Demand Destruction

Sentiment was muted Tuesday, as investors searched for something to latch onto in the void before US CPI data due later this week.

The January vintage of the NFIB Small Business Optimism Index showed firms continue to struggle with a familiar list of problems. The headline gauge was a slight miss, and at 97.1 now sits at the lowest in 11 months.

More than one in five businesses said inflation is their single most important business problem. A net 61% of owners reported raising average selling prices, up four points, and the highest reading since Q4 1974. “More small business owners started the New Year raising prices in an attempt to pass on higher inventory, supplies and labor costs,” NFIB Chief Economist Bill Dunkelberg remarked. “In addition to inflation issues, owners are also raising compensation at record high rates to attract qualified employees.”

Same as it ever was, I suppose. I’d submit these kinds of anecdotes suggest an unfavorable setup is developing in the world’s largest economy. Businesses are desperate to pass on higher costs tied to everything from inventories to wages, and while consumers were happy to pay it last year, it’s not clear for how much longer.

“In addition to the payback for last year’s over consumption, there is growing evidence that the consumer may be in a weaker position to spend even if she wants to,” Morgan Stanley’s Mike Wilson said. “Consumer confidence measures continue to remain in recession territory, mostly due to inflation that could start to be demand destructive, particularly for discretionary items,” he added, calling the risk “acute” for lower-income cohorts, who spend more of their disposable income on the items for which prices are rising the most. That’s the “K-shaped” inflation dynamic again.

“Bottom line, we think consumer spending is at risk and and it’s not all due to Omicron,” Wilson wrote, in the course of warning that the expiration of government transfer payments is now colliding with surging prices, a scenario conducive to demand destruction. I’ve said as much myself in these pages on too many occasions to count.

US 10s are making a serious run at 2%. Bear with me (no pun intended), as this isn’t a non sequitur. The yield on the benchmark of all benchmarks hit 1.956% overnight Tuesday (figure below).

The repricing “would be contingent on the January CPI release showing ongoing upside risk on the inflation front, not a difficult assumption to make at this stage in the cycle, particularly in the wake of a payrolls report that revealed average hourly earnings are growing at an annual pace of 5.7%, the fastest earnings have increased since May 2020 when the elimination of low wage earners from the labor force distorted AHE higher,” BMO’s Ian Lyngen and Ben Jeffery wrote Tuesday, before noting that despite the blistering pace of wage inflation, earnings aren’t keeping up with the increase in consumer prices.

“Real wages have been negative since April 2021 [and at] some stage in the cycle, declining real income will become problematic for the pace of real growth anticipated as the recovery unfolds,” Lyngen and Jeffery went on to say, adding that “the Fed’s efforts to normalize rates and the balance sheet only complicates the outlook further as price stability will be a net positive for real spending and hiring, although higher rates and less ready access to credit will be a headwind.”

Eventually, the tension inherent in everything noted above will need to resolve, and I’ll admit to being sympathetic to Wilson’s contention that demand destruction is the most likely outcome. That would challenge predictions for sharply higher long-end yields. When you consider the fact that US Treasurys have natural buyers all around the world, you’re left to ponder the prospect of inverted curves as the Fed tightens and/or some manner of black swan rally that sends yields tumbling. One caveat is that the American consumer has a penchant for spending come hell or high water. So, I suppose it may be misguided to assume outright retrenchment.

In any event, the stocks are… well, they’re fine. I guess. If you ask JPMorgan, the inability of equities to sustain a rally is evidence of “overly bearish market sentiment at the moment.”

“We see volatility moderating and expect strong equity inflows from systematic investors (e.g. risk parity, volatility targeting), as well as corporate buybacks that are increasing after recent earnings-related blackout periods,” the bank said.