Did you miss yesterday’s Daily Edge?

Worried About Inflation and Supply Constraints? Try Being a Small Business. Larger companies have used their heft to turn higher demand into increased earnings, but smaller firms are adding debt and burning cash

(…) Two-thirds of small businesses impacted by supply-chain constraints said suppliers are favoring large businesses because of the volume of orders, according to a recent Goldman Sachs survey of more than 1,400 businesses. Eighty-four percent of small businesses said inflationary pressures had worsened since September, according to the Goldman survey, with more than three-quarters reporting that inflation had hurt their business’s financial health.

“Larger firms have been able to weather rising costs and labor shortages better than smaller firms, which is likely a function of larger workforces, greater pricing power and stronger margins that have allowed them to absorb economic pressures more easily,” said Mahir Rasheed, U.S. economist at Oxford Economics. (…)

Sixty-two percent of small businesses said they had applied for a loan or considered doing so to fund additional expenses because of inflation, according to a survey of more than 2,000 small firms by Hello Alice, a software platform that provides resources for small-business owners. (…)

Funds from the federal Paycheck Protection Program and other aid efforts initially helped cushion the economic blows, he said. “That liquidity is waning,” said Mr. Taets. “That’s why we are starting to see these requests.” (…)

In the same WSJ article, we learn that some companies are raising prices retroactively:

In December, Honeywell International Inc. added an 8% inflation surcharge for existing and new orders from its U.S. Fire unit. In a call with analysts in early February, Honeywell chief executive and chairman Darius Adamczyk said that “swift pricing actions allowed us to stay ahead of the inflation curve,” increase revenue and expand profit margins. (…)

Vendors now routinely add surcharges of as much as 21% to items ordered months earlier.

From The Transcript:

• “Looking at price versus cost, we continue to experience high inflationary impacts for material cost, labor, and freight. The pricing that we put in place last year is currently lagging inflation. That coupled with productivity challenges is a major contributor to margin declines in Q4. We implemented additional price increases during the fourth quarter and have already announced another price increase for Q1 2022 that goes into effect this month. We are aggressively pursuing price across all products and in all channels to offset unprecedented inflation and expect price to exceed inflation in 2022.” – Allegion (ALLE) CEO Dave Petratis
• “Inflationary pressures continue but have yet to curtail demand, so we remain optimistic about the underlying strength of the industry. we’ve really not seen any decline and rather pools are getting fancier, they’re not into value engineering…An $80,000 pool doesn’t buy you as much as it did a few years ago, but it really has yet to curtail demand.” – Pool (POOL) CEO Peter Arvan
• “We have labor problems everywhere. We can’t find people. Our labor costs are going up significantly, well beyond minimum wage for certain functions that used to be minimum wage – – We just can’t find people. The people we find if we find them are not trained to the extent we would like them to be trained. And they may work 2 or 3 weeks and leave. It’s very, very hard to find competent people.” – Ark Restaurants (ARKR) CEO Michael Weinstein

Prices rise at record rate as eurozone growth rebounds in February

(…) The easing of supply constraints recorded during February also helped moderate manufacturers’ input cost inflation. Although average prices paid for materials rose sharply again, the rate of increase was the slowest since March of last year.

However, although raw material price inflation in manufacturing eased, service sector input cost inflation accelerated to a record high reflecting rising wages and soaring energy costs. The resulting overall rate of input cost inflation seen across both sectors rose to the second-highest on record, surpassed over the past 24 years only by that seen last November.

Average prices charged for goods and services rose at the sharpest rate yet recorded by the survey as firms increasingly sought to pass persistent higher cost inflation on to customers. A record high rate of inflation in the service sector was accompanied by a near-record rate in manufacturing.

The intensifying selling price pressures seen in February therefore suggest that consumer price inflation could also rise further during the month, having already risen to 5.1% in January – the highest in the history of the euro. (…)

In the U.K.:

Such strong input price growth suggests no imminent cooling of consumer price inflation pressures, which are currently running at the highest for three decades.

Inflation Starts to Show Up in Asia Early warning signs of inflation are appearing in some parts of Asia, as higher energy and food prices start to bite in countries that recently seemed immune to cost pressures.

(…) India’s inflation accelerated to 6% in January, well above the trend of around 3.6% in the three years leading up to the Covid-19 pandemic, while Sri Lanka’s inflation hit 14.2% that month, the highest in more than a decade. In South Korea, core consumer inflation recently rose to 3%, its highest level since January 2012.

Thailand’s consumer price inflation is now 3.2%—after averaging less than 1% in the three years leading up to 2020—even though the tourism-reliant country has one of Asia’s weakest economies. (…)

Consumer price pressures are particularly weak in China, despite recent cost increases for factories. (…) Consumer inflation inched up just 0.9% in January from a year earlier, down from December’s 1.5% gain. It is widely expected to stay below 3% this year. (…)

Food prices globally rose 28.1% in 2021, according to the Food and Agriculture Organization of the United Nations. After doubling in price during 2021, U.S. West Texas Intermediate crude futures have climbed another 20% this year to around $91 per barrel. (…)

From January’s Japan Manufacturing PMI:

January data signalled further rises in average cost burdens among Japanese manufacturers. The rate of input price inflation was substantial amid higher raw material prices, though was broadly unchanged for the third month running. That said, firms were increasingly reporting that costs were partially being passed to clients to protect margins, with output prices rising at the fastest pace since July 2008 and the second-fastest in survey history.

From its February Flash PMI:

(…) supply chain disruption continued to hinder manufacturing activity in February as a marked lengthening of delivery times exacerbated material shortages, leading to a further rapid rise in input cost inflation. (…)

With demand conditions weakened by the ongoing pandemic, Japanese service providers attempted to draw in customers with a renewed reduction in prices charged, the first since last August. This was despite the joint-sharpest rise in input prices for 13-and-a-half years.

Reuters: “Investors are reviving one of the most unprofitable wagers of the past two decades and betting that a combination of politics and price pressures would prompt the unthinkable: a hawkish shift at the Bank of Japan, perhaps as soon as the summertime.

Oil Nears $100 a Barrel After Putin Orders Troops Into Ukraine. Why $130 Is in Sight.

BTW: Ukraine is a huge exporter of corn and wheat.

Fiscal Stimulus Is Turning Into a Fiscal Drag, in a Big Headwind for Growth Drop in federal relief could help curb inflation, while elevated savings should blunt impact on consumers

(…) By the fourth quarter of 2021, the various Covid-19 relief packages enacted since 2020 had boosted the level of U.S. GDP by just under 6 percentage points, said David Mericle, chief U.S. economist at Goldman Sachs. Mr. Mericle estimates by the end of 2022 that boost will shrink to a little less than 2 percentage points. That’s equivalent to 4 percentage points of drag on economic growth compared with what would have been if pandemic programs offered the same support as in 2021.

“That is a pretty big pullback in the level of fiscal support to the economy,” Mr. Mericle said. “Our base case is that other factors can offset that and the economy will keep growing, but it is a lot to contend with.”

Goldman expects GDP to grow 2.2% in the fourth quarter of this year from a year earlier. The average of economists surveyed by The Wall Street Journal in January was 3.3%. (…)

Still, with consumer prices rising at the fastest pace since February 1982, “the really big risk for this year is that consumers don’t dip into those excess savings as much as we anticipate because of concerns about inflation,” Mr. Dent said. (…)

Through February 14, the Chase card spending tracker points to flat nominal control sales after January’s jump which followed weak Christmas sales.

The fiscal drag + rising inflation, particularly on essentials, but also on services will in themselves slow GDP growth. The Fed has no reason to hike more than 25bps but 4-5 hikes in 2022 will add to the economic headwinds. I am much more concerned about corporate margins than about inflation which should abate during the second half. Unless:

If we really screw it up, I don’t mean we, if the world really screws it up, it’s going to be a headwind to growth and there’ll be a consequence to that. I mean, I’m a great student of the ’70s, and I’m not saying we’re going back to the 1970s, but everybody is used to asset appreciation in everything that we do, we might have a period of time where there’s less asset appreciation. If you own equities during the 1970s, from 1970 to 1980, you owned U.S. equities. The U.S. equity is worth 50% less in 1980 than they were in 1970. Nobody remembers that. Now I’m not saying we’re going back to that. But how we navigate those policy decisions from here will have an impact on the environment” – Goldman Sachs (GS) CEO David Solomon

Too Complex To Follow? Look To the Bond Market for Orientation

By Hubert Marleau at Palos Management:

(…) It’s not going to be like it was during the past 10 years. The old way of trading stock may be over. Blame it on elevated inflation. Until recently, risk was on when the economic data was strong because inflation was so low the Fed was not expected to remove monetary support. Now that we have high inflation, risk is on only when the prints are weak, because it reduces the chances that the Fed might be too aggressive. In a world where everything seems weird, I go to the bond market for guidance. I rely on it as I would on a compass to set direction. (…)

Evidently, bond investors cannot give us god-like predictions, but their reflections on what the future bears is worthy of serious consideration. (…) The point is that the bond market offers the best guess for where we are headed. Firstly, bond traders, unlike stock traders, can trade billions of dollars worth of trades without going to their bosses for permission. Secondly, they are the smart ones who incorporate the monetary and Keynesian theories in their thinking, diligently following macroeconomic developments, and interpreting data prints rationally. Thirdly, central banks rely on their expectations to orchestrate macroeconomic outcomes.

What they expect is written in the yield curve: the gap between the neutral and policy rates, and 10-year real rates. For guidance and without much effort, stock market civilians should look there in order to see what the rational expectation of the bond experts is. Given that the future will in time become the present, the rationality of the bond market can assist investors pick a macro-path that will help the job of managing asset allocation.

The bond market is signalling:

1) That inflation is embedding itself in the economy everywhere except in long-run expectations.

2) A 100% chance that the Fed will raise its policy rate by 25 bps at its next meeting, to be held on March 15-16. The market sees only a 30% probability of a half a point rate increase, but has baked in 5 rate hikes over the next 12 months.

3) Based on the theory that the yield on five-year notes fairly represents a neutral policy rate that is consistent with output being at full potential with stable inflation, it’s unlikely that the Fed will drive the Federal Funds rate any higher than 1.50%. The narrowing yield curve is either telegraphing that the Fed is acting just as inflation is about to start falling back to its 2.0% goal, or just as growth is about to slow down close to its pre-pandemic path of 2.0%. Investors should note that the shape of the yield curve signals recession only when the 3-month interest rate and two-year bond yield are both higher than 10-year Treasury yields, not when the curve is flattening. The spread between 10-year and 2-year Treasuries is roughly 50 bps and 160 bps between 10-year and 3-month Treasuries.

4) If bond investors were really worried about a recession, they would completely avoid default-prone, high yield bonds. Some money has fled the junk bond funds–$3.6 billion. However, it would be an over-stretch to say credit is cracking: junk bond issuance is still being snapped-up. The allocation of credit remains smooth, credit spreads are wider but anchored, and the capital market is open to triple-C-rate bonds.

5) The spread between the 5Y5Y rate, the Fed’s destination (2.00%), and the 1Y1Y rate – the Fed’s policy gap (4.50%) – defines the boundaries for its activity. The wider the gap between the short and terminal rates, the more scope for stock market volatility. As one can see the spread is wide. Hence volatility.

6) Real rates have risen considerably, not because prospects are for faster growth. Lack of visibility, when it comes to long-term forecasting, has brought about higher term premiums. Indeed, contrary to the past 20 years, bond investors now want to be compensated for the risk they take.

7) Bond market derivatives are predicting that the inflation rate will fall to 4.5% by February 2023, 2.7% in February 2024, 2.5% in February 2025 and 2.0% in February 2026.

(…) The message that I get from the bond market is that withdrawing money from the stock market would be the wrong thing to do at this time. Bond traders are predicting that the Fed will execute a soft landing, extend the growth cycle and prevent runaway inflation.

Ray Dalio has this caveat:

(…) History has repeatedly shown that people tend to have a strong bias to believe that the future will look like a modestly modified version of the past even when the evidence and common sense point toward big changes. I believe that’s what’s going on and that we are in the part of the cycle when most people’s psychology and actions are shifting from deeply imbued disinflationary ones to inflationary ones.

For example, people are just beginning to transition from measuring how rich they are by how much “nominal” (i.e., not inflation-adjusted) money and wealth they have to realizing that how rich they are should be measured in “real” (i.e., inflation-adjusted) money and wealth. From studying history, and with a bit of common sense, we know that when people shift their perceptions in that way, they change their investment and non-investment behaviors in ways that produce more inflation and that make central banks’ difficulties in balancing inflation and growth harder.

For example, people realize that cash is a trashy investment rather than a safe one, that virtually all debt assets (i.e., bonds) are bad, that inventories and forward coverage should be built up to protect against inflation, and that cost-of-living adjustments should be built into contracts to protect against inflation—all of which make upward inflation pressure more intense.

Think of bond investors. Prices rose for over 40 years and yields declined to lousy levels (in both nominal and real terms), and they accepted them. Now they still have those lousy yields (though slightly better than when they were at the absolute lows) plus they are now experiencing price losses. After that huge 40+ year bull market in bonds, imagine how many investors are complacently long and beginning to get stung, and imagine how their behaviors could change to become sellers of bonds, and imagine the effects that would have. (…)

HSBC takes charge on Chinese real estate and warns of wealth slowdown Outlook blemishes otherwise buoyant fourth-quarter earnings as profit doubles and targets boosted