Investors Must Watch This in the Coming Months

The speculative bubble forming in stocks right now has gotten the attention of Janet Yellen, who will be meeting with various regulators on Thursday. But for Real Money readers, how the Fed might react is probably of greater import. Also this week, two important signs that the labor market might be regaining momentum and inflation pressures are already building. Could it be that the Fed winds up tightening sooner than markets think, either to curb a bubble or to get ahead of inflation? Here are my thoughts on all these subjects -- and the item that must be watched over the next several months.

The Powell Doctrine

Fed Chair Jerome Powell was asked three questions about GameStop (GME) at his post-meeting press conference last week. As I wrote in our Fed reaction piece, the chair shrugged them off. Looking back at everything Powell has done in the last two years, not just the pandemic response, but the rate cuts in 2019 and the adoption of Average Inflation Targeting (AIT) in 2020, a clear doctrine has emerged. Jay Powell is singularly focused on running the labor market as hot as possible. Everything else is either secondary (such as inflation) or not the Fed's problem (such as asset valuations).

You may agree or disagree with this from a policy perspective, but as investors, this has very clear consequences. The Fed isn't going to kill this bull market by tightening policy. On the other hand, that doesn't mean the Fed has your back. Part of the reason why there is so much speculative behavior right now is this sense that the Fed won't let markets go down. I'm afraid this is a poor assumption. The Powell Doctrine cuts both ways. If a fall in stocks or some other assets doesn't affect the outlook for the labor market, the Fed isn't going to care. Those are the assumptions that should go into your investment theses.

Labor Market Might Be Heating Up

On Wednesday, ADP's private employment survey showed that the economy added 174,000 jobs in January. In addition, the December estimate was revised up by 45,000. To be fair, ADP survey isn't always too predictive of where the monthly Non-Farm Payroll survey winds up. But it isn't the only positive employment sign we saw in the last week. The ISM Services report showed a sharp rebound in hiring intentions in January. The December read of 48.7 suggested more firms were intending on shrinking headcounts than otherwise, but the January 55.2 figure is actually the strongest since before the pandemic. 

A huge question looming over 2021 is how aggressively firms will hire and invest. This will determine everything from how strong earnings will be to how quickly interest rates can rise. Ultimately this comes down to how optimistic firms are about 2021. In other words, if firms expect strong demand for their products, they will hire and invest in growth. If firms are unsure, they will hold off. Either way it is somewhat self-fulfilling.

So, seeing these strong hiring surveys along with solid employment growth would be an indicator of business optimism. Firms don't expand headcount unless they think they'll need those people to meet customer demand. It is a great sign.

Cost-Push, Meet Demand-Pull

In that same ISM Services report, the "Prices Paid" component hit 82.1. That's a stunning figure. It is a measure of the input costs firms face, and is the highest read since mid-2008 when oil prices were surging over $100 per barrel. That could be a transitory effect of pandemic-related supply issues. But it also could be an important test of how inflation will act when the pandemic is over.

For most of the last decade, we've all waited for extraordinary monetary policy to finally turn into inflation. Among the reasons why it hasn't is a lack of pricing power, especially at the retail level. For the most part, price competition has been fierce over this period, driven by improved consumer ability to price compare with technology, innovations in logistics that expanded online shopping. With this in mind, consider the surging costs indicated in the ISM report. If firms don't have any pricing power, the increased costs just squeeze margins. Unless they can make it up by growing the top line, that turns into weaker earnings.

For there to be inflation post-pandemic, something about this pricing power dynamic will have to change. People talk about "cost-push" inflation, but it doesn't really exist. If companies could just raise prices, they'd do so regardless of costs. Who doesn't want higher margins? If companies aren't raising prices it is because they can't.

What does it take for pricing power to change? I could throw out theories, but the what isn't actually so important. What matters is the "whether." There is a good chance that as costs surge, some companies will at least try to raise prices. What we need to watch is whether those price increases stick. I'm reading company earnings reports for exactly this. At the retail level, it will start in the form of less "promotional" pricing -- in other words less putting things on sale. 

If companies can't raise prices and these cost pressures persist, earnings are very likely to disappoint.

I believe this is the most important thing for investors to watch in the next three to four months. If companies can't raise prices and these cost pressures persist, earnings are very likely to disappoint. As we all know, a lot is priced in valuations right now, and it appears to me that there is an assumption that the short-term cost pressures will abate as the pandemic passes. I'm not sure that's a given, especially in regards to wages.

On the other hand, if companies can raise prices, then inflation is going to be a problem more quickly than is currently priced into the bond market. That doesn't necessarily mean the Fed is raising rates in 2021, but just a whiff that rate hikes could come in 2022 would touch off a "taper tantrum" type response. Not only would interest rates rise, but we all know that low interest rates have buoyed valuations. All markets are at risk if inflation is a problem in 2021.

I remain bearish on longer-term rates, being either short or underweight bonds 10-years and longer. In recent weeks we've moved to a more cautious position on corporate bonds as well, basically because valuations are such that there's so little room for error. This is the general problem with tight valuations, where it becomes increasingly difficult for companies to deliver on high expectations. In this period specifically, I think inflation is the thing to watch.

At the time of publication, Graff was short 10-year and Ultra 10-year Treasury futures.