The Fed Is Walking a Tightrope Trying to Fight Stagflation

 | Mar 16, 2017 | 9:00 AM EDT
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The big question that's been overhanging the market this week was cleared up yesterday, when the Fed announced the next upward move in interest rates -- something the stock market has been increasingly expecting over the last several weeks. In looking at the Fed's new forecasts compared to those issued three months ago, there were no material changes in the outlook for GDP, the unemployment rate, or expected inflation.

We find the Fed's action yesterday rather interesting against that backdrop, especially given its somewhat lousy track record when it comes to timing its rate increases: more often than not, the Fed tends to raise interest rates at the wrong time. This time around, however, it seems the Fed is somewhat hellbent on getting interest rates back to normalized levels from the artificially low levels they've been at for nearly a decade.

Even the language with which they announced the rate hike -- "In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 3/4 to 1 percent" -- makes one wonder exactly what data set they are using to base the decision.

The thing is, recent economic data haven't been all that robust. Yesterday morning, the Atlanta Fed once again slashed its GDPNow forecast for the first quarter of 2017 to 0.9% from 1.2% last week and more than 3.0% in January. That's a big downtick from 1.9% GDP in the fourth quarter of 2016! Given the impact of winter storm Stella, particularly in the Northeast corridor, odds are GDP expectations will once again tick lower, as consumer spending and brick and mortar retail sales were both disrupted.

Despite that lack of wage growth evidenced by real average hourly earnings in February, we have seen inflation pick up over the last several months inside the Purchasing Managers' Indices published by Markit Economics and ISM for both the manufacturing and services economies as well as the Producer Price Index.

Year over year in February, the Producer Price Index hit 2.2, marking the largest 12-month increase since March 2012. Turning to the Consumer Price Index, the headline figure rose to 2.7% this past February compared to a year ago, making it the 15th consecutive month. The 12-month change for core CPI was between 2.1% and 2.3%. We've all witnessed the rise in gas prices, up some 18% compared to this time last year, and while there are adjustments to strip out food and energy from these inflation metrics, our view at Tematica is food and energy are costs that both businesses and individuals must bear. Price rises for those items impact one's ability to spend, especially if wages are not growing in tandem.

It would seem the Fed is caught once again between a rock and a hard place: the economy is slowing and inflation appears to be on the move. The economic term for such an environment is stagflation. In looking to get a handle on stagflation, the Fed is walking a thin line between trying to get a handle on inflation while not throwing cold water on the economy as it continues to target two more rate hikes this year.

Once again, we find ourselves rather relieved that we don't have Fed Chairwoman Janet Yellen's job.

The renewed "commitment" by the Fed bodes well for interest rate sensitive companies such as banks like Wells Fargo (WFC) , Citigroup (C) and Bank of America (BAC) , to name a handful, as well as Financial Select Sector SPDR Fund (XLF) shares. At the margin, however, those higher rates could hurt when paired with credit card debt levels that are approaching 2007 levels, as well as adjusted rate mortgages and auto loans, particularly subprime auto loans.

Even before the rate increase, data published by S&P Global Ratings shows U.S. subprime auto lenders are losing money on car loans at the highest rate since the aftermath of the 2008 financial crisis, as more borrowers fall behind on payments.

But there's more...

In the fourth quarter of 2016, the rate of car-loan delinquencies rose to its highest level since the fourth quarter of 2009, according to credit analysis firm TransUnion (TRU) . The auto delinquency rate -- or the rate of car buyers who were unable make loan payments on time -- rose 13.4% year over year to 1.44% in the fourth quarter of 2016, per TransUnion's latest Industry Insights Report. That compares to 1.59% during the last three months of 2009, when the domestic economy was still feeling the hurt from the recession and financial crisis. And then in January we saw auto sales from General Motors (GM) , Ford (F) and Fiat Chrysler (FCAU) fall, despite leaning substantially on incentives.

Over the last six months, shares off General Motors, Ford and Fiat Chrylser are up 19%, 4.5% and more than 70%, respectively. A rebound in European car sales as well as share gains help explain the strong rise in FCAU shares, but the latest data out this morning shows European auto sales growth cooled in February.

So, what's an investor in these auto shares to do, especially if you added GM or FCAU shares in early 2016? Do the prudent thing and take some profits, and use the proceeds to invest in companies that are benefitting from multi-year tailwinds, such as Applied Materials (AMAT) , like we have over at Trifecta Stocks.

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