Steno's Signals: Could Falling Inflation Lead to Layoffs?

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1:24And now to the top analysis of today's markets.

1:33The signals are telling me that inflation will soon be gone, but your job might be gone too. That is the sad message in this live edition of StenoSignals. We are going to elaborate on the inflation evidence that we've gathered over the week and why falling inflation could be an issue for corporate profits. So let's have a look at the data incoming over the week to get an overview of the inflation pressures around the West, because I think we find new compelling evidence that inflation is veining fast now and that inflation will soon be gone as a topic in financial markets. This week, we had the inflation number from May out of Europe.

2:20And if we look at European inflation relative to the US inflation picture on the first chart I've brought today, we're now clearly seeing a pattern of European inflation catching down to the trends that we've seen in the US over the past quarter or two. This week, European inflation surprised clearly to the downside of expectations. And it was a pretty broad-based picture across the European continent. German inflation surprised on the low side of expectations. French inflation surprised on the low side of expectations. And only in Italy, inflation increased relative to what was expected. So we are now at 6.1 % in Europe, down from double-digit territory last year.

3:03And my best guess is that we are below 5 % already next month. And well, soon we might be headed towards target on inflation. The reason is that if we look at some of the forward-looking indicators for inflation, both in Europe and the US, we continue to get price negative signals from both companies and consumers. And if we start with the European Union, what I like to use as a leading indicator for the overall price pressure is the Spanish inflation. And why is that? Well, Spain is a country that allows energy prices and food prices to very swiftly pass through to consumers. And that's been an ongoing theme throughout this inflation cycle that we've seen a spike in Spanish inflation ahead of European peers, but also a decline in inflation ahead of European peers as they allow the volatility in energy prices and food prices to pass through to the end consumer very swiftly.

4:08And currently, the evidence is pretty firm from Spain that we should expect the overall price pressure in Europe to wane over the next quarter or so. If you ask European companies, you get similar signs right now. And that is one of the things that I've been looking at throughout the week. the evidence is relatively clear if you ask companies both in the US and in Europe when it comes to their price plans for the upcoming period. So if we move to the next chart on price plans, then we have first here the price plans among SMEs in the US. So this is taken from the monthly NFIB survey, probably my favorite forward-looking indicator on inflation in the U.S.

5:00since the survey is gathered among SMEs with a large cost base related to wage growth. And 80 % of the companies asked or surveyed in this survey are in the service sector. So this is also a measure of what we typically deem to be sticky inflation. And on the chart here, you have the relationship between the survey and the median inflation number in the consumer price index. So the median value of the consumer basket and the increase in that particular component on a running basis. And what you can see here is that price plans are now declining, rapidly meaning that on a net-to-net basis, fewer companies expect to be able to hike prices over the period ahead.

5:50And that is something that typically spills over to lower consumer inflation after a time lag of in between one and two quarters. And if you look at the left-hand axis, we should actually expect inflation to reach around 3 % in median terms already in October or November in the US, which is pretty compelling evidence of disinflation, I'd say. If we look at the similar survey in Europe, we actually got a new update from the European Commission. And the commission conducts this survey on a monthly basis, asking companies in Europe for their price plans, the exact same setup as the NFIP survey in the US.

6:33And on a net-net basis, only 7 % of companies surveyed now expect to hike prices over the next two quarters. And typically, as you can see from the left-hand scale, that is a number that is consistent with inflation below the 2 % target in Europe. That is quite the game changer relative to the inflation that we experienced in Europe throughout 2022. and I think it will come as a surprise both to the central bank and to the public basically if inflation drops back below target already within 2023 and obviously if these forward-looking indicators are right then we should obviously also expect this to have an important bearing on the interest rate outlook for the European central bank and for the Federal Reserve.

7:27If we look at the interest rate outlook for the European Central Bank first, then still after this very soft inflation print this week, we have expectations penciled in for hikes both in June and in September. I think that is about as much as we should expect, two times 25 basis points in total. I would be extremely surprised to see them delivering more than that. Also, given the mediocre growth outlook earlier this week, we received the confirmation that Germany is actually already in what you could call a technical recession with two quarters in a row of negative GDP growth in real terms. So two hikes is the absolute maximum from here, given what we see on inflation and given what we see on growth in my perspective.

8:18If we look at the similar picture for the Federal Reserve, then currently eight, nine basis points are priced for the June meeting. Is that too much? Well, at least it opens the door for a potential rate hike, even though I think the Federal Reserve aimed at a so-called skip at the June meeting. So a non-event without a hike, and then they would basically prefer to wait and see. last week we had some evidence that could point in the direction of a hike. But I guess given what we've seen this week, the probability has clearly decreased again. And my base case is still that we've seen the last hike from the Federal Reserve already.

9:01So let's see. They will probably decide to skip the meeting in June and then communicate that they will wait and see whether further interest rate hikes are needed in months ahead. So the question is now whether this waning inflation pressure will spill over to less wage growth. And what we see right now is an interesting cocktail of clearly declining headline inflation and still very sticky wage growth. I guess the reason is that wage growth typically lacks the development in consumer prices. So first you see prices rising and then after that you negotiate a higher wage growth. And if we look at the European picture first, if we look at inflation versus wages in Europe, we now have early evidence, I'd say, of a slight decline in the momentum in wages.

10:01But just this week, we received the latest indicator of so-called negotiated wages in Europe. A big part of the labor market is covered by this statistic since wages are centrally negotiated for a lot of workers. And we got another big spike towards 4.5 % on a yearly basis. But you need to compare that to the 10 % inflation that we saw in Europe through 22. So this is still less than a full recovery of the inflation seen last year. But the wage growth is on the rise in Europe still with few but very early hints of declining momentum into the second half of the year. So clearly when inflation drops, if these forward-looking indicators on price pressures are correct, then wages will not follow suit immediately.

10:52it will take at least another couple of quarters before the wage growth starts veining from a momentum perspective. And if you look at the US picture, it's sort of the same, just with a slight bit more of evidence that wage growth has actually started to decline. We're still running at, say, 6 % or 7 % annualized wage growth in the US, which is obviously too much for the Federal Reserve. But the big and interesting topic and maybe the big schism now is whether this is good or bad news. Because let's assume that wage growth runs at, say, 4 to 6 percent, both in Europe and in the U.S. over the next year.

11:36Hey, everyone. We're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing. Have you ever wanted to trade Bitcoin but haven't dared try? With Plus500 Futures, you can trade crypto without the hassle of opening a wallet. With just a few clicks, you can register and start practicing with their free and unlimited demo. See a trading opportunity? You'll be able to trade it in just two clicks. Feel ready? You can move to real money with as little as$100 once your account is approved. And the great thing is that in addition to crypto, Plus500 gives you access to a wide range of instruments.

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12:49And headline inflation drops to 2%. Then we're back in so-called positive territory for the real wage growth, the wage growth minus the development in prices at the shelf. And on the surface, that's obviously good news. You and I as a consumer will be able to spend more based on our monthly wage relative to a scenario where prices grow faster than the wage growth. But the issue is that companies may start to struggle should inflation decline faster than wages. Remember that inflation is essentially a measure of the prices that companies are willing or are getting from clients. So if the inflation drops and wage growth remains sticky, it should lead to a pressure on corporate margins.

13:48And therefore, I'm not completely sure that a drop in inflation is good news overall for the private sector. It's obviously good news for the consumer, but not necessarily for your employer, so to speak. And if we look at the empirical evidence of how various equity sectors perform when inflation starts to fade, we get a very mixed picture across the equity landscape in the US. So this is a so-called beta study on inflation relative to returns in various equity sectors. So if there is a light blue bar, it means that the return is positive when inflation rises. And if there is a dark blue bar, it means that the return is negative if inflation is on the rise.

14:35And currently with declining inflation momentum, you should look to the sectors at the bottom of this leaderboard to find shelter. because these sectors typically rely on cheap funding costs and lower interest rates. And some of the sectors worth mentioning here would be technology, artificial intelligence as the ultimate high beta bet on this, and also consumer discretionary stocks like Tesla and goods in the sort of upper tiers of the Maslow's hierarchy. And on the other hand, we have classic industrial companies. We have companies in the materials sector. We have companies in the energy space, et cetera, suffering when inflation starts declining.

15:29So therefore, I think the empirical evidence is pretty much there to say that when inflation drops from, say, 6 % to 2%, it's not necessarily good news on an aggregate basis for most companies in the private sector. There are pockets of strength, but there are also a majority of companies suffering from a margin perspective when inflation starts dropping. And you could actually showcase that on the next page here because I've looked into the profit cycle both in Europe and the US relative to the development in real wage growth. So what you have on the chart here in all of the call it series is the running real wage growth in European countries.

16:19So if it's above zero, it means that wages improve faster than inflation and vice versa, if we are below zero. And needless to say, 2021 and 2022 was a complete outlier from a real wage growth perspective, a massive decline in the relative price of labor compared to inflation. And I think this is the exact reason why the labor market has held up so strongly into 2023. If the price of labor drops relative to the selling prices of companies, obviously you demand more labor. And now that the tide has turned, as you can see, we're slowly but surely getting back towards positive territory. I also tend to think that the tide turns on the demand for labor.

17:10And the reason is the purple line. It is an aggregate measure of corporate profits in Europe and the growth in the profit on a yearly basis. And as you can see, there is a tendency for profits to decline every time real wages improve. And I guess the reason is that the average cost base of a company related to its wages increases relative to its selling prices every time real wage growth increases. So in sharp contrast to sort of the vanilla conclusion, it is not necessarily good news on an aggregate basis that real wages increase. At least short term, it puts pressure on corporate profitability, and it could lead to a series of layoffs as soon as the corporate profitability is compressed and squeezed by this increase in real wages.

18:07And if you look at the exact same picture in the US, we have the real wage growth in light blue on the next chart relative to the corporate profit margin growth in dark blue on a yearly basis. And as you can see, it's almost the perfect mirror image. So as soon as real wages pick up, it squeezes the profitability of your employer. So inflation might be headed down, but so will corporate profits and margins. And I think this could turn into the theme of the second half of the year, if my forward-looking indicators on inflation are right. because with headline inflation headed towards 2 % both in the US and in Europe already towards the end of the year and wage growth in the range of say 4 % to 6%, we will get to almost uncharted territory on real wage growth, meaning that corporate profitability will also take a hit.

19:15And I also think we start to see the first signs of cracks in the global economy. I'm Danish and I live very close to the Swedish border and we had numbers out of Sweden this morning suggesting that the Swedish economy is already in a recession that is obviously not of relevance on a standalone basis since Sweden is a small country and no one cares but the interesting thing is that Sweden tends to be a canary in the coal mine because of its very open and export oriented nature. So you could consider Sweden, the South Korea of the West, basically, since it is such an open economy with such a clear tie to the demand growth abroad.

20:01It sort of feels the heat from changing trends in global demand much earlier than peers with a larger domestic demand base, so to speak. And if you look at the dark blue line here, we have the PMI from the Swedish industrial sector out this morning, European time, and it printed at 40. So 10 index points below the 50 threshold. And the new orders component printed at 33. So miles below the 50 threshold and typically something that screams contraction, recession, and so on and so forth. So I think the actual production levels will decrease in Sweden over the next quarter or two, and this could be a harbinger for other European countries and ultimately also the US.

20:55We received the ISM manufacturing numbers just before we went on air here, more or less, from the US, and they surprised negatively. They also surprised on the downside when it comes to orders. The orders component printed at 43, so seven index points below the 50 threshold. And if you look a bit ahead, given the details of the ISM report, we should probably expect the headline index to print below 45 next month. Also, if you look at prices paid in the ISM survey today, it declined to 44 again. So prices are outright declining in the manufacturing sector. Very benign news for the Fed, at least from an inflation perspective, not as much from a growth perspective.

21:40So all in all, if we summarize it in our aggregate recession probability indicator for the U.S. economy as the last chart here. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

22:03We are now above 50 % probability of a recession come Q3 2023. This chart is slightly forwarded in time since what we measure here is the exact lag between various financial indicators and the subsequent decline or improvement in actual economic activity. And now we're running at plus 70 % probability of a recession by Q3. So I'm starting to convince myself that it is a very high likelihood that we will enter a recession within, say, a month or two from here. And typically, that means that rates will head lower. It means that bonds will start performing a bit better than what we've been accustomed to over the past few years.

22:52And it probably also means that you should seek shelter in equity classes, relying on lower funding costs and lower inflation. And I frankly still think that technology and AI would be a perfect cost for that. So as the final thing before I allow for questions, here's the updated portfolio dashboard of StenoSignals. And as you can see, we've had a lot of luck riding this wave of AI hype. We're along the WTAI ETF, currently with a 7 % gain over a week or so. Obviously, a bit less good performing today. And then we're along TLT since earlier this week. So the long end of the treasury curve. We're along the dollar here versus the CNY.

23:48you could have done it versus basically almost any other currency worldwide and then we are also long japan the ewj at the bottom of the board everything is very transparent in this dashboard it is um traded live and and it is something that you can access at steno research.com i think those are the words for for my presentation let's have a look at the questions coming in. We have a question from Paul. CCJ is up almost 10 % this morning. What's your view on uranium, lithium, and copper right now? I think the price action relates to the surprise numbers that we had from China overnight. The Chinese manufacturing PMI printed at 50.9 in sharp contrast to expectations of a further decline below 50 and uh that obviously spills over to to um the exact uh part of the commodity space that paul refers to here so i'm not overly convinced that china will rebound like crazy if the manufacturing cycle is doing as bad as as it is on my indicators in the west so i i urge a bit of caution on on this this part of the commodity space right now.

25:02I was very positive on copper in particular, but also partly lithium through January and into February, but we've taken our profits on that bet and we are now sidelined in commodity space. We have a question on the sort of more medium term inflation picture, say one or two years ahead outside of this six month period that we've discussed today. and whether I see any risks of a re-acceleration of inflation into, say, 24, 25. And I think this is a really good observation from Nikhil since everything now depends on the political reaction to declining inflation momentum. It is, of course, a tricky path to navigate for central banks and also fiscal policymakers when inflation slowly but surely moves towards the target of 2%.

25:59Should you start easing at 3 % or is that a high risk to do? And I still see a large probability of them easing too fast, both from a fiscal perspective and a monetary perspective. And if they've eased both fiscal and monetary policy at the same time, we need to have the alarm bells ringing again when it comes to a risk of reacceleration of inflation. So, yes, the base case is still for me that we get a second wave of inflation. But I think it is a story for maybe the middle part of 2024 or thereabout. It also depends on the Chinese rebound. And so far, we don't have compelling evidence of China rebounding in a way that allows commodities to reflate again.

26:46So I think, yes, we will be back discussing inflation in 2024. But for now, the price action clearly moves in the other direction. Question from Jordan in relation to the participation of workers in the labor market. Do you think, given the participation rate, that we will have any meaningful layoffs in the U.S.? It seems like we're pretty low on workers already, according to Jordan. And I mean, still, if you look at the amount of job openings in the US, it still looks extremely elevated relative to earlier cycles. And given the relative price of labor, as I discussed earlier, I think it's fair to assume that this cycle will look different from other cycles when it comes to the labor market.

27:36And likely a lot of employers are still scared of not being able to recruit the right people. And therefore, I think this round of layoffs will look relatively benign compared to, for example, 08 or other crisis events. So I fully buy the narrative that employers will be a bit more conservative when it comes to layoffs relative to other economic cycles. Last question from Batsirai. will this impact the 2024 crypto bull market? And I actually think that slowing inflation increases the probability of a bull market in crypto because slowing inflation also increases the probability that central banks will have to debase the fiat currency again to recreate inflation momentum.

28:30So should we get below 2 % on inflation, that is clearly your clue to go long crypto by a mile. And I think crypto is the ultimate high beta bet on a reversal of the course of both the European Central Bank and the Federal Reserve. Final question from Stephen. Will the rise of the gig economy and the lack of labor overall for SMEs, do you see labor rates staying high on a secular time frame? and sorry i guess the dark horse here is whether artificial intelligence will wreak havoc with the labor market currently i don't see the signs of that but it's clearly a risk scenario over the secular time frame and if ai wrecks havoc with the overall labor market outlook then the rise of the gig economy and the lack of labor will be a story of the past very soon so i think the jury is still out and we'll see in a few years from now.

29:29Sorry, those were the words from this week's editions of Stenus Signals. We will be back again in a few weeks from now. Next week is the Festival of Learning on AI. So, Stephen, ask your question again next week. Remember that this is just a window into my trading and my thinking. I cannot guarantee that you have the same risk appetite as me, but I can guarantee you that we will follow the macro developments on an ongoing basis in StenoSignals. Thank you for watching.

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30:53With a simple and intuitive platform, you could trade anytime, anywhere. Experience the fast, accessible futures trading you've been waiting for with Plus500. With over 20 years of experience, Plus500 is your gateway to the markets. Visit us.plus500.com to learn more. Trading in futures involves the risk of loss and is not suitable for everyone. Not all applicants will qualify. Plus500. It's trading with a plus.