It’s All About Inflation
By Crest Capital Advisors on September 16, 2022
Dow: (4.13%) to 30,822.42
S&P 500: (4.77%) to 3,873.33
Nasdaq: (5.48%) to 11,448.40
Russell 2000: (4.50%) to 1,798.19
10 Year Yield: 3.45%
Outperformers: No positive sectors for the week.
Underperformers: Materials (6.65%), REITs (6.48%), Communication Services (6.43%)
Major US equity indices were notably lower this week, with the S&P 500 logging its fourth weekly decline in the past five weeks, taking the market down nearly 10% since before Jerome Powell’s Jackson Hole Speech. Growth was an underperformer to value once again, though both factors were lower. Treasuries were weaker with yields pressured higher. The 2-year treasury climbed as high as 3.9% on the week as investors anticipate still higher rates from the Fed.
Overall, the market was ready to rally as we entered the week, but the worse-than-expected headline CPI report Tuesday morning sent the market into a tailspin. This caused investor fears of a more-aggressive Fed to resurface as the long-awaited dovish pivot continues to be elusive. The stronger CPI report also undercuts economic “soft landing” hopes, which had been cited as a source of market support last week.
While the focus on Friday turned to recession-narrative confirming corporate headlines from the likes of FedEx, the reality is the path of least resistance/pain trade has been to the downside since Tuesday, driven almost entirely by concerns that sticky inflation will drive a more aggressive Fed tightening cycle, ultimately leading to a possible recession. Looking ahead to next week, the ball is firmly in the court of the Fed to determine whether stocks can find footing for a rebound rally, or continue lower on the fears of increasing hawkish rhetoric from the Fed. Will they raise 50, 75, or 100 basis points? The market is certain it will be at least 75. While we wish it would be less, we agree with the market here. Nevertheless, anything less would be wildly bullish. On the other hand, anything stronger (such as 1 full percentage hike) might further unsettle skittish traders. We’ll find out on Wednesday. There is very little else that will matter to markets next week.
CPI Post-Mortem: Fighting the Wrong War
The bottom line is we received a big disappointment via the August CPI report this week, with gasoline the only significant deflationary component. Markets immediately puked on the news, turning in the single worst daily performance since June 2020. Interest rate markets now fully expect a 75 bp hike at the September Fed meeting next week and have raised the expected cycle-peak funds rate to ~4.3%, from ~4% prior.
Despite the disappointment, headline CPI on a year-on-year basis peaked in June and has fallen for two months sequentially, including August. This remains consistent with the 13-month lag in our money supply (M2) model, reflecting that the steep decline in M2 growth began to sharply decelerate exactly 13 months ago. But, due to the headline noise in this month’s report, the race between receding inflation and the contractionary costs of an unnecessary Fed hiking cycle has just been diminished by one month. So are we waving the white flag here that inflation has metastasized and embedded across the economy, and that, at best, a downward fluctuation in gasoline prices can only mask this awful truth temporarily? Not. At. All.
Our serious takeaway is that the following high-level reality remains: Headline CPI peaked in June on a year-on-year basis and has moved lower for the two following months, including August. The data comprising the CPI is backward-looking, and with a large lag in many of the data sets, housing in particular. Just as many pundits argued that we were experiencing worse inflation than the data was showing in 2021 and early 2022, similarly we expect we will be overstating inflation for the next 6-12 months as the lagged data makes its way into the calculations. On the ground, we are seeing massive shifts lower. The economy has slowed considerably, and the Fed rate hikes (and forward guidance) has achieved its objective.
We can never be sure what Fed Chair Jerome Powell will do, however. The third of the three inflation-fighting principles elucidated in his Jackson Hole speech is “we must keep at it until the job is done”. But Powell’s homilies say nothing about how we will know the job is done, particularly when inflation statistics like this week’s are necessarily backward-looking, reflecting monetary policy decisions locked in months or years ago – and so, of course, any new decisions won’t show up in the data for months or years from now. The valid concern here is the Fed is too focused on fighting the previous war against inflation (the 1980s Volker era), as opposed to today’s challenges. Friday’s warning from FedEx is yet another sign that on-the-ground inflation and customer demand have been radically impacted. We hope they figure it out before it’s too late.
Earlier we described a race between receding inflation over the coming year – baked in the cake thanks to the decline in M2 growth – and the contractionary effects of Fed policy. Prior to this week’s report, it seemed to us that receding inflation was well ahead in the race, leading us to the expectation that the Fed would at least slow its hiking cycle sooner and at lower levels of the funds rate than markets expect. A bullish outcome. With this week’s CPI report, it appears that reality may be delayed by yet another month or so. By saying that, we don’t mean we think inflation will recede over the coming year – we are sure it will. But a race is a matter of timing, and our more optimistic view of inflation probably just lost a month.
That said, the chart below shows the month-over-month rate of increase in CPI over the past 3 years. As you can see (circled below), the last two months of reports have been extremely benign and if extrapolated forward will result in much lower inflation ahead.
But how much lower you might ask…Well, the chart below shows (red bars represent future projections) what would happen if the month-over-month change in CPI were to remain on average 0.0% (the rate of the past 2 reports). It shows us the headline index would return to 3.0% by Q2 2023.
If you’re still skeptical of the lag in CPI data, particularly the core data which is nearly 50% housing, take a look at the chart below. It shows the owner’s equivalent rent, which has been the worst part of the CPI report, reaching the highest level in 32 years. The owner’s equivalent rent moves with house prices but with a lag! If we overlay the data on top of the housing index (moved forward by 1 year), we see that a substantial hook lower is on deck. (Red arrow)
The forces that make goods deflation inevitable are strengthening. Weak unit demand is driving involuntary inventory accumulation up the supply chain from retailers to wholesalers, with manufacturing new orders and goods imports now sliding. Weaker goods pricing power is coming – just not fast enough to satisfy the Fed, and not enough yet to offset accelerating service inflation.
Contrarian Alert
Despite the late summer rally and accompanying FOMO (Fear Of Missing Out) sentiment, we’ve seen a very sharp reversal in investor risk appetite since Powell’s Jackson Hole Speech. According to the BofA Bull/Bear indicator, we are back at “0” again! As bad as it feels, investors would be wise to consider the last time we were at this level was late June, just as the aforementioned summer rally was ready to commence.
And it’s not any better in the bond market. The chart below shows the Barclays Aggregate Bond Index, a mix of US Government and Investment Grade Corporate Bonds, is experiencing its largest drawdown in history!
Buyback Fuel
With the new 1% buyback tax expected to go into effect on January 1st, total buybacks are on a record pace and likely to exceed $1 Trillion this year. As we highlighted at the time of the bill signing, this will most likely result in companies pulling forward buybacks into 2022. Tax policy does matter for capital allocation decisions.
Perhaps even better though, these ongoing buybacks provide a source of equity demand at a time when investor psychology is extremely depressed. This buying fuel could surprise to the upside and help drive an unexpected year-end rally.
Economic Funnies
Investor psychology 101…..
Crazy Stat(s) of the Week
Here are this week’s crazy stat(s):
- Tuesday’s trading, in reaction to the CPI report, was the biggest one-day drop in the S&P 500 index since June 2020.
Quote of the Week
“In terms of spending across income levels, affluent spending is still very strong. You see that in restaurants. You see that in credit. You see that in travel, high-end hotels, high-end restaurants, and so on. And the lower-income spender is also holding up well. Maybe they’re spending in somewhat different areas. For example, food and drug are holding up very well, maybe helped a little bit by inflation there and so on because we only see the nominal growth. But there’s no evidence of a slowdown in spending across income cohorts nor is there any — when you look at early bookings of travel, they seem to be holding up pretty well so far — But when you put them together, effectively, between July and August quarter-to-date, we’re indexing at about 146% to 2019.”
-Vasant Prabhu, Visa CFO
Calendar of Events to Watch for the Week of September 19th
It’s going to be all about the Fed this week as the much-anticipated FOMC meeting concludes mid-week with investors now expecting at least a 3/4% rate hike. Just as important will be any commentary from Jerome Powell in terms of the Fed’s outlook on future hikes as well as how the Fed views the state of the economy. There is a growing chorus of savvy investors and economists calling for the Fed to slow down the pace from here as the on-the-ground data has turned markedly in recent months. Will the Fed acknowledge these aspects or plow ahead full steam ahead? This is the singular issue markets are most obsessed with today. Everything else is taking its cue from these policy actions.
Monday 9/19– The NAHB Housing Market Index for September is expected to come in at 48.0, down from 49.0 last month.
Tuesday 9/20 – August Housing Starts and Building Permits data are both expected to contract from the previous month’s levels. Builders are responding to higher rates and housing uncertainty by reducing activity, working against the Fed in a way by cutting ensuring a supply/demand imbalance persists.
Wednesday 9/21 – The main event today will be the conclusion of the FOMC meeting and the market is hanging on not only the magnitude of the rate hike (3/4% is an almost certainty but could it be more?) as well as the outlook for the path of future hikes. On the economic front, more housing data will be released with Existing Home Sales for August expected to decline by -2.6%.
Thursday 9/22 – US Leading Indicators for August are expected to improve by 0.5% month-over-month. The weekly unemployment claims data released each Thursday will continue to get outsized attention as well.
Friday 9/23 – The Preliminary Markit PMI survey results for Manufacturing and Services in the month of September will be out with economists expecting readings of 51.0 and 44.5 respectively.
Source: FactSet
