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Key Points for the Week

  • Inflation surged in the U.S. in October. The Consumer Price Index (CPI) rose 0.9% during the month and is 6.2% higher over the last 12 months. The CPI year over year has now been at or above 5% for six straight months. There have only been six other periods since World War II where year over year CPI has done this.
  • With 92% of S&P 500 companies reporting, earnings increased approximately 39% last quarter.
  • The percentage of the labor force voluntarily quitting their jobs reached a record 3%.

Last week, investors noticed it. The Consumer Price Index (CPI), which is a measure of inflation, rose 0.9 percent in October and 6.2 percent over the last 12 months, according to the Bureau of Labor Statistics. (When volatile food and energy prices were excluded, the CPI was 4.6 percent for the period.)

That’s the highest level for inflation in 30 years, according to The Economist, and well above the United States Federal Reserve’s policy goal of two percent inflation over the longer term.

Uncertainty about the nature of inflation has left the U.S. Federal Reserve wedged in an uncomfortable policy position. The Economist explained:

As inflation has accelerated economists and officials have debated whether it is a transitory phenomenon—reflecting overstretched supply chains—or a more persistent problem. It is far more than an academic debate. If inflation is short-lived, the right move for the Federal Reserve would be to look through it, aware that jacking up interest rates may do more harm than good. If, however, inflation is stubbornly high, the central bank is duty-bound to tame it.

The Economist

Taming inflation could mean tapering bond buying and raising rates more quickly than planned, and higher rates tends to slow and, sometimes, stall economic growth.

When making policy decisions, Personal Consumption Expenditures (PCE) is the Fed’s preferred inflation gauge. The readings for the CPI and the PCE rely on information from different sources.

What is the difference between CPI and PCE? The CPI measures the change in the out-of-pocket expenditures of all urban households and the PCE index measures the change in goods and services consumed by all households, and nonprofit institutions serving households.

The CPI uses data from household surveys; the PCE uses data from the gross domestic product report and from suppliers. In addition, the PCE measures goods and services bought by all U.S. households and nonprofits. The CPI only accounts for all urban households.

Fanglue Zhou, Callan Associates

Why does the Fed use PCE instead of CPI? The reason is that its formula uses updated data, as the PCE is believed to be a more accurate reflection of price changes over time and across items. Over time, the two measures tend to show a similar pattern, but the PCE tends to increase between 2 and 3 tenths less than the CPI.

PCE data will be released on November 24.

This Week in the Markets

An inflation surprise created a challenge for investors. The Consumer Price Index rose 0.9% last month. The monthly increase was the largest reached in 2021, and the yearly increase of 6.2% was the largest since 1990, when the Gulf War contributed to a surge in oil prices. It is interesting that international economies are not experiencing inflation rates this high.

Corporate earnings results provided a salve for those worried about inflation. Earnings skyrocketed 39% last quarter as companies bounced back from weaker sales due to the pandemic. A higher percentage of companies beat expectations and beat them by wider margins, contributing to the strong results.

The inflation data proved too much for markets last week. The S&P 500 fell while the MSCI ACWI was basically unchanged. The Bloomberg U.S. Aggregate Bond Index dropped as higher inflation provides a direct hit to the real return of bonds.

Inflation Becoming Entrenched

Inflationary pressures are becoming more ingrained in the economy. Last month’s 0.9% increase in the CPI raised the annual inflation rate to 6.2%. The large monthly increase and relatively low inflation in the same month last year pushed the annual number higher and ended a period wherein the annual inflation rate moderated. Supply chain woes continued as more ships were unable to unload and many unfilled jobs are providing challenges for companies.

Much of the inflation came from the volatile food and energy segments. Energy prices are up 30% in the last year and food prices have jumped 5.3%. Core inflation, which excludes food and energy, increased 0.6%. Core prices are up less than overall inflation, but prices are still rising more rapidly than the Federal Reserve desires. The shortage of semiconductor chips is forcing auto manufacturers to raise prices. New vehicle prices jumped 1.4% last month and used vehicle prices bounced 2.5% higher. Produce prices also remained strong, rising 0.6% last month.

Many wonder why inflation is picking up so quickly after being so low for so long. The quickest answer is the economy is trying to adjust to the items demanded from the pre-COVID economy. During the pandemic, goods have been easier to use than services. Shifts toward consumers buying more goods has pressured the capacity of the global supply chain, which suddenly feels elongated and vulnerable to shutdowns. The disbursement of direct payments to citizens likely contributed to demand for more goods just as supply was contracting.

Companies are concerned about inflation. The term “inflation” is typically mentioned in about 25% of company earnings reports. For the third quarter earnings-to-date, 57% of companies cited the term “inflation” in their reports, which is the highest percentage since 2010. The industries that had the highest concentration of inflation mentions were materials (89%), consumer staples (88%), and energy (86%). However, talk of inflation in these reports is mostly forward-looking. Profit margins are at a near-record high of 12.9%, which indicates either companies are passing the higher costs on to others or they haven’t experienced the rising costs yet.

Companies are caught in a difficult situation of trying to ramp up production without being able to find workers. Job openings remain above 10 million, and an estimated 3% of the U.S. workforce quit in September. In the leisure and hospitality industry, which includes restaurants, the quit rate was 6.4%. When workers are in short supply, pay increases are one way to recruit the necessary staff even as prices often increase to reflect the higher costs.

The high rates of inflation are beginning to pose a challenge to the Federal Reserve. When the Fed is targeting core inflation of 2% and inflation is above 4%, the Fed is pressured to taper and eventually raise interest rates. Market expectations for a hike in interest rates by the Federal Reserve increased to 71% from 53% one week earlier.

If the Fed moves up its first hike from the end of next year to the middle of next year, expect a “hike across the bow” where the Fed raises rates one time and pauses to gauge the effects. A shot across the bow is a naval term meaning warning shot. A “hike across the bow” would let investors know the Fed remains serious and diligent as the economy continues to work through a unique market period. Fed communication has become a bigger risk as any Fed action must be well communicated to not unnerve investors.

Provisions Contained in the Infrastructure Bill

Information Reporting for Brokers and Digital Assets

Per Code Sec. 6045(a), brokers will be required to make a return showing the name and address of each of its customers, with such details regarding gross proceeds and such other information as the IRS may, by forms or regs, require with respect to such business.

The Act provides that the definition of broker is expanded and includes “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” This definition would include cryptocurrency exchanges, which function in many ways like a broker-dealer does in the securities market.

With respect to certain covered securities, (in general, a specified security acquired on or after the applicable date), the return must include the customer’s adjusted basis in the covered security and whether any gain or loss with respect to the covered security is long-term or short-term.

The Act also provides that a digital asset is a specified security, effective January 1, 2023. This treatment would require brokers to track and adjust the customer’s cost basis, similar to a stock today, for digital assets purchased on or after that date.

The Act defines a digital asset as, except as otherwise provided by the IRS, “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the [IRS].” This applies to common cryptocurrencies, including bitcoin and ether, that are recorded on a blockchain.

The clarification of the definition of broker applies to returns required to be filed, and statements required to be furnished, after December 31, 2023.

Digital Asset Treated as Cash for $10,000 Reporting Purposes

Any person engaged in a trade or business who, in the course of that trade or business, receives more than $10,000 in cash (in one or more related transactions), must file an information return with the IRS and furnish the payor with a statement.

The Act provides that cash includes any digital asset (as defined in Code Sec. 6045(g)(3)(D)) (Code Sec. 6050I(d)(3)).

The amendments made by Act Section 80603(b)(3) apply to returns required to be filed, and statements required to be furnished, after December 31, 2023.

Did you Know? This Week in History

November 15, 1867: First Stock Ticker Debuts

On November 15, 1867, the first stock ticker was unveiled in New York City. The advent of the ticker ultimately revolutionized the stock market by making up-to-the-minute prices available to investors around the country. Prior to this development, information from the New York Stock Exchange, which has been around since 1792, traveled by mail or messenger.

The ticker was created by Edward Calahan, who configured a telegraph machine to print stock quotes on streams of paper tape (the same paper tape later used in ticker-tape parades). The ticker, which caught on quickly with investors, got its name from the sound its type wheel made.

The last mechanical stock ticker debuted in 1960 and was eventually replaced by computerized tickers with electronic displays. A ticker shows a stock’s symbol, how many shares have traded that day and the price per share. It also tells how much the price has changed from the previous day’s closing price and whether it’s an up or down change. A common misconception is that there is one ticker used by everyone. In fact, private data companies run a variety of tickers; each provides information about a select mix of stocks.

Weekly Focus

It’s not too much food. This is what we’ve been training for our whole lives. This is our destiny; this is our finest hour.

Lorelai Gilmore, Fictional Character in Gilmore Girls

I suppose I will die never knowing what pumpkin pie tastes like when you have room for it.

Robert Brault, Author