We are seeing a pullback in commodities, currencies and equity markets

Outlook: We are seeing a pullback in commodities, currencies and equity markets that does not arise from any particular economic event or data. This could be rising risk aversion but we can’t put a finger on a driving factor–nothing specific jumps out. The only real Big Event is the UK budget, and it’s not inconceivable that the market is still judging whether it wants to accept it. The budget proposal in a nutshell is “about £30 billion in spending cuts and £25 billion in tax increases, including a six-year freeze on income tax thresholds and lowering the top income tax rate to £125,000,” as Trading Economics puts it.

The UK aside, the pullback in multiple asset classes may mean the pullback is pure positioning and therefore short-lived—not a reversal back to the primary trend.

The US news today includes Oct housing starts, likely another drop but not as awful as Sept (-8.1%). We all know about the big and ongoing drop in house prices and seller reluctance, so an ongoing decline in starts is hardly surprising. The reversal in home inflation has two major effects—it can lower inflation reports generally going forward (shelter is 24% of CPI, if badly formulated). It can also drive GDP down.

The Atlanta Fed knocked socks off with the latest GDPNow for real GDP growth in Q4. That’s seasonally adjusted and annual—and it’s a whopping 4.4% from 4.0% on Nov 9.  The driver is the growth of real personal consumption expenditures arising from the retail sales numbers yesterday. We get another update today.

This information informs our opinion about inflation. You can get dizzy reading so many differing views on inflation, and it can be hard to pick apart arguments to find the key assumptions that determine outcomes. Here’s an argument that starts with a fully disclosed assumption: the American consumer is endlessly materialistic and greedy. He will continue to buy no matter where prices go. Poor people will buy because they need to eat, middle class people will run up credit card debt for the latest fashion, tech toy, and concert ticket, and rich people—well, rich people buy art, jewelry and more real estate (they already have yachts).

The American consumer can continue to consume due to massive savings accumulated during the pandemic, plus recent wage gains and borrowing capacity. The NY Fed reported consumer borrowing up $351 billion in Q3. (Total household debt is $16.52 trillion…. ). 

The persistence of inflation is the same picture worldwide. The Economist writes “We calculate that the prices of 67% of items in the average rich country’s inflation basket are rising by more than 4% year on year, up from 60% in June.”

What about those nay-sayers at FedEx, Target and Amazon who say earnings are lousy because the customers are “stressed out” and sales are trending way down? The likely explanation is these are outliers. Others in the retail space are doing just fine. Granted, holiday spending is up in the air and might disappoint, and sales abound—but not all of the gains in retail sales can be attributed to inflation alone. Besides, the sales outlook is highly sector-dependent–home improvement and gardening up, electronics down. As Wolf Street writes, “In the early 1990s, department stores sales accounted for nearly 10% of total retail sales. In October 2022, they accounted for less than 1.9%–on track to irrelevancy.”

Now take Assumption No. 2: unemployment will not go up all that much. The labor shortage is real and will persist. Wages will go up, if not as much as inflation in goods and services.

Bottom line: Inflation may have peaked, but will remain high, say 4.5-5.5%, for several years. To imagine it will get back under 2% by end-2024 is a pipedream and inconsistent with what we know about the consumer—unless unemployment really does go nuts, as the Fed so fervently wishes. Granted, growth may slide downhill and the economy contract or grow only by fractions, but that will be due more to non-consumer behavior.  Assuming the Fed doesn’t chicken out, that chart showing Fed funds kissing 5% briefly but then retreating to as low as 3% by end 2024 is not realistic.

One implication of this combination of factors—persistent high inflation AND strong consumption—is that the Phillips curve really is dead. Its demise has been heralded multiple times but it keeps coming back to mislead us. The inverse correlation of employment and inflation has some effect, but not a ruling one. Yellen is not at the Fed anymore but gave a speech at the Boston Fed in September in which she gives far more weight to inflation expectations than to the Phillips curve, never mentioned by name but noted as not having worked very well in the last recession.

This may put us in the stagflation camp, and we don’t really want to join any club headed by that boor Larry Summers, but the longer-term inference is that the Fed must keep on hiking and for years, not just the one year they see now. It will be two, or three.

As for the near-term forecast, the probability of the current dollar pushback turning into a rally is pretty low. But Bloomberg has a technical analyst who sees it as the real deal.: “The correction in the dollar might be over, according to some technical indicators and the latest repricing in the options space. On a trade-weighted basis, the greenback retreated by 7% from its cycle highs back in September, mainly driven by position rebalancing over a potential Federal Reserve pivot. The extent of this drop in the spot market now satisfies a so-called ABC correction of a full Elliott Wave cycle that started a year ago.

“Moreover, the dollar’s rebound Tuesday from intraday lows came after testing a pivotal support level, namely the 38.2% Fibonacci retracement of its rally since early 2021. Given another positive signal emerged, a DeMark Buy Setup on the daily chart, the dollar’s technical outlook has turned bullish, at least in the short-term.

“Options-wise, traders are back into adding topside structures over the one-month tenor that captures the release of the next employment and inflation reports out of the US, as well as the Fed’s policy meeting in December. So it could be that options market makers are now less convinced that the greenback is in for more losses, especially as FOMC officials keep reminding us that the terminal rate matters more than the size of the next hike. That Fibonacci support, close to the Tuesday lows, has now game-changing potential, either way.”

Golly. We agree that the corrective mode is strong, technically—everything had been overbought. But that calls for correction, not reversal. We won’t call reversal until we see the whites of their eyes. 

US Politics: The Republicans captured a majority in the House, but are like the dog that caught the car—now what? In the absence of any principles and policies, they will use House power to take over committees and launch investigations. Pundits concur the investigations will be ill-founded and stupidly partisan (Hunter Biden’s laptop). On the Trump front, former supporters are jumping ship in droves, including some economists, leaving the Trumpy ragtag minority in Congress with not much to do except cause trouble. 

This is an excerpt from “The Rockefeller Morning Briefing,” which is far larger (about 10 pages). The Briefing has been published every day for over 25 years and represents experienced analysis and insight. The report offers deep background and is not intended to guide FX trading. Rockefeller produces other reports (in spot and futures) for trading purposes.

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