Morning Report: Double digit inflation

Vital Statistics:

S&P futures4,18523.2
Oil (WTI)96.20-6.59
10 year government bond yield 2.09%
30 year fixed rate mortgage 4.43%

Stocks are higher this morning as we begin the FOMC meeting. Bonds and MBS are down.

Inflation at the wholesale rose at a 10% clip in February, according to the Producer Price Index. Ex-food and energy it rose 8.4%. Rising energy costs were the big driver of the increase and we are seeing increased diesel prices push up transportation costs, which is now flowing into intermediate goods. The Fed will almost assuredly raise rates this week, however all eyes will be on the dot plot and the new economic forecasts.

The Nasdaq officially closed in bear market territory as many high flyers are getting some air taken out of their multiples. Leaders like Netflix and Tesla have been smacked down hard so far this year. The mortgage bankers have been wrecked as well.

Sarah Bloom Raskin, Biden’s nominee just had a blow dealt to her nomination after West Virginia Senator Joe Manchin expressed opposition to her nomination. Without Manchin’s support, she will need a Republican to vote for her, and that chance is remote.

What is the issue here? Well, she wanted the Fed to take into account climate in banking regulation. In practice this would mean restricting credit to the energy industry. For example, the Fed could decide that excessive energy exposure would cause a bank to flunk its stress test, which would limit dividends and buybacks.

Note that ethical, social governance (ESG) investors are pushing energy companies to shut down production, along with a group of banks and money managers which control $60 trillion in assets via Climate Action 100+ which have refused to lend to natural resource companies. The Arizona AG is investigating this group for antitrust violations under the theory that colluding to raise prices is illegal regardless of whether it is done for profits or ideology.

The bottom line is that increasing production to counter higher prices is going to be more difficult than it was in the early 00s, the last time energy prices spiked. In normal times, the cure for high prices is high prices. That might not be the case this time around. Which means the Fed has its work cut out for it.

Mortgage delinquencies fell to 3.4% from 5.8% a year ago. “Nonfarm employment grew by 6.7 million workers during 2021, the largest one-year increase, supporting income growth and keeping more families current on their loans. Nonetheless, places hit hard by natural disasters have experienced a spike in missed payments. Serious delinquency rates for December in the Houma-Thibodaux metro area were nearly two percentage points higher than immediately before Hurricane Ida. ”

Back to the issue with energy companies. ESG investors and the big passive investors are driving corporate decision making in a way that didn’t exist even 5 years ago. To grasp the implications of this, it is important to understand the way index fund managers are paid: They are paid to mimic the index, not to pick good stocks. In other words, if XYZ corp is a dog with fleas, but the index they are matching has 2.452% of XYZ corp, the manager will have to hold 2.452% of his or her fund in XYZ corp.

This creates something similar to what business school professors would call an agency cost. The incentives of the manager and the shareholder are not aligned. The manager of your index fund doesn’t have to care how the stock performs. Since they have no skin in the game with corporate performance they can costlessly push for things that might not be investor’s best interest. Ain’t their money. And that, folks is the “cost” of that rock bottom management fee. . At a minimum, it certainly raises fiduciary responsibility questions. If you support the ESG ideology, great, but if you don’t chances are your retirement fund does.

I have a feeling that the era of outperformance by passive fund managers is about to come to an end as the big index names get tied down with ideological institutional investors. It will become what people used to call “a stock picker’s market.”


Author: Brent Nyitray

In the physical sciences, knowledge is cumulative. In the financial markets, it is cyclical

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