Surveillance: Peak Inflation With Carpenter

you are known to write short, sharp notes. Seth Carpenter has been acclaimed at doing that across Wall Street for years, and he joins us for his first Bloomberg Conversation his chief global economist at Morgan Stanley. Seth, congratulation on your new position. You gotta go fly fishing with Alan Setner. That's the indoctrination it Morsha Stanley, I love the short sharp note. Everybody calmed down about inflation. Why should we

calm down about inflation? I think if you look at the details about what's really driving the inflation, there's lots of reasons to believe the inflation and physical goods really is being driven by supply chain destructions. We've heard about that for a long time. I mean when we talk to our equity analysts. It seems like most of those supply chains are starting to get a little bit better and at best, you know, and at least not get

any worse. And so that means that the price level increases for those physical goods should be coming to their end pretty soon. We think we've actually peaked in the US when it comes to inflation now. Maybe a little bit later for Europe. But the point is the price level for those goods effected has probably peaked. They're gonna start to ease off a little bit. That's gonna pull down inflation for the index overall. It's maybe not a

global question, but I have to go to America. John Ferroll mentioning this earlier real estate homes rents folds into this call, certainly for G G ten or maybe even G turning to how does housing fold in to a subsiding inflation, it is the force that's pushing in the

opposite direction, especially here in the US. The Morgan Stanley team you mentioned, Alan Zentner of the who runs US economics for US for a long time, has pointed to a really bullish attitude we've had on commercial real estate, multi family home sector, so strong rent increases really will help booie uh those inflation measures. So you've got two

forces pushing against each other. Rents are gonna be creeping up, but we're gonna essentially be where we were pre COVID on sort of the underlying run rate on on rent inflation, and sort of surged a bit coming out of COVID after some ups and downs. Now we're settling into you know, fairly firm, fairly robust housing market that's gonna lift inflation.

The reversion though, when it comes to those consumer goods themselves, that's going to be the things that keeps inflation from rising further from here overall, since said that inflation had paid, can you help me understand where we stipilize? Do we stipilize at a higher level than why we were pre pandemic? So I don't think so. And the one point we've been trying to stress to clients is there's actually two sided risk. I find the the story the narrative to

be inflation is high. It's probably transitory, but there's always the upside risk. And to be sure, we are in very different times, and anyone who has a hundred percent conviction on the outlook is either lying to themselves or they're lying to you. Uh. That said, I think there

is the chance of downside risk as well. So if you think of supply chain disruptions, if they get fixed sooner than we think, if some businesses have started to add capacity on the hopes of this COVID rebound, then you can actually see those prices fall more than anticipated. And so you've got two way risk of the outlook for inflation. So where does it end. I think for the US middle of next year, on a twelve month change basis, you could be looking at two percent, could

be a bit lower that outcome. That post ability was highlighted in the minutes to the last fe C meeting where the staff forecast has their PC measure of inflation going below two percent in the middle of next year. I think that's a realistic possibility. Reminds me that famous quote, what was it? Seth? I forget who said it. If you interrogate the data for long enough, it will confess to anything. It's like the moment we're in right now,

doesn't it. If I look at the labor market, I can get this labor market dates to town we thinks are very tight. I can get it to tell me that things are very loose. When you look at it, what does it tell you? Uh So I look at a few things. One, I look at where things happening, so decompose issues. In the shortfall we had in in last week's data, which was pretty surprising for us on the town side. A lot of shortfall in hospitality and

leisure not surprising, Delta expost not surprising. The delta variant surging means that a lot of those industries they're just seeing a pullback. We think it's temporary. We think delta will have peaked and will come down in the recovery will continue. But for me, that's one of the key points in terms of thinking about demand on the supply side. I look at UM labor force participation, especially prime major labor force participation. It's been creeping up for the past

three months. It's well below pre COVID levels. I think there's every reason to suspect it will continue to rise overcoming quarters and possibly even years if we get continued strong growth. So if we just tie this all together, when you say that inflation has peaked in the US, do you include wage inflation in that or is it entirely a supply chain story. A very good distinction, very

important distinction. I was talking about consumer prices there, and that's the part that's going to matter the most for monetary policy. Explicitly. Wage inflation is in fact a different phenomenon. I think one key point that gets lost, and you can look at some of the research coming out of the FED from some of their top economists in the Research and Statistics division, not a huge amount of evidence in the United States of this wage push inflation phenomenon.

The link between wage inflation and contin is consumer price inflation in the US has actually been pretty weak over the past couple of decades. Wage inflation is clearly strong. There's been lots of disruptions their businesses having to pay up to hire people back. I think we want to be very very cautious, however, and look at some of the measures that do a better job of adjusting for composition, because again for the last employment report, we saw this

big chick up in wage inflation. It was biggest in hospitality and leisure, which is also where we know the under performance was. So when you're not hiring back the people who are at the middle and lower end of the income distribution, that calculated average hourly learning is going to get biased upwards. So I think we want to be super cautious here about any sort of medium and longer term inference about wage inflation. It was Ronald Coast just in case, thanks you, good to catch up, sets

really good to hear from you. Seth confidence to Morgan Stanley, chief Global Economists, did you and it's now it's our global market strategist, Ben. I want to start with Bank for America's cool Cevita is going to join us a little bit later this morning. She goes to fully two fifty by year end. That implies six percent downside. It's an upgrade from thirty eight hundred, but let's be clear, the bear is still slightly bearish. Here's the line, euphoric sentiment,

margin risk, record duration, pose additional risk. Then as a bull, as an echoy market bull, yourself, what do you say back to that? Yeah, sentiments sentiment is pretty full, right, But I think the fundamentals keep delivering as I think they're going to um and bonds stay reasonably low, which I think they're going to. I think that gives you that clear roadmap two over five thousand for next year.

You know, um, I think we're gonna gets growth next year, which is which is double consensus, and I think that's both top line and margins, and we can get into it.

But I think you have very good visibility, you know on that, and bondyld's gonna move up a little bit and they're gonna be a fraction of where they were and when we come out of the last couple of recessions, so it's going to stay, you know, reasonably dark is I think to take sort of insurance on that this economy is really recovering and that's going to keep valuation type. Put that together and you know, I know, you know, I'm very comfortable with over five thousand with the next year.

Then the narratives that are being written are written of caution, maybe not gloom, but caution. How's a ball market happen given caution and that gloom? Yeah, I I think it happens because of caution, right, I mean, this is this wall of worry that you know, we're now continuing to climb. Right, we have some back to school nerves, you know into the market. We've had this sort of remorseless rally since November,

which is sort of worrying people. And we have sort of have this trio of sort of you know, event risk coming out of DC, whether it's you know, the the renomination of Ventcha Powell, or the or the budget limit or sorry, the dead limit, or or this you know three point trillion that the Democrats trying to sort of you know run through Congress. I mean, all that may introduce some noise, introduce some volatility. I think none

of that will derail de rail of this market. Um, it's really you know, it's all about the fundamental saying earnings expectations are still rising, companies are getting more visibility back and they're talking about it more. I mean, that's pushing all these earnings numbers up. And at the same time, the Fed is you know, gradually pushing back, um, you know, expectations for the taper and for the increasing interest rates. And I think you know that's that goldie lots combination.

Can you say the fundamentals we're talking about the fundamentals of the earnings of specific companies that dominate the SMP five hundred in particular, that actually have perhaps fewer employees relative to their overall business. How much is that a feature that you actually celebrate that you basically want to go into the dominant players in the SMP because perhaps they're a little bit more removed from this stagflationary light environment that we saw out of the bag book and

out of a whole host of other data. Yeah. I mean, the stock market is not the economy, and we've certainly saw that a lot last year, and we've enjoyed some of that this year. But I think, you know, look forward, where does the you know, where does the incremental earnings come from. It comes from those reopening stops, It comes from that, you know, it comes from there's a real

economy which is under representing the stock market. That's where earnings are, you know, still down from from pre pandemic levels. And I think that's what I think you should be focusing on right now. I mean, the sort of growth nerves now, the sort of backward looking sort of jobs report we had on you know, on on on Friday, I mean that's a reflection of sort of peak virus cases. But virus cases have been coming down for three weeks in a row globally and uh and potentially peaking now

in the US. So I'm actually looking forward to that next step. You know, where are we going to start seeing that growth re acceleration. When are we going to start talking about all these companies that are you not making any money now? When are they going to start, you know, making money? And that delta is going to be enormous. I'm seeing the worst of it. Ben Allen Center and Morgan Stanley would agree with you. Andrew sheis and Morgan Stanley underweight us? Could he stough? He's looking

at Europe. You're making this call out of London, look across the channel to Europe for us. What's the Europe call now for you? Yeah? I mean I think I think Europe actually leads to all right, I mean you do look at who's recovering from this sort of virus third way best, who has the highest p M eyes um, you know, growth outlook in the world. It's Europe. Who's best prepared to benefit from that with you know, the

most typical indices and the cheapest valuations. It's Europe. And who has the policymakers that are basically going to sit on their hands for an extended period of time and let growth run. I think the CB may tap the brakes a little bit today, but you know, I think they're gonna be one of the last central banks to UH to actually increase interest rates, and physical policy is going to remain pretty loose. So acually think the next

couple of years. Um, you know, European GDP is could be on par or even outpace that in in the US. And you know, we've just come off an earning season in Europe with a hundred and forty percent earnings growth. Um. You know that tells you. I think the earnings lie Bridge which which you're seeing today, that is quite a cool on GDP in Europe. Ben greater catch up, Sir, Ben labor Uta global markets strategist Cevita superman of Bank America, the head of US equity and quantitative strategy, and she

joined us right now. Savita, I'm interested in the process. It goes from thy fifty. Some people might call that capitulation. I'm not sure I'm in that camp. Just walk me through your approach to this market, to your forecast with other people throwing out numbers like five K for next year. Sure, yeah, the process is, it's it's a it's a discipline process. So we have a you know, five five signals that we look at, which range from things like sentiment to

fair value valuations, earnings revisions. Here's what's happened over the last month a few months. Earnings have come in much better than expected, and the market has basically doubled off of the COVID loads. So essentially a lot of what we've done in terms of thinking about our target from here is how much good news is priced into the market. How much more can the market rise from these levels or as their downside risk in the months to come.

And I think you know, part of what we're looking at is the idea that the market is essentially the valuations of the market right now, we're leaving very little margin for air. Meanwhile, earnings have come in strong, but we're starting to see some harbingers of risk, and you know everybody's talking about supply chain risk and inflation. We're

actually starting to see that come in the numbers. So every month we track this guidance ratio, look at the number of companies that are guiding above versus below consensus earnings revisions or a consensus earnings estimates. Over the last let's call it four weeks, we've seen that guidance ratio moved from record highs to a big southward move. We're starting to see companies worn on profits and it's showing

up in a broader way across the SMP five hundred. So, first of all, earnings are at risk from just a cyclical pressure of input costs, wages, supply chain dislocation, et cetera. Second of all, when you look at the second their pressures on margins. We've had this great period of time for the SMP five hundred of globalization. The past twenty thirty years have been about US companies getting more global, you know, kind of arbitragey taxes, labor class, etcetera. Now

look what's happening. We're at peak globalization. We're starting to see companies on shore. And what that's gonna do is again potentially installed or reverse this kind of long term great theme that we've had for big multinationals. In to me, I want to pin you down in this partition. For me, the earnings dynamic, the nugget that we call earnings growth, a dollar amount of earnings of SMP index versus the partial differentials of price to earnings. Which of those dynamics

are you focusing on with such a narrow call. Well, you know, I think it's more the pe that's that's making us think, Okay, there's not a lot of upside from here. And I'll tell you one thing, Tom, So we have a evaluation frame or cuts not very predictive over the near term, but it's kind of all that matters over the long term. The are squared on this framework is eight in terms of you know, this is critical. I don't mean to interrupt this, folks, is math. It's important.

Is your are squared valid given the dominance of those giga tech companies. Well, I'll tell you this much. It worked during the tech ball and this is an important point. I'm glad you brought up the giga tech tech companies because the last time this S framework was as negative as it is today was in another period where we were all kind of calling out the primacy of technology. And I think that today the bubble is potentially even more dangerous because it's not about you know, growth stocks

which were tech ultimately grew into its multiples. It's about bonds, bonds and interest rates remaining as low as they are for perpetuity. I mean, this is what's scares me, Tom, is that the SMP five hundred has essentially turned into a thirty six year zero coupon bond. If you look at the duration of the market today, it's basically longer

duration than it's ever been. So what that means is that any move higher in the cost of capital, the get interest rates, credit spreads, equity risk premia, that's basically going to be a huge knock on the market relative to the sensitivity we've seen in the past. So just real equipment here. You did upgrade your forecast, however, you moved up from thirty eight hundred. Why does this not become the bear case the originally saw? Well, look, I mean I think that the market couldntest could move as

low as thirty eight hundred in the near term. But when we look at our frameworks and we think about okay, where do we I mean points in time, forecasts are fraught with peril. But but I think you know, our our view is okay. Earn us have come in a little bit better. Companies have been able to navigate a lot of the margin pressures were actually at peak margins today for for SMP. So it's a pretty remarkable story that corporate America has been able to manage um, you know,

the COVID related risks as well as it has. But I think that now we're starting to see some of those areas prey and we're sort of waiting to see how corporate American deals with it. What would make me more embarrassing go back to three hundred is a last the implation persistent and dangerous and companies unable to pass any of it on through prices um And if we

saw a more hawkish FED. I think the other thing that we pointed out in our note is that earnings matter for the market, but post crisis, what matters even more is the FED. And I think, you know, it's kind of remarkable. We have a chart in our note that shows that the FED has basically explained half of the market moves outside of earnings UM since the global financial crisis. So you've got this market that it's basically been fed by stimulus. We're now at a point where

the FED is talking about tapering. It's hard to imagine they're going to accelerate asset purchases. I mean, what gives And you know, the evaluations don't reflect any of those risks. So basically, yeah, I've only got sixty seconds left on the clock, but I don't want to leave you before asking what do you want to own right now? Within

the secondity market away from the index level stuff. There's always a full market somewhere, And what you want to own is the key scares theme today, which is inflation protected yield. So let's say the Fed keeps where it's low forever, but inflation is starting to bubble up. Don't buy bonds, bonds to offer you a fixed coupon that's

not going to keep up with inflation. By energy dividend yielders, by financials dividend unders by companies that are tethered to positively tethered to inflation and can pay a growing yield. I think that's the that's the that's the call right now is really focused on income and inflation protections. This was great. Can you promise me one thing next time you come back. Let's get together with John I thank god a credit sweets again and which we can do

a repeat. Let's still repeat that. Savada is going to catch up. We appreciate your time as always, send our regards to the team. Savita Subramani of Bank of America. We are thrilled to provide clarity here, maybe Hulger Schmiden joins us with Barenburg their chief economists. Hulger, I want to go to the politics of the moment I'm sure be unspoken within the press conference the Hawks, the traditionalists at the ECB, which you have beautifully enunciated over your career.

How does Bundesbank respond to this semantic jumping through hoops on debbish practices. Well, the bank won't quite like it. But what we probably will learn is that two day's statement they press conference, it's only the prelude to the really big decision. The Hawks will now probably try to sum up all the strength to influence the December decision. In December the easy we will probably not be able to duck the issue, namely, when does the emergency end?

When does the paper emergency program has to end? And as a result, expect the Hawks to make quite a few noises incoming weeks to prepare for probably a decision in December that will be hotly contested and may give us a better clue about the genuine tapering that will come at some time next year, whether it starts in April or whether it will take longer. Okay, this is really difficult for people to follow because there's two programs running in parallel. This PEP on the one side, there's

a p P on the other. If they ENDPAP, because actually say the clue is in the name emergency. If that ends, what does it mean for the asset purchase program. That's another big open question. It probably really will mean that the normal as a purchase program is beamed up, and I expect it to be made moderately more flexible to react to market conditions, but to not be anywhere

as flexible as the current emergency program. So the compromise will likely be in my view, and it will be hotly contested that in December the ECB tells us yes the PEB the emergency program will be phased out from April onwards. At the same time, the standard program that is open ended will be raised a bit and made more flexible. So but that's the debate for the next few weeks. With the December decision, rather than anything, we

will probably learn the details about today. Today is probably just the day when we may learn, Yes, there is a serious debate going on and they have agreed to disagree until December. On a broader level, however, the message from the e c B is similar to the one from the Fair. They will use all tools to get the average inflation rate at target, even if it exceeds it temporarily, They're not going to be phased by that, and frankly, they talked about potentially even adding accommodation should

that become necessary. This was incredibly duvish, and you do see bonds in the euroregion actually rallying to a significant degree. Is this basically the market saying that they don't believe that the ECB could ever reach that goal that they're

setting out in inflation. Well, the easy B statement today seems to be almost the same as the previous statements, so there is no change except for this moderation of the pace of asset purchases, which however, was tracked in advance so much so that the bond markets you could say,

reacted already to that. Again, the outcome of what we will here in December at the real decision is open and the hawks will probably in coming months get even higher inflacial rates transitory but higher inflacial rates to make their point. So that will be very interesting question in the pressor for President Leguard Hulga. What is it? Sorry? Say it again. Please, if you've got a question for President le Guard and the pressor the news, come it's

in about thirty seven minutes time. My key question would, of course be how flexible can the standard asset purchase program be the open ended program once the East finally declares the pandemic emergency over. It's not just the size of asset. Could also this flexibility to react to market conditions, which is if need be helped Italy and the like. It is also that element which really among the Hawks is hotly contested, and that's putting it. We did not

discuss that at today's meeting, Mr Smeding. We are committed to financial conditions remaining easy through the projected horizon. Holgus Smedie thank you. You know what's going to happen at eight thirty Eastern. Bloomberg Chief Comust, thank you very much. This is the Bloomberg Surveillance Podcast. Thanks for listening. Join

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