Broker Check

The Ides of March, Again and Again

| March 22, 2022

The Federal Reserve approved a 25 basis point interest rate increase last Wednesday and hinted at more in the future. Given this action, we thought it was appropriate to address why such increases are needed, how they relate to inflation, and reestablish our playbook as the first quarter winds to an end.

Interestingly, a lot of this revolves around the Ides of March, which corresponds to March 15, an important time in Roman history. This day was marked with many religious observances in Roman culture as well as a deadline for settling debts. Later, it became synonymous with the assassination of Julius Caesar.

Clearly the Ides of March play a big role in Roman history. Well, March 15 is increasingly playing a large role in American financial history.

To frame how we got here, remember on March 15, 2020, the Fed held an emergency meeting and reduced rates to 0%. Then Modern Monetary Theory (MMT) moved from textbooks to reality in America as the Fed and Treasury threw $6 trillion of new money around.

Then a year later, on March 15, 2021, the major practitioners of MMT began to deny their role in the inflation mess by using the word “transitory” as their habitual adjective.

Now, on March 15, 2022, the February Producer Price Index (PPI) was released. This index measures the average change over time in selling prices received by domestic industrial producers. It’s a leading inflation indicator as it shows what’s happening upstream from consumers.

Well, the PPI rose 0.8% in February, which is a 10.0% increase over a year ago:

The main drivers were energy (up 8.2%) and food (1.9%). Combined “Core” producer prices rose “only” 0.2% in February, which is still up 8.4% versus 2021. And, with commodity prices soaring, the March PPI will be even higher.

Keep in mind, the PPI is a leading indicator for the Consumer Price Index (CPI), a common inflation indicator. As that rises, we naturally ask why.  Well, with more money to spend, prices increase:

Our readers know we vehemently disagreed with the term “transitory,” even as Fed officials were pounding the table. Remember, the Fed has more than 400 PhD economists on staff. Admittedly, I do not have a PhD in economics. But I know what the letters “B” and “S” stand for. I also know that MS means “more of the same.” And PhD stands for “piled higher and deeper.”

Here at CFS, we don’t understand what the disconnect is with these 400 economists. Perhaps their economics professors thought Milton Friedman was a kook teaching voodoo economics when he said, “Inflation is always and everywhere a monetary phenomenon.” Friedman also said, and I’m paraphrasing, if you print boatloads of money and drop it out of helicopters to nearly everyone, high prices will follow and not in a transitory nature.

Keep in mind, the charts above do not include March 2022 inflation data, which is almost certain to be higher than the current numbers. The 10% rise in inflation doesn’t even account for what’s happened in the last few weeks.

So, our question is – how did all 400 Fed economists miss this link? It’s now causing the Fed to scramble to bring policy up to date. The Wall Street Journal had an interesting article recently featuring an interview with economist John Cochrane, where he said:

With that off my chest, let's refocus on the PPI released last week, along with the Fed’s 25 basis point interest rate increase. In our opinion, the risk today is not that the Fed acts too aggressively in response to a rising crisis, but rather that it moves too slowly and is forced to become significantly more aggressive as it finds itself further behind the curve.

Remember, our current inflationary environment (regardless of what politicians say) is not due solely to Russia, solely to greedy companies, or solely to supply chain issues. Those factors produce inflation at the margins. The true driver of inflation is the 40% increase in the M2 money supply as a response to COVID-19.

While the 10% year-over-year PPI increase is dramatic, it will be nothing like the March data, which will arrive on April 12-13, 2022. Commodity price increases reflected in the March CPI data will be significant, especially nickel and wheat.

Wheat soared to record highs last week due to fears that Ukraine’s breadbasket would wither. That follows the London Metal Exchange suspending trading in the nickel market after an unprecedented price spike.

And here are additional year-over-year price increases in some key commodities:

Keep in mind, few if any of these numbers include the bad effects of the Russian invasion. It’s going to get worse.

But let’s finish our inflation bashing with some good news.

It won’t go on forever. Plus, the Fed has been cutting back on its quantitative easing binge and is beginning rate increases. We also don't see Congress being able to pass any further massive bailouts in an election year. And we can all hope that the war in Ukraine will be over sooner rather than later and that it coincides with COVID-19 being reduced to an endemic.

From a stock market perspective, today's higher energy prices will serve to squeeze out consumer cash from bidding up other prices. This will dampen demand in other areas, shrinking prices perhaps by year end, which will cool inflation and provide support to stocks.

While it may not sound like it, high inflation may be on its way out…maybe even by the next 15th of March.

Applying the Good News to Stocks, Earnings

Stocks follow earnings and interest rates. Inflation has pushed interest rates up, making stocks more volatile. That makes having a realistic take on earnings more important than ever, specifically from a sector basis.

When you buy a stock, you're buying a share of a company's profits. Naturally, you’d expect stocks to track earnings. But the relationship between stock prices and earnings may be tighter than we think:

Looking back to 2021, S&P 500 profits grew an almost unbelievable 47%. That's a hard act to follow. But there is still earnings growth on the horizon.

We know the top macro risks: Ukraine war, inflation, a compressing Treasury yield curve, and so on. Well, we also know that it rarely pays to get defensive or to try timing the market – you'll just watch the parade go by.

In this environment, we're already seeing commodity sectors like energy and materials continue to outperform as they also pay big dividends (dividend growth!) and have historically been under-owned by institutional investors. We've also recently seen utilities do well and we think that is because of dividends and pricing power, as well as not having any foreign exposure.

Interestingly, institutional or “big money” investors agree with this thesis. From our friends at MAPsignals, we see energy, utilities, and materials have the highest MAP scores, indicating strength:

You'll notice these sectors seemingly have weaker fundamentals, but that’s due to earnings still needing to catch up with increasing costs. The main source of their strength is on the technical side, which is another way of saying huge buying.

As evidence, these charts show how energy is going from strength to more strength, utilities have come on extremely strong, and the materials sector is seeing big buying as commodity prices ramp up:

While the war in Ukraine will potentially make it harder for the Fed to cool inflation in the short term, we want to focus on stocks whose profits are most inflated from that macro minefield. The “big money” is showing us the way through energy, utilities, and materials.

CFS has been and will continue to follow suit. It’s worth repeating – stocks follow earnings:

Securities sold through CoreCap Investments, LLC.  Advisory services offered by CoreCap Advisors, LLC.  Cornerstone Financial and CoreCap are separate and unaffiliated entities.