Broad tech industry outperformance. Of the 13 S&P 500 Technology industries we track, the stock market performance of seven beat the S&P 500 in 2021, five had returns north of 40%, and only one ended the year in negative territory.
Here’s the performance derby for the S&P 500 Technology industries’ 2021 stock price returns: Semiconductor Equipment (56.6%), Systems Software (49.2), Communications Equipment (47.7), Electronic Equipment & Instruments (47.5), Semiconductors (47.5), IT Consulting & Other Services (36.1), Technology Hardware, Storage & Peripherals (34.4), Electronic Manufacturing Services (23.8), Electronic Components (21.1), Application Software (19.8), Internet Services & Infrastructure (14.6), Technology Distributors (1.6), and Data Processing & Outsourced Services (-4.7).
(3) A look ahead at earnings. The S&P 500 Technology sector’s 2022 earnings growth is expected to slow from last year’s results, but still grow faster than the S&P 500’s. Here’s the performance derby for the S&P 500 sectors’ 2022 earnings forecasts: Industrials (36.2%), Consumer Discretionary (29.8), Energy (28.1), Information Technology (10.2), S&P 500 (8.7), Health Care (6.6), Communications Services (6.4), Consumer Staples (6.3), Materials (3.9), Utilities (3.1), Financials (-8.6), and Real Estate (-8.6).
Six S&P 500 Technology industries are expected to have faster earnings growth than the S&P 500 and only one industry—Technology Hardware, Storage and Peripherals (home to Apple)—is expected to lag by a significant amount. The Semiconductor Equipment industry’s growth continues to be faster than most as semiconductor companies scramble to add capacity. Earnings in the Semi Equipment industry grew 26.5% in 2020 and are forecast to climb 57.5% in 2021 and 25.5% this year.
Here’s the performance derby for the S&P 500 Tech industries’ 2022 earnings growth: Semiconductor Equipment (25.5%), Data Processing & Outsourced Services (18.0), Systems Software (14.0), Application Software (11.5), IT Consulting & Other Services (11.2), Electronic Equipment & Instruments (9.2), Electronic Manufacturing Services (8.7), S&P 500 (8.7), Communications Equipment (7.6), Internet Services & Infrastructure (8.1), Semiconductors (7.4), and Technology Hardware, and Storage & Peripherals (4.7).
Disruptive Technologies: AI in China. Last week, one of China’s largest artificial intelligence (AI) companies, SenseTime, went public in Hong Kong. Its founder Tang Xiao’ou and his students at the Chinese University of Hong Kong developed an algorithm in 2014 that identified faces with 98.5% accuracy. It exceeded the accuracy of human eyes and all other facial recognition algorithms on the market at the time. The company along with competitors Megvii, Cloudwalk Technology, and Yitu Technology are called “the four dragons” of China’s AI and computer vision industry.
SenseTime’s road to a public listing wasn’t straight. Prior to pricing the IPO, the US Department of Treasury placed SenseTime on a blacklist of Chinese companies that support China’s military, which meant that US investors could not participate in the offering. The company was already on the US Commerce Department’s Entity List, which prohibits it from doing business with American companies without a license.
The US alleged that SenseTime’s facial recognition software was used to suppress the Uyghurs in western China. SenseTime disputed the claims, having sold its 51% stake in a “smart policing” joint venture in Xinjiang in 2019. After amending IPO documents, the $744 million offering went forward, with the shares pricing at HK$3.85 at the end of December. Since then, they’ve more than doubled to HK$7.74 as of Tuesday’s close.
Given the importance of AI and the controversy, we decided to take a deeper look at the company that’s sometimes called “the Google of China”:
(1) Harnessing AI for good. SenseTime, like others in the AI arena, is harnessing its technology to make life easier. Its facial recognition technology is being connected to digital wallets to make purchases faster. SenseTime supplies autonomous driving technologies to Japan-based Honda Motor. It has expanded into virtual reality mobile apps. Its software has been used to screen for Covid by checking body temperature at restaurants, gyms, and offices and for proper mask-wearing by scanning faces in several Chinese cities.
SenseTime also provides traffic-flow optimization, fire detection, and other technologies to 119 cities, mostly in China. “In one city, its systems are being used to detect people not wearing seat belts in cars, with a claimed precision rate of 94 per cent. It can also spot drivers who are using mobile phones with 86 to 96 per cent accuracy. In another top-tier city … SenseTime’s traffic management system logged traffic violations by people on mopeds [which] dropped by more than half in just a couple of months. The number of drivers choosing to wear a helmet, meanwhile, rose from under half to 94 percent,” a September 28 FT article reported.
(2) Going global. SenseTime’s reach is expanding around the world. Wendy’s restaurants in Japan are using SenseTime technology licensed by Japan Computer Vision (JCV), a wholly owned subsidiary of Softbank, a SenseTime investor. JCV owns an equity stake in US startup PopID, which runs PopPay, an online payment service. PopPay uses SenseTime technology to match a customer’s face and a registered photo to complete payments at Wendy’s touchscreen panels in Japan, a December 15 Nikkei Asia article reported. All customer information is stored in Japan and not shared with the Chinese government.
In 2019, the company announced a new EMEA R&D headquarters in Abu Dhabi that focuses on developing AI capabilities across seven industries, including healthcare, remote sensing, and education. Last year, the country announced 15 charter schools would use SenseTime facial recognition technology, crowd management monitoring, and augmented reality features to make the schools safer and healthier. The tech will call out bullying and track compliance with Covid-19 precautionary procedures. If the pilot program goes well, it could be deployed across all charter schools.
SenseTime and G3 Global have entered a partnership to bring and develop AI in Malaysia. The deal includes developing a $1 billion, 315-acre park where AI solutions in computer vision, speech recognition, and robotics will be developed. In addition, SenseTime’s curriculum will be brought to Malaysia’s schools to develop in students the skills needed for AI work.
(3) Harnessing AI for evil. The same facial recognition that’s being used to pay at Wendy’s can also be used by governments to target ethnic minorities. While the Chinese government and Chinese AI companies say they aren’t doing so, the patents they’ve filed indicate otherwise.
A number of Chinese firms have filed patents to protect their “ethnicity-tracking biometrics,” according to a January 12, 2021 article by IPVM, a self-described agency that provides information about and advocates for ethical practices in video surveillance. SenseTime filed a patent on July 2019 for a “method and device for retrieving images.”
The SenseTime “method” can categorize people by ethnicity, determining whether they are Han, Uyghur, non-Han, non-Uyghur, and unknown, the patent states according to the article. The patent uses an Uyghur man as an example of a target image, allowing users to input several values—such as Uyghur, sunglasses, beard, and male—into the system to find a person with the same attributes.
SenseTime said: “This particular AI research includes facial recognition of all ethnicities without prejudice. The reference to Uyghurs is regrettable and is one of the examples within the application intended to illustrate the attributes the algorithm recognizes. It was neither designed nor intended in any way to discriminate, which is against our values.”
SenseTime was not alone. Huawei and Chinese AI software startups Megvii, Intellifusion, and SensingTech each had patents on AI software or systems that referenced the ability to identify Uyghurs and/or other people’s ethnicity. When asked for comment, Huawei said that it would take out the patent’s reference to race and that identifying people by race was “never part of the research and development project.” Megvii said the patent “is in no way an intention to develop ethnic identification solutions” and told the BBC it would withdraw the patent. Intellifusion and SensingTech didn’t respond to the article’s author’s requests for comment.
(4) Some numbers. SenseTime reports that it’s the largest AI software firm in Asia, with an 11% market share, but the company is still in the red. It spent $278 million on R&D during H1-2021, more than the $259 million of revenue it generated, a December 30 WSJ article reported. Revenue increased 13.9% y/y in 2020 to $534 million, but the company reported a loss. The company blamed Covid for slowing revenue growth from 63% y/y in 2019, an August 31 article in Protocol reported.
SenseTime’s revenue is concentrated, particularly among Chinese governments. Its five biggest customers generated almost 59% of SenseTime’s H1-2021 revenue, and mainland Chinese customers kicked in more than 85% of H1-2021 revenue, a December 30 WSJ article reported. Large early investors include SoftBank Group, Alibaba Group Holding, and Silver Lake.
Covid-19, Mag-8, And FOMC-19
January 5 (Wednesday)
US Economy: Is Inflation Peaking Already? Last year, during his November 3 and December 15 press conferences, Fed Chair Jerome Powell conceded that inflation was more persistent and less transitory than he had expected. Some contrarians immediately concluded that inflation might turn out to be even more persistent and problematic than Powell acknowledged. The alternative contrarian bet is that inflation will turn out to be relatively transitory after all. Debbie and I are taking this bet.
Needless to say, we were pleased to see that the prices-paid index in December’s M-PMI survey fell to 68.2 from the cyclical high reading of 92.1 during June (Fig. 1). Nevertheless, this is the 16th month in a row that the index has been above 60%. The survey’s press release stated: “Aluminum; corrugate and packaging materials; electrical and electronic components; energy; lumber; freight; and some steels continue to remain at elevated prices due to product scarcity amongst high demand. A [prices-paid] Index above 52.7 percent, over time, is generally consistent with an increase in the Bureau of Labor Statistics (BLS) Producer Price Index for Intermediate Materials.”
Pandemic: Is Covid Peaking Already? Will the rapidly spreading Omicron variant of Covid mark the end of the pandemic? Stock investors certainly seem to think so given that the S&P 500 rose to yet another new record high on Monday, the first trading day of the new year. We agree with them. In any event, while the pandemic may not be over as soon as many of us hope, we certainly are learning to live with it. Consider the following:
(1) Omicron is the fastest-spreading virus known to humankind. Barely a month after its detection in southern Africa, it was already dominant in countries around the world, and there have been more cases than ever before. According to an infectious disease expert at Massachusetts General Hospital quoted in a January 3 El País article, one case of measles would cause 15 cases within 12 days. One case of Omicron would give rise to another six in four days, 36 in eight days, and 216 in 12 days. With current conditions, a simple exponential growth model would show 14 million people infected in 60 days from a single case, compared to 760,000 with measles in a population with no specific defenses, according to the epidemiologist.
(2) Omicron is capable of infecting people who’ve been inoculated with Covid vaccines, but the vaccines still prevent serious disease, as confirmed by a recent study by two Dutch virologists mentioned in the El País article. By one estimate, the new variant is 25% less severe than the Delta variant, identified in India a year ago, in people who have not been vaccinated or previously infected.
Six preliminary studies suggest that Omicron is able to invade the upper respiratory tract more easily than Delta but is less effective at infecting the lungs. That would explain its higher contagiousness and lower mortality. One very small study, published on December 27, suggests that Omicron infection protects against Delta infection.
(3) Investors are clearly hoping that Omicron will set the stage for the pandemic to turn endemic. In combination with vaccinations, it might lead to enough herd immunity so that the pandemic ends the way wild brushfires stop spreading. Some immunologists expect that the human immune systems will continue to get better at recognizing and fighting back. The hope is that Covid becomes more like the common cold or the seasonal flu.
(4) Meanwhile, the wildfire is raging. In the US, the number of new cases rose to a new record high at the end of last year, slightly exceeding last year’s peak (Fig. 2). Hospitalizations remain below the peaks of the previous two waves, but they are rising.
The Mag-8: Will They Remain Magnificent in 2022? On Monday, Apple became the first company to cross the $3.0 trillion market capitalization mark, even if for only a moment. Bloomberg reported that the tech giant will be launching lots of new products in 2022. Also on Monday, Tesla shares soared 13.5% on news that the company delivered 308,600 cars during Q4, as compared to analysts’ expectations of 263,000 units. The market capitalization of Apple and Tesla rose to $2,986 billion and $1,205 billion, respectively, on Monday.
The two companies are in our Magnificent 8 composite of the MegaCap stocks in the S&P 500. The Mag-8 are Alphabet (Google), Amazon, Apple, Meta (Facebook), Microsoft, Netflix, NVIDIA, and Tesla. For quite some time, Joe and I have been chronicling the dramatic impact that they have had on the S&P 500. Here’s an update:
(1) The Mag-8’s market capitalization rose to a record $12.1 trillion at the end of last year, up from $1.2 trillion at the start of 2013 (Fig. 7). They accounted for 25.7% of the market cap of the S&P 500 at the end of last year, up from 7.3% at the start of 2013 (Fig. 8).
(2) The market cap of the S&P 500 was up 222.1% from the start of 2013 through the end of 2021 (Fig. 9). Over this same period, the market cap of the S&P 500 excluding the Mag-8 was up 158.2%. In other words, these eight stocks have accounted for 29% of the market cap gain in the S&P 500 since the start of 2013.
(3) The Mag-8 are all in the S&P 500 Growth index. However, they are not all in the S&P 500 Information Technology sector. Only Apple, Microsoft, and Nvidia are in this sector, and they accounted for 52% of its market cap at the end of last year. Alphabet, Meta, and Netflix are in the Communication Services sector and accounted for 47% of its market cap at the end of last year. Amazon and Tesla are in the Consumer Discretionary sector and accounted for 44% of the sector’s market cap at the end of last year.
(4) Here were the market capitalizations of the individual Mag-8 stocks at the end of last year: Apple ($2,913 billion), Microsoft ($2,525 billion), Alphabet ($1,921 billion), Amazon ($1,691 billion), Tesla ($1,061 billion), Facebook ($936 billion), and Nvidia ($735 billion).
(5) At the end of last year, the industry analysts who follow these stocks projected that their revenues and earnings will increase 14.8% and 9.7% over the next 12 months. Those are relatively high growth rates, but they are realistic (Fig. 10).
The Mag-8’s forward profit margin at the end of last year was 20.4% with Amazon and 27.8% without Amazon (Fig. 11). The forward profit margin of the S&P 500 was 13.2% with the Mag-8 and 12.5% without them.
(6) Needless to say, the Mag-8 stocks aren’t cheap. Their collective forward P/E was 33.8 at the end of last year compared to 21.3 and 18.6 for the S&P 500 with and without them (Fig. 12).
FOMC: Which Fed Heads Rotate? It’s time for the annual member rotation of the 19-seat Federal Open Market Committee (FOMC). On January 25 and 26, the FOMC will gather for its first monetary policy meeting of the new year. The presiding Fed governors and the president of the New York Federal Reserve Bank (FRB) will retain their permanent voting status on the FOMC. However, as is annual tradition, the four rotating regional FRB presidents with FOMC voting rights will be replaced with new ones, though all 12 of the regional FRB presidents will continue to participate in the FOMC meetings.
In the past, the FOMC started to tighten monetary policy when the committee judged that inflationary pressures were starting to heat up. Such anticipatory moves didn’t happen at the Fed this time around for a couple of reasons. As we’ve often discussed, the August 2020 update of the FOMC’s overriding “Statement on Longer-Run Goals and Monetary Policy Strategy” put the employment goal ahead of inflation. Additionally, the Fed has adopted a new approach to targeting inflation, which favors overshooting its long-standing goal of 2.0% annually to make up for previous inflation misses, a strategy dubbed “Flexible Average Inflation Targeting” (FAIT). We call it “FAITH,” tacking on an “H” for “hope” at the end.
The Fed had “hoped” that they could bring inflation back under control after letting it run wild, but that strategy hasn’t been working out so well. As a result, most current Fed officials, including those FRB presidents who are rotating in as voters, have shifted to the hawkish view that policy needs to tighten to curb inflation now. However, the hawks may be muted if US President Joe Biden nominates more “dovish” progressive-leaning counterparts to the open Fed governors’ seats, as we expect he’ll do at some point. The President has expressed his commitment “to improving the diversity in the Board’s composition,” but failed to make nominations in early December as previously intended.
Biden did make good on his word to nominate a Fed chair by the end of last year, renominating incumbent Fed Chair Jerome Powell. Under Powell’s continued leadership, tightening likely will remain the course of policy for 2022. The rapid spread of the Omicron variant could slow things down a bit, but the latest Fed consensus is that it’s time to end the Fed’s period of easy monetary policy and raise interest rates. Consider the following:
(1) New voting Fed heads. New to the voting block for 2021—but not new to their roles as FRB presidents—are James Bullard (St. Louis, 2008), Esther George (Kansas City, 2011), Loretta Mester (Cleveland, 2014), and whomever is appointed to the open president’s post in Boston. Kenneth Montgomery is the Boston FRB’s interim president, succeeding former Boston FRB President Eric Rosengren. “According to Fed practice, Philadelphia Fed President Patrick Harker, generally viewed as a centrist on monetary policy, will likely substitute for the Boston leader as an FOMC voter until the Boston Fed has a new president,” reported the WSJ.
(2) Vacant Fed heads. In addition, US President Joe Biden likely will have three out of seven Fed board governors to appoint. Those include the open seat left by Randal Quarles during 2021 and the one that Richard Clarida, vice chair of the FRB, is expected to vacate when his term ends at the end of January. The Fed board has operated with at least one open slot for the past eight years. Quarles’ seat is particularly important because it includes the double duty of Fed governor and the lead bank supervisory role at the Fed. Rosengren’s and Quarles’ resignations were announced in 2021 amid controversy over their trading activities at the height of the pandemic. Clarida was also accused of misconduct. Dallas FRB President Robert S. Kaplan also left his position as a result of the controversy, but the Dallas president doesn’t vote during 2022 anyway.
(3) Hawkish Fed heads. During a December 3 speech, Bullard noted: “The FOMC at upcoming meetings may want to consider removing accommodation at a faster pace.” In a November 5 speech, George stated: “It is also clear that the risk of a prolonged period of elevated inflation has increased. The argument for patience in the face of these inflation pressures has diminished.” In a December 1 Bloomberg interview, Mester said: “I do think that we have to be in a position that if we need to raise rates a couple of times next year, we’re able to do that.” This hawkish chorus of voters rotating in is likely to be joined by Fed Governor Christopher Waller, who turned heads when he said in a December 17 speech: “Turning to inflation, it is alarmingly high, persistent, and has broadened to affect more categories of goods and services, compared with earlier this year.”
(4) Dovish Fed head candidates. Nevertheless, the pack of hawks could be muted if, as we expect, Biden nominates more dovish counterparts into the open governor seats. The WSJ reported on Friday that Biden could appoint former Fed Governor Sarah Bloom Raskin to the supervisory role and Michigan State University Professor Lisa Cook and Davidson College Professor Philip Jefferson to the other two Fed governor positions.
Treasury Secretary Janet Yellen reportedly had considered Raskin to head the US Treasury’s new climate hub. In Raskin’s former role as deputy Treasury secretary in the Obama administration, following when she worked alongside Yellen as a Fed governor, Raskin warned in interviews and speeches that US regulators must do more to strengthen the financial system’s resilience to climate risks.
(5) Fed-head-in-chief. Controversially, Biden announced his intent to nominate Fed Chair Powell for an additional four-year term November 22 as well as to nominate Fed Governor Lael Brainard as vice chair. That followed accusations of the previously mentioned ethics violations, which didn’t involve Powell personally but did occur on his watch.
Senator Elizabeth Warren (D-MA) blasted the Fed chair at a hearing in October, calling him a “dangerous man to head up the Fed.” Warren has opposed Powell’s perceived relaxed view on bank supervision. Biden said that he picked Powell because he “provided steady leadership during an unprecedently challenging period,” communicating respect for the Fed’s political independence. Brainard reportedly had been considered as a replacement to Powell but ended up with the nod as vice chair. Biden’s expected pick for the supervisory role, Raskin, is expected to appease Warren.
In any event, the leader of the Fed heads is heading toward tightening. In a December 15, press conference, Powell said: “We’re in a position where we’re ending our taper by March, in two meetings, and we’ll be in a position to raise interest rates as and when we think it’s appropriate.” The Fed also signaled that it likely will raise interest rates by about 75 basis points before the end of 2022 in its latest Summary of Economic Projections. Each of the 18 officials submitting expectations saw rates rising in 2022, and most of them saw three 0.25ppt increases.
Bonds Have More Fun With Old People
January 4 (Tuesday)
Bulletin Board. Don’t forget to listen to replays of Dr. Ed’s Monday webinars if you miss the live events. A few of our accounts who are influential alumni of their alma maters have joined my effort to promote my latest book In Praise of Profits! among college and business students to enlighten them about entrepreneurial capitalism. Let me know if you would like to join our campaign. You can download a complimentary copy of the book here.
Bonds I: Back to Normal In 2022? Among the biggest surprises in 2021 was the bond market. Lots of the traditional drivers of the 10-year US Treasury bond yield strongly suggested that the yield should rise to at least 2.00%, if not 2.50%. Yet last year’s high was 1.74% on March 31 (Fig. 1). It’s been mostly hovering around 1.50% since then even though inflation has turned out to be higher and more persistent than widely expected (Fig. 2).
The Fed has responded to that inflation surprise by moving faster to taper its bond-purchasing program, setting the stage for as many as three rate hikes this year and sooner rather than later. Reflecting these rising expectations for rate hikes, the spread between the 2-year Treasury note yield and the federal funds target rate has widened from near zero during the first half of 2021 to 61bps at the end of last year (Fig. 3 and Fig. 4).
At the beginning of last year, Debbie and I predicted that the bond yield would rise to 2.00% by the end of the year. That forecast seemed to be on track during the first three months of the year. But then the yield fell and fluctuated around 1.50% the rest of last year. In mid-2021, we reeled in our year-end target to 1.50%. Now 2.00% is our year-end 2022 target. We won’t rule out 2.50%, which is still quite low relative to our 3%-4% inflation forecast for the second half of this year, as we discussed on Monday.
When the bond yield went off track over the second half of 2021, we posited that massive bond purchases by the Fed and commercial banks might explain why bond yields remained low (Fig. 5). However, the yield remained around 1.50% through the end of 2021 even after the Fed announced its tapering program on November 3 and accelerated the tapering schedule on December 15. Then again, the yield started the new year off by rising to 1.64%.
Another possibility is that near-zero 10-year government bond yields in Germany and Japan are providing some gravitational pull on US bond yields (Fig. 6). We are coming around to believe that perhaps the best explanation for the abnormal behavior of the bond market might be the Age Wave. Consider the following:
(1) Bearish economic indicators. The most bearish indicators for the bond market have been all the uniformly ugly inflation statistics. For example, last year, the y/y CPI inflation rate rose above 2.0% during March. By November, it was up to 6.8%. The copper-to-gold price ratio has been hovering around 2.50% since late April of last year (Fig. 7). The V-shaped recovery in the M-PMI since summer 2020 should have been more bearish for bonds as well last year (Fig. 8).
(2) Bullish geriatric demographics. In my book Predicting the Markets (2018), I recounted explaining during the 1980s why a strong correlation might exist between the “Age Wave” and both inflation and the bond yield. The Age Wave is the percentage of 16- to 34-year-old people in the labor force (16 and older). It rose from 37% during 1962, when the oldest Baby Boomers turned 16, to peak at 51% during 1980, when the youngest ones turned 16. The oldest of them turned 65 during 2011, and the youngest will do so in 2029. The Age Wave percentage fell to a low of 35%–36% from 2011 through 2021 (Fig. 9).
The growth rate in the civilian noninstitutional working-age population (based on the y/y percent change in the 12-month average) fell to 0.4% during November—the lowest since the early 1950s (Fig. 12). The labor force was flat on the same basis. We expect that business managers will continue to respond to chronic labor shortages by boosting their spending on productivity-enhancing capital equipment and technologies. That should help to moderate inflation and keep a lid on bond yields.
Bonds II: More Bullish Demographic Trends. From an Age Wave perspective, the most bullish demographic trends in the world for bonds have been unfolding in Japan for several years. The country’s population has been falling over the past 10 years (Fig. 13). Deaths have exceeded live births since July 2007 (Fig. 14). Over the past 12 months through July, deaths in Japan exceeded births by 504,000. The population of people 14 years old or younger has dropped from 24.7 million at the end of 1988 to 15.5 million at the end of 2021. The labor force there has been essentially flat since the late 1990s. The 10-year Japanese government bond yield has been hovering around zero since late 2016.
The US seems to be following Japan down the same demographic path:
(1) As noted above, US population growth is close to zero. Live births still exceed deaths, though barely owing to Covid (Fig. 15). Deaths should decline as the pandemic abates. But births have been in a downtrend since they peaked at a record 4.33 million, on a 12-month basis, during February 2008. They were down to 3.58 million during June 2021.
(2) One of the reasons that Americans are having fewer babies is that they are getting married later in life. The median age at first marriage during 2020 was 30.5 years old for men and 28.1 years old for women (Fig. 16). Both are record highs. The median age of the population rose to a record high of 38.3 years during 2020 (Fig. 17).
(3) As a result, the percent of the working-age population that is single, was 51.3% in November, holding near September’s record 51.5%, with never married people at 32.3% and 19.1% accounting for all other singles (Fig. 18).
And what do older folks like to do with their spare change? Some invest in stocks and real estate. The big surprise is that even though bond yields are historically low, they like to invest in bonds. How else to explain the record inflows into bond mutual funds and ETFs during 2021 (Fig. 19)?
Stocks I: Best and Worst S&P 500 Industries in 2021. We start every year by singing “Auld Lang Syne,” which is Scottish for “days gone by.” As we start 2022, let’s review which sectors and industries led and especially lagged the S&P 500 in 2021, as some of the latter might make good possible contrarian bets for this year.
Here is the performance derby of the 11 sectors of the S&P 500 during 2021: Energy (47.7%), Real Estate (42.5), Information Technology (33.4), Financials (32.5), S&P 500 (26.9), Materials (25.0), Health Care (24.2), Consumer Discretionary (23.7), Communication Services (20.5), Industrials (19.4), Consumer Staples (15.6), and Utilities (14.0). Now here are the best- and worst-performing industries in each sector (see our 2021 performance derby tables for the S&P 500 and its sectors and industries):
(1) Consumer Discretionary: Automotive Retail (58.4%) & Casinos & Gaming (-11.7%)
(2) Consumer Staples: Food Retail (42.5) & Brewers (2.6)
(3) Energy: Exploration & Production (81.4) & Equipment & Services (25.4)
(4) Communication Services: Interactive Media & Services (46.8) & Interactive Home Entertainment (-19.9)
(5) Financials: Investment Banking & Brokerage (48.9) & Property & Casualty Insurance (15.6)
(6) Health Care: Health Care Facilities (43.9) & Biotechnology (9.3)
(7) Industrials: Human Resource & Employment Services (78.5) & Airlines (-1.8)
(8) Information Technology: Semiconductor Equipment (56.6) & Data Processing & Outsourced Services (-4.7)
(9) Materials: Steel (114.6) & Commodity Chemicals (1.6)
(10) Real Estate: Real Estate Services (73.0), Hotel & Resort REITs (18.9)
(11) Utilities: Water Utilities (23.1) & Independent Power Producers & Energy Traders (3.4)
Will the first come in last and the last come in first during 2022? Plausible arguments can be made for this to happen in some of the sectors.
Stocks II: The Best in the World in 2021. Joe and I have been recommending overweighting the US in global equity portfolios almost since the start of the bull market in 2009. So far, so good. Here is the performance derby of the major MSCI stock price indexes in local currencies and in US dollars since March 9, 2009 through the end of last year: US (611.8%), Japan (182.8, 142.8), Emerging Markets (179.5, 153.9), EMU (177.9, 150.0), and UK (98.8, 95.8) (Fig. 20 and Fig. 21).
Here is the comparable performance derby for 2021: US (25.2), EMU (20.1, 11.7), UK (15.0, 13.9), Japan (11.4, -0.1), and Emerging Markets (-2.3, -4.6). (See our 2021 performance derby tables for the MSCI global market indexes.)
The outperformance of the US is attributable to several of the S&P 500 sectors. Here is the performance derby for the 11 sectors of the S&P 500 from March 9, 2009 through the end of last year: Information Technology (1,430.6%), Consumer Discretionary (1,181.2), Financials (676.0), Real Estate (631.1), S&P 500 (604.5), Industrials (573.8), Health Care (549.1), Materials (423.5), Utilities (219.6), Communication Services (203.6), and Energy (36.0) (Fig. 22 and Fig. 23).
During 2021, in local currency, the global winner among the 56 MSCI stock price indexes we monitor was the Czech Republic with a 52.0% gain, while the biggest global loser was China (-22.7%). Contrarians are recommending overweighting China this year. At the risk of never going to China again, I think it’s clear that the Chinese Communist Party has been turning increasingly totalitarian, which is extremely bad news for China’s people and for foreign investors.
January 3 (Monday)
YRI Webinar. Join Dr. Ed’s live Q&A webinar on Mondays at 11 a.m. EST. You will receive an email with the link to the webinar one hour before showtime. Replays are available here.
Strategy I: Santa Delivered the Goods. At the end of last year, Santa outpunched the Grinch tag team of the rapidly spreading Omicron variant of Covid and the more hawkish variant of the Fed. The S&P 500 rose to a new record high of 4793.06 on Wednesday, December 29 (Fig. 1). On an intraday basis, it slightly exceeded our year-end target of 4800. Consider the following:
(1) Omicron takes charge of the pandemic. The number of new positive Covid results soared to 247,844 on December 29, based on the 10-day moving average, the highest since January 15, 2021 (Fig. 2). Hospitalizations rose to 74,235 on December 31, based on the 10-day moving average, the highest since October 1, 2021.
Apparently, investors believe that Omicron, which is spreading like wildfire, may flame out sooner rather than later and provide widespread herd immunity. There are reports that Omicron, which tends to have milder symptoms than previous variants of Covid, may also provide immunity against its predecessors. (This potential upbeat outlook has been confirmed by a few of my doctor friends.)
Investors were also relieved that President Joe Biden backed off from even suggesting that another round of social-distancing restrictions, especially lockdowns, would be mandated by the federal government. Instead, on Monday, December 27, he said: “Look, there is no federal solution. This gets solved at a state level.” That very same day, the Centers for Disease Control and Prevention (CDC) issued the following statement: “Given what we currently know about COVID-19 and the Omicron variant, CDC is shortening the recommended time for isolation from 10 days for people with COVID-19 to 5 days, if asymptomatic, followed by 5 days of wearing a mask when around others.”
(2) The Fed hasn’t spooked the bond market so far. The December 15 statement of the FOMC announced that starting this month, the Fed’s purchases of Treasury and agency mortgage-backed securities will be reduced by $30 billion per month from $120 billion per month (which has been the pace since the start of 2021) to $90 billion this month, $60 billion in February, $30 billion in March, and zero in April.
The end of tapering will set the stage for three 25bps hikes in the federal funds rate over the rest of this year, according to the FOMC’s latest dot plot. At the end of last week, the two-year US Treasury note yield was 0.73% and the 12-month federal funds rate futures was 0.70%, confirming that investors are expecting to see a 0.75% federal funds rate a year from now (Fig. 3).
At the end of last year, stock investors seemed remarkably calm about this outlook. That’s because the prospects of a federal funds rate only 75bps above zero later this year doesn’t seem like a showstopper for economic growth. Of course, much will depend on how the bond market reacts to tighter monetary policy. The 10-year US Treasury yield was remarkably subdued around 1.50% last year despite the jump in inflation (Fig. 4 and Fig. 5).
At the start of 2021, Debbie and I were predicting 2.00% for the bond yield at year-end. It got as high as 1.74% on March 31. In mid-2021, we reeled in our year-end target to 1.50%. Now 2.00% is our year-end 2022 target. The yield-curve spreads between the 10-2 years and 5-2 years notes suggest that bond investors believe that a federal funds rate of 0.75% might be enough to slow down both inflation and economic growth (Fig. 6). For now, we are inclined to agree, though we admit we are doing so mostly because we don’t want to fight the bond market.
(3) Santa’s earnings-led meltup. We started last year with a target of 4300 for the S&P 500 price index. It got there well ahead of schedule on July 1. By mid-2021, we had raised that target to 4800. We reckon that the Santa Claus rally started early this year, i.e., well before Thanksgiving, when the index bottomed at 4300.46 on October 4. It is up 10.8% since then through the end of last year and up 113.0% from its March 18, 2020 bottom. Ho-ho-ho!
The initial meltup from 2021’s bottom was led by an explosive jump in the forward P/E of the S&P 500 from 12.9 at the end of March 2020 to a high of 23.2 during September 2020. Since then, the meltup has been led by forward earnings, i.e., the time-weighted average of analysts’ consensus earnings estimates for this year and next. As shown by our Blue Angels framework, forward earnings continued to rise to a new record high during the December 28 week, while the forward P/E has remained surprisingly elevated in the 20.0-22.0 range since mid-2021 (Fig. 7).
The forward P/E of the S&P 500 has remained remarkably high, mostly because the valuation multiple of the S&P 500 Growth stock price index has been amazingly steady, at around 28.0 since mid-2020 (Fig. 8). That’s very unusual given the surge in the inflation rate and the increasingly hawkish stance of the Fed. We attribute that resilience to the ample liquidity provided by excessively stimulative monetary and fiscal policies since the start of the pandemic, as we discuss after the next section.
US Economy I: 2021 Ended with a Bang. US economic growth ended 2021 with a boom. The boom might continue into this year if the Omicron variant of Covid continues to spread like wildfire, causing the fourth wave of the pandemic to peak within the next few weeks and resulting in widespread herd immunity, as we discussed in the first section. That would boost consumer spending, particularly on services.
Another positive in the outlook is a prospective rebound in motor vehicle production (and sales), assuming that the shortage of semiconductor chips that has weighed on the auto industry eases. Inventory restocking of autos and other durable goods should also fuel economic growth. So should strong capital spending. Here are the latest booming indicators:
(1) US consumers were born to shop. According to Mastercard SpendingPulseTM, holiday retail sales excluding automotive increased 8.5% y/y this holiday season, which ran from November 1 through December 24. Online sales grew 11.0%. Mastercard SpendingPulse measures in-store and online retail sales across all forms of payment. Of course, some of the increase was attributable to inflation.
(2) Q4 real GDP boomed. In any event, the Atlanta Fed’s GDPNow model shows real GDP tracking at a booming annual rate of 7.6% (saar) during Q4, as of December 23. Real consumer spending is tracking at 5.5%, while real gross domestic investment growth is a whopping 16.9%.
(3) Fewer kinks in the supply chain. Supply-chain disruptions don’t seem to be a serious obstacle to growth. In any event, they seem to be receding. In the US, Debbie and I monitor the average of the unfilled orders and delivery times indexes of the regional business surveys conducted by five of the Federal Reserve Banks. This average index peaked at a record 27.3 during May (Fig. 9). It was down to 16.3 during December, the lowest reading since February.
Over in Japan, auto production plunged during the summer and fall as a result of parts shortages. Output soared during November (Fig. 10). Toyota Motor Corp. last week said its global output had bounced back in November to just 1% below last year’s level.
(4) Consumers were happier during the holidays. The Conference Board Consumer Confidence Index increased again in December after an upward revision in November. The Index now stands at 115.8, up from 111.9 in November (Fig. 11). The labor market remains strong, as 55.1% of consumers said jobs were “plentiful,” down from 55.5%—still a strong reading historically (Fig. 12). In addition, 25.1% of consumers expect more jobs to be available in the months ahead, up from 22.8%.
Interestingly, concerns about inflation declined after hitting a 13-year high last month, as did concerns about Covid-19, despite reports of continued price increases and the emergence of the Omicron variant.
(5) Purchasing managers remain upbeat. Markit’s flash US Composite PMI posted 56.9 in December, down slightly from 57.2 in November. Service-sector business activity (57.5) remained strong, with manufacturers (57.8) registering a slight downtick in the pace of expansion in production (Fig. 13).
(6) CEOs are upbeat too. The Business Roundtable’s survey of CEOs shows that their confidence index rose to a record high of 123.5 during Q4 (Fig. 14). This series is a very good coincident indicator of the y/y growth rates of both nominal and real capital spending in GDP. Clearly, CEOs aren’t fretting much about supply-chain disruptions, labor shortages, or rising labor and commodity costs. Instead, they are likely to do what they can to overcome these challenges by spending more on productivity-enhancing capital equipment and technologies. We believe that they are rising to the challenges they face!
US Economy II: More Liquid Liquidity. Why is the economy booming? Why are consumer and asset prices soaring? Since the start of the pandemic, fiscal and monetary policies have been flooding the economy and financial markets with unprecedented liquidity. Debbie and I aren’t worrying that the economy will fall off “fiscal and monetary cliffs” because there still is ample liquidity to keep the economy growing and to boost stock prices to new record highs in 2022. Consider the following:
(1) Since February 2020 through November 2021, M2 is up $6.0 trillion to $21.4 trillion. M2 is now equivalent to almost a year’s worth of nominal GDP. That’s a record. Leading the way higher has been M2’s demand deposit component, which is up $3.1 trillion over this same period to $4.8 trillion (Fig. 15). Demand deposits now account for 22.2% of M2, up from 10.5% during February 2020 (Fig. 16). The M2 measure of liquidity is the most liquid it has been since March 1975!
(2) We estimate that the amount of excess liquidity resulting from pandemic stimulus policies is currently around $3.0 trillion. That’s the difference between the actual level of M2 during November and our extrapolation of the pre-pandemic trend in M2.
(3) Fiscal pandemic stimulus policies swelled the federal government deficit. In fiscal year 2021, which ended on September 30, the federal budget deficit totaled nearly $2.8 trillion—about $360 billion less than the deficit in 2020 but nearly triple the shortfall incurred in 2019, before the pandemic (Fig. 17). This reflected three rounds of “Economic Impact Payments” and lots of other relief and support programs.
(4) The Fed’s balance sheet has expanded by almost $5.0 trillion since the start of the pandemic to a record $8.7 trillion at the end of last year (Fig. 18). Over the past 11 months through November, the Fed purchased $120 billion per month in bonds. It started to taper that pace during December but won’t stop this purchase program until March.
The end of this program and the likely commencement of rate hiking by the Fed could cause the bull market in stocks to stall for a short while. However, there is ample liquidity left from all the rounds of pandemic stimulus to drive stock prices higher next year. The Fed is widely expected to raise the federal funds rate three times next year to 0.75%. That won’t be a surprise, and it’s only 75bps above zero.
US Inflation: Volcker 2.0? We expect the PCED inflation rate, on a y/y basis, to range between 4.0%-5.0% through mid-2022 and to fall into the 3.0%-4.0% range during the second half of 2022 through all of 2023 (Fig. 19). We may have to raise these ranges given that the headline PCED inflation rate rose to 5.7% y/y during November. However, for now, we are sticking with them.
Our relatively optimistic outlook for inflation isn’t based on a Volcker 2.0 scenario, which would be pessimistic for the economy. In 1979 and 1980, Fed Chair Paul Volcker broke the back of the Great Inflation of the 1970s by letting the federal funds rate soar, thus triggering a severe recession. In our Roaring 2020s scenario, rebounding productivity growth should help to avert the kind of inflation problem that occurred during the 1970s, when productivity growth collapsed (Fig. 20). Here are some other disinflationary considerations:
(1) Nondurable goods prices. The core PCED inflation rate at 4.7% y/y during November was still within our range. Food and energy are the main items in the nondurable goods component of the PCED, which rose 7.9% y/y during November, the highest reading since September 2008 (Fig. 21). It tends to be quite volatile along with food and energy prices.
We aren’t expecting the kind of energy-led shock now as occurred twice during the 1970s. We are encouraged to see that US crude oil field production continues to recover (Fig. 22). We are also assuming, of course, that the worst of the pandemic will be over within the next couple of months, or even weeks. A prolongation of the pandemic in 2022 could disrupt the availability of workers in the food processing industry, which would exacerbate shortages and cause food prices to move even higher.
(2) Durable goods prices. The current bout of inflation was triggered by a demand shock caused by excessively stimulative fiscal and monetary policies that, in turn, overwhelmed supplies. The resulting supply shock was especially intense in the markets for durable goods, which rose to 9.7% y/y during November, the highest pace since September 1980.
Durable goods prices have been mostly falling since the mid-1990s. Lots of pent-up demand for durable goods has been satisfied since the end of last year’s lockdown during March and April. That’s not the case for autos, however, where production has been depressed by parts shortages. New and used car prices in the PCED rose 10.8% and 54.0% y/y during November (Fig. 23). As noted above, the sharp rebound in Japanese auto production during November suggests that the auto industry’s parts shortage problem may be abating.
(3) Services prices. In the PCED, services prices rose 4.3% y/y in November, the highest since February 1991. These admittedly are harder to forecast, especially in the medical care sector. We do know that historically PCED medical services prices have risen at a slower pace than CPI medical services prices (Fig. 24). That’s because the former includes prices that are influenced by government health care programs, while the latter reflects mostly out-of-pocket medical services expenses.
Less hard to predict is rent inflation. Over the past 12 months through November, rent of shelter in the PCED rose 3.4%, with tenant-occupied rent up 3.0%, owners’ equivalent rent up 3.5%, and lodging away from home up 25.5% (Fig. 25). Given that the new median single-family home price has soared 25.6% since February 2020 through November 2021, it is likely that rent inflation will be moving higher.
(4) Supply chains. Also helping to bring inflation down should be fewer supply-chain disruptions. As noted above, the five Fed regional business surveys are showing that these problems may have peaked. These five surveys also show that in the past few months through December, prices-paid and prices-received indexes remained at or near previous record highs but have stopped climbing (Fig. 26). We are expecting to see them mostly decline in 2022.
Movie. “Being the Ricardos” (+ +) (link) is about one week in the life of Lucille Ball and Desi Arnaz, whose sitcom I Love Lucy aired on CBS for six years from 1951 to 1957. It was the most-watched show in the US in four of its six seasons. Their company Desilu Productions also produced The Dick Van Dyke Show, The Untouchables, Mission: Impossible, and Star Trek. However, their marriage was tumultuous, and they split in 1960. They managed their business much better than their marriage. Ironically, Lucy was falsely accused of being a communist even though she was married to Desi, who was a fierce anti-Marxist after communists forced his aristocratic family to flee Cuba. Nicole Kidman is great as Lucy; her performance should earn her an Oscar nomination. Javier Bardem does a good job of playing Desi.