SGOV: The Labor Market May Weaken In 2025 While Inflation Rebounds

seekingalpha11-22

SGOV is only a good investment if we can safely assume its yield will be above the inflation rate, which has been the case since 2022.The market is bracing for a total 50-75 bps rate cut over the next...

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Richard Drury My most prominent portfolio position has been short-term government debt for the better part of two years. Although short-term Treasury bills like the ones held in the iShares 0-3 Month Treasury Bond ETF (NYSEARCA:SGOV) have not had the same overall performance as many other investments, they have no volatility and, until recently, had a much higher yield than most stocks and long-term bonds. My view shifted over the summer as some signs of labor market weakness indicated a more significant decline in inflation, supporting larger rate cuts. As expected, the Fed pursued \"jumbo\" rate cuts over the fall, lowering the one-month Treasury rate to ~4.65% today and the two-year Treasury rate to ~4.3%. Crucially, progress in lowering inflation may be stalling, particularly as the unemployment rate remains elevated but is not rising. The stagnant labor market and inflation data have lowered the odds of an immediate Federal Reserve rate cut. Over the past week, since the last inflation data, the probability of no rate cut in December rose from 27% to 44%. The most likely outcome is still a 25 bps cut, but it is less likely than it was previously. I believe SGOV is a sound investment if we assume its yield will be above the inflation rate. The year-over-year inflation rate is 2.6%, while SGOV's total return was ~5.4%, giving it a healthy return over inflation, for the most part, that has been the trend since rates rose in 2022, as seen in the ratio of SGOV's total returns over the CPI: Data by YChartsOf course, after accounting for Federal income taxes, many SGOV investors should be roughly breaking even with inflation today. Looking six months ahead to May Fed rate contracts, the market is bracing for a target rate of 4-4.25%, 50 bps below the current level. There is a 32% chance of 4.25% to 4.5% and a 17% odds of a more significant cut to 3.75% to 4%. Thus, it is pretty likely that SGOV's forward performance should be around 1%-1.25% less than what we've seen over the past twelve months. Further, without a recession, I do not expect inflation to slow. Given we're seeing some signs of latent inflation combined with a stagnant labor market, it may be possible that the Fed cuts rates into higher inflation. If so, SGOV may be a poor investment in 2025 compared to the past two years, encouraging investors to switch toward inflation-hedged assets. Why Inflation May Rise While Labor Slows It is a general economic principle that there is an inverse relationship between inflation and unemployment, also known as the \"Phillips curve.\" SGOV's value to investors depends on this pattern, as the curve implies rate cuts should occur as labor pressures slow inflation. However, data shows that the Phillips curve has flattened since around 2000. Since inflation was elevated while unemployment was low around 2022, many thought its importance had returned. Indeed, core inflation and unemployment have held an inverse relationship over the past four years. See below: Data by YChartsToday's slightly elevated unemployment and lower inflation give credence to the pattern. It is far less reliable than in the past. The underlying theory is based on a demand model wherein high consumer and commercial demand during high employment periods will often cause shortages (of goods and services), lifting prices. However, in 2020, unemployment was high, and the government poured monetary stimulus into the economy, artificially lifting demand while artificially limiting supply through lockdowns, thereby creating a large inflation wave. Fundamentally, the significant inflation in 2021-2023 was partly created by high unemployment because that unemployment encouraged excessive fiscal and monetary stimulus without stimulating production. SGOV was a terrible investment from 2020 to 2022, as interest rates were around zero while inflation shot up. If the labor market weakens in 2025, fiscal and monetary stimulus efforts could repeat that scenario, pushing inflation even higher. In that case, as in 2021, I expect the Federal Reserve would be reluctant or slow to raise rates. Although the overall unemployment rate has not made a new high for a few months, the \"U-6\" unemployment rate, which accounts for underemployment (part-time workers laid off from full-time jobs), did peak a month later than the overall rate. Combined with the continuing jobless claim trend, which is rising sharply, the trend toward a weaker labor market remains intact. See below: Data by YChartsThe Fed often focuses on the job opening rate to indicate labor market health. However, as many have pointed out, the rise in \"ghost jobs\" or \"fake\" job postings may seriously distort job openings data. Companies now often keep job openings available to hold their hand in the labor market, even if they have no desire to hire. Though job openings are falling, they're still relatively high by historical standards. However, the more critical private hiring rate is depressed, around levels seen during the height of the 2008 crash. Companies may report job openings, but they aren't hiring. Further, though it can hardly be seen in the below data, the private layoff rate has also ticked up in recent months: Data by YChartsLooking back to 2008, we can see how job hiring plummeted at the onset of the recession. Around halfway through the recession, layoffs began to rise. Again, the overall US employment level is decent today, but it's increasingly skewed by part-time work, which is a tell-tale recession signal. A few companies have only recently begun to seek layoffs and have avoided hiring for the past two years. Overall, the fundamental labor market trend is negative today. However, a few areas of strength exist, notably in services, such as the information technology sector. The services PMI was steadily falling, though it remained over ~50, but surged recently, indicating renewed growth in the services sector. This trend aligns with a rebound in the hiring rate for information technology jobs. Further, the producer price index for services has consistently risen faster than the PPI for goods since 2022. See below: Data by YChartsPeople's opinions on the strength of the US economy differ widely today for a reason. The data show a fundamental break between the goods/manufacturing economy and the services economy. Service workers have had relative stability and improvements over the past three months, particularly in technology, healthcare, and government. Conversely, manufacturing, construction, and other economically sensitive segments have rapidly declined. The producer price index for goods is only up 36 bps YoY, while services are up 3.3%. This is the opposite trend from 2020-2022, which saw immense inflation in goods, with relative deflation in services as demand for services collapsed in the initial lockdown. The divergence between the goods and services economy makes estimating the Federal Reserve's next actions difficult. Indeed, I believe this is a significant reason why there is much confusion in the Federal Reserve's statements and signaling. One large segment of the economy, technology, is doing great today, but the more blue-collar physical-based sectors (manufacturing, construction, transportation, etc.) are showing weakness. I believe the inflation in services is a sign that underlying US inflation is still elevated today. This is not necessarily due to monetary stimulus but significant shortages for a smaller subset of highly skilled jobs (specifically healthcare and technology). There is little reason that the trend should end soon. However, the overarching hiring rate trend is definitively falling, while layoffs appear to be ticking up. For this reason, I suspect that 2025 may see more clear signs of a labor-market-driven recession without disinflation. More specifically, I suspect deflation in durable goods (vehicles, etc.) and sustained service inflation (healthcare costs). I expect the Federal Reserve will meet a recession with QE and more significant rate cuts, as has been the precedent; however, that may only exacerbate long-term inflation pressures. Tariffs and Geopolitics May Increase Inflation For numerous reasons, as detailed in \"XLE: Trump SPR Refill And Geopolitical Risk Point To Oil Rally In 2025,\" I think there is reason to expect oil and gasoline prices may rise next year regardless of the economy. This risk is partly based on recent geopolitical events that threaten Asian oil exports. A significant spike in global oil prices, caused by a sharp decline in export capacity, would likely spike inflation while slowing the US economy. The oil market is a thorn in the Federal Reserve's side because it cannot control oil prices or supply-side inflation. Trump's tariff plan is almost certainly inflationary, too. Tariffs are also fundamentally a supply-side inflation factor because they raise the costs of imported items. This issue is exacerbated by the US's current extreme import dependence, with the trade deficit sharply growing this year. From a long-term manufacturing jobs and stability standpoint, I think tariffs or other efforts to balance the trade deficit may improve the US economy. Again, the US faces significant supply-side inflation risk due to geopolitical factors that could hamper global exports into the US. This issue would be solved by more US production. However, if tariffs take effect next year, prices will rise immediately, and it may take many years before that translates into an improved US goods economy. I think it is a short-term loss with the potential for long-term gains if done wisely. Regardless, tariffs should raise inflation over the short term, likely lowering consumer spending capacity on goods. The Bottom Line I believe the YoY inflation rate is bottoming out, while the labor market appears poised to weaken further. Assuming recent trends continue, we should see more service inflation and unemployment in non-service sectors. Of course, if Trump cuts Federal government jobs, then we may expect more widespread increases in unemployment. Further, higher geopolitical risks and tariffs could increase goods prices on imports. Overall, I think there is significant evidence that 2025 may see a recession and higher inflation, mainly if the Federal Reserve is quick to cut rates and pursue QE. Based on the Fed's 2020 precedent, a sharp dovish shift is likely. In 2020, the Trump administration also rapidly pursued deficit spending programs, such as direct consumer stimulus checks, which I believe increased consumer demand with reduced supply, contributing to the inflation wave. My view on SGOV is neutral today, and I do not see it as a preferable investment option. Its yield is likely to decline, potentially as inflation increases. Thus, investors looking for a low-risk investment are likely better off in inflation-indexed Treasury securities, particularly short-term ones such as those held in the Vanguard Short-Term Inflation-Protected Securities ETF (VTIP). The five-year inflation-indexed security rate is 1.84% today, meaning inflation-indexed bonds with five-year maturities should pay around 1.84% above the CPI inflation rate. They are guaranteed to outperform inflation (technically, as long as the government does not default), while, to me, SGOV is likely to underperform it. VTIP's maturity is longer at an effective 2.5 years, giving it more volatility than SGOV but still far less than most fixed-income investments.  The most significant risk with VTIP over SGOV is deflation. If my view is wrong, and consumer prices fall with a potential rise in unemployment, VTIP should underperform SGOV on an inflation-adjusted basis. Although I do not think this is likely, consumer prices usually fall due to an economic decline. However, given external factors and the US government's shift toward \"modern monetary theory,\" I expect deflation would not be sustained, being quickly met by fiscal and monetary stimulus.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"analysis","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2485428894"}