New Year, New Paradigms
A deep dive into digital retail evolution, inflation dynamics, and the changing relationship between government debt and markets
By Bob Sheehan, CMT, CFA
As we settle into 2025, the economic landscape presents a fascinating puzzle of resilience and vulnerability. As of yesterday morning, the latest data from the Commerce Department indicates that U.S. retail sales rose by 0.4% in December 2024, reaching a total of $729.2 billion. This marks the fourth consecutive month of growth in retail sales, with a year-over-year increase of 3.9% compared to December 2023.
The digital transformation of retail continues unabated, with e-commerce ("nonstore retailers") now commanding more than 16% of total sales – more than doubling its piece of the pie compared to a decade ago, even after normalizing the COVID bump.
Diving deeper into the inflation narrative, we're witnessing a story of gradual but uneven improvement. While we've moved well past the acute phase of 2022, service sector inflation (excluding shelter) continues to run hot at around 4%.
The divergence in inflation components tells a complex story. While core inflation has shown signs of moderation, food and energy prices continue to exhibit significant volatility, creating challenges for both policymakers and consumers. The Atlanta Fed's sticky price measure and other core metrics like the median CPI at 4% and trimmed mean CPI at 3.2%, are suggesting a slower journey toward the Fed's 2% target.
The labor market remains a crucial piece of the economic puzzle:
The labor market continues to be resilient, as evidenced by the continued low unemployment rate. However, there are some pockets of worry. For starters, this strength presents a double-edged sword for inflation control efforts. Employment Cost Index is still elevated and tends to lag Quit Rates so while inflationary wage may subside, it may be three more months until it even hits 3%, much less being at the Fed’s 2% target. To that end, while Quit Rates have been moving consistently lower, this typically happens as the market weakens, as employees weigh the cost of quitting against the ability to find another job in a deteriorating market.
The consumer’s wallet could begin to shrink more dramatically if wages continue to fall at the same time yields rise and debt burdens increase. The interplay between wage growth and real disposable income reveals the true impact on household finances. Household Debt Service as a Percentage of Income is at its highest levels since pre-Covid, though still below the historical average. While nominal wage growth has remained robust, the real purchasing power of consumers has been eroded by persistent inflation, creating a more nuanced picture of consumer health than headline figures might suggest.
A New Kind of Inflation?
The bond market is currently undergoing a 'bear steepening' - where longer-term yields are rising faster than short-term ones. This, combined with cautious equity markets, suggests investors are adapting to a new reality.
Typically, when our economy heats up, we see a predictable pattern: consumers spend more, businesses expand, and this surge in demand naturally leads to rising prices. During these traditional cycles, stock markets initially thrive as corporate profits grow, while bonds take a hit from rising inflation. Eventually, this pattern reverses itself as inflation begins to eat into consumer spending power.
However, the market is beginning to discount the risks of an inflationary regime fueled by supply shocks. So, instead of demand pulling prices higher, we're seeing supply constraints pushing them up. Investors are discounting higher rates and stickier inflation for longer as Trump’s tariff focused trade policy agenda will be kicking off over the coming months. This could potentially have large effect on the supply side of things, leading to a significantly different environment than the Demand-Driven Inflation discussed above.
Supply shortages cause inflation to shift higher much faster than it happens from a demand driven inflation regime. This is due to a near immediate issue of scarcity and the rapid repricing that follows. The chart below illustrates how drastic the shock of the pandemic had on the supply chain, reaching more than +4 StDev of “normal” supply chain pressures. The speed and intensity of supply shocks tend to feel a lot more jarring. Like getting cold water thrown in your face to wake you up as opposed to an extra alarm clock that slowly gets louder and louder. Neither are enjoyable experiences, but no one leaves you feeling a lot more shaken.
When this occurs, Demand is completely undercut by inflation, as consumer spending power erodes more rapidly than usual and dampens economic activity. It's like throwing sand in the economic engine: everything slows down at once. This creates an unusual scenario where both stocks and bonds face challenges and sell off simultaneously, flipping from the negative correlation the pair have historically.
This shift has deep historical roots. For most of the post-war era, when governments increased their borrowing, interest rates would typically fall. This made sense because high government debt usually signaled weakness in private sector spending – think of it as the government stepping in when consumers and businesses step back. But during unique periods of supply disruption – like the oil shocks of 1973 and 1979, or more recently during the pandemic – this relationship flips. In these cases, government spending during supply-constrained periods tends to amplify inflation pressures, pushing interest rates higher rather than lower.
Understanding this dynamic is crucial for investors navigating today's markets. The old playbook of using bonds as a reliable hedge against stock market risk needs careful reconsideration. We're not just seeing a temporary deviation from the norm – we may be witnessing a fundamental shift in how different asset classes interact in this new economic environment.
What does this mean for investors? The market is demanding higher yields to compensate for this new risk pattern. It's particularly noteworthy because it challenges the post-WWII pattern where higher government debt typically led to lower yields. Now, in our supply-constrained environment, increased government spending might actually push yields higher - similar to what we saw in the 1970s and during the recent pandemic.
This shift requires a thoughtful approach to portfolio construction, particularly in how we think about the traditional bond-equity relationship.
As we progress through 2025, successful navigation will require a balanced approach: maintaining exposure to areas of strength while building in appropriate hedges against the numerous risks on the horizon. We'll be paying particular attention to the interplay between consumer spending patterns, inflation dynamics, and political developments, as these factors will likely drive market performance in the months ahead.
That’s all for now, team. Let’s do it again soon. Until then….
I’ll keep the light on.
