ast week's inflation readout was shocking, to say the least. Despite showing some meaningful moderation of core-CPI, non-core items blew out expectations by 40 basis points. Month over month growth, estimated to be 30 basis points, was actually double at 60. The market was clearly not priced for such an upside surprise, as core indexes finished between 4.5% and 6.5% down for the week. At the same time, wage growth declined 3.4% over the same period.

The numbers speak for themselves, but was any of this predictable? Indeed, it was. Each quarter, the Federal Reserve releases a report detailing economic activity in the 12 districts from the preceding quarter, called the Beige Book. That report, while often ignored by retail investors, can be a huge leading indicator of economic reporting to come.

Based on the summarized activity in the Beige Book, we determined inflation was likely continue to slightly moderate from the June, 2022 high of 9.2% while core inflation moderated heavily, thanks to a change in employment activity in the services industry and the lower prices of many key input goods. Despite this, CME Fedwatch is now showing an 80% probability of a 75bps rate hike this week, down from 98% last Tuesday. The alternative is 1%.

cme fedwatch predictions show 80% probability of 75bps hike
source: cme fedwatch

The Beige Book is broken down into several subcategories within each district, but for this report, we will only analyze Banking and Lending, Agriculture, Real Estate, Prices, and Labor.  

Economic activity was mostly unchanged since July. In all districts, the labor market remained tight, with plenty of new jobs filled despite ongoing fears of a recession. Auto sales decreased, which explained the lower cost of used autos in non-core CPI. Manufacturing activity increased slightly, with more new orders off the back of decreased inventories, and real estate development continued at a moderate pace. Wage growth also moderated significantly in every district, something from last week's report that many missed. Additionally, some districts reported more services employment, which implies a future moderation of services-demand-driven inflation.

The biggest indicator of food inflation was agricultural reporting. Not only did manufacturing and agriculture firms see significant input price increases, demand for agricultural products remained elevated. The agriculture and manufacturing sectors experienced continued supply chain bottlenecks and input shortages that contributed to price increases. Strangely, input prices for manufacturers were actually unchanged in the Richmond district, one of the most important for manufacturing output.

So, inventories are decreasing but production times are still slow. If demand for goods increases as demand for services decreases, manufacturing may be in trouble again. The prevailing narrative from every district is that manufacturing was slowing substantially and inventories were falling across the board.

Hot weather and dry spells damaged crop yields, particularly corn. Prices paid to farmers were elevated but fell somewhat for corn and milk. Restrictions on imports from China led to higher demand for domestic cotton. Demand for poultry exceeded supply, while the beef market held steady. Long lead times for machinery and parts forced many farmers to use decommissioned machinery and some small farms suffered crop losses due to inoperable equipment. By and large, agricultural income expectations were unchanged for 2022.

A growing number of American farmers are unable to make ends meet. Fertilizer prices are up, supply shortages and right-to-repair issues are decreasing accessibility to well maintained equipment, and driver shortages are leaving product unmoved.

map of federal reserve districts
source: federal reserve

Meanwhile, banking and lending activity had a shift in distribution. While consumer lending decreased substantially, commercial lending remained strong despite huge increases in interest rates. In our view, the acceleration of commercial lending in all districts could be due to two factors.

The first: companies did not anticipate a need for future cash cushions because they did not foresee supply chain bottlenecks to remain for so long and for orders to increase so suddenly after a six-month glut.

The second: many companies bought into the ‚Äútransitory‚ÄĚ inflation narrative and did not believe their margins would be so heavily affected. Instead of building up more cash, companies left their capex unchanged and are now forced to borrow at higher rates to finance their immediate cash needs. Alternatively, companies may be unable to meet the demand for goods due to manufacturing slowdowns or supply chain disruptions, which implies less free cash flow and a need to borrow in the short to medium term.

YoY inflation appears to have peaked
source: bloomberg, bls

This can be disastrous for corporate valuations across all industries. Borrowing at higher interest rates generally increases a firm's weighted-cost-of-capital (WACC), a key discount rate applied to corporate earnings. With the cost of debt up in an inflationary environment, the cost of equity must increase as well to reward investors for holding a risk-asset with such a low, inflation-adjusted return.

But these changes can take many months or quarters to materialize on balance sheets. As economic conditions worsen, manufacturing credit-terms relax, or the proportion of bad debt increases, corporate earnings will materially decrease through the future.

Furthermore, we predict the following interest-rate dynamic play out. The Federal Reserve continues to hike 75 basis points in September and November, knowing well that those rate hikes will take a quarter or more to affect the economy. The current decrease in oil prices (thanks to the Biden Administration draining the SPR) will reduce transportation costs, and falling commodities prices will soften the PPI, moderating prices and CPI. But, as oil jumps to new highs and commodity prices increase again this winter, the Fed hikes 25 basis points in the spring.

Suddenly, spiraling springtime input prices drive inflation up once more. The Fed hikes one more time by 50 basis points in late-2023, bringing the terminal Federal Funds Rate to 4.75 - 5% in 2024. Wage growth decreases and employment stops - the Fed has met its dual mandate, and a recession begins.

The most important future releases will not be inflation reports, they will be Beige Books.  


Sep 20, 2022
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