Inflation’s Last Hurrah

Despite a massive 2.5%+ rally on Thursday (October 13) (Financials +4.1%, Energy +4.1%, Tech +3.1%), markets still ended the week lower. The table shows that two of the four major indexes have now broken below their September lows; the “Bear Market” continues with its trademark volatility.

Thursday’s rally appeared to be sparked by technicals: oversold conditions, short covering (the most shorted stocks rose +7%), and a bounce off the 50% reversal of the prior “Bull Market.” In addition, markets were buoyed because the Bank of England (BoE) intervened in the currency market to support the British pound, the Truss government back-tracked on their tax reduction proposal, but especially because there was a recommendation by staff at the European Central Bank (ECB) to limit rate hikes (a “hopeful” signal to the Fed), as European yields fell 10 basis points (bps).

A near 1400-point swing in the Dow Jones Industrial Average doesn’t happen often, but one never sees such volatility in “Bull Markets,” only in “Bears.” Rosenberg Research counted 30 sessions of Dow Jones movements of +400 points or more so far in 2022, while the index, itself, is down -6,700 points. Rosenberg says that in the 2011-2017 bull market, there were a total of five such +400 point sessions. The volatility reminds us that it is premature to call a bottom in stocks when the Fed is still aggressively tightening and the nasty part of the Recession is still ahead.

Inflation and the CPI

The CPI number on Thursday morning certainly disappointed financial markets, politicians, and likely anyone else who was paying attention. At first, markets declined (DJIA down -550 points), before rising +828 points on the day. (Talk about volatility!) Besides the events discussed above, there also is an idea that this was inflation’s last hurrah! We agree with this notion.

· The CPI rose +0.4% (a +4.9% annual rate), double expectations. That inched down the Y/Y rate to 8.2% from 8.3%.

· The real issue in the CPI report was the rise in the “core” rate (ex-food & energy) of +0.6% (+7.4% annual rate), raising the Y/Y level to +6.6% in September from +6.3% in August and +5.9% in July. Looks like inflation is getting hotter, not cooler. This is the highest level of the “core” rate since August 1982, and sure to garner the Fed’s attention.

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  • Of significance was the fact that “core” goods inflation in September was 0%!
  • The culprit was “core” services, especially rents which rose +0.8% (and is 30% of the CPI calculation). The rise in Owners’ Equivalent Rent (OER) was the most rapid in 32 years. We’ve commented in past blogs about BLS’s antiquated calculation method for OER and rents in general. Suffice it to say that private sector indicators are showing that rents have begun to fall, and the coming influx of new multi-family units will quell the rents issue in the first half of 2023.
  • We see signs of disinflation everywhere including in sporting goods, apparel, appliances, moving expenses, movie/concert tickets, sports events, used cars, prescription drugs, information services, hotels/motels … Surveys show wage pressures are easing. We think that at least part of Thursday’s equity market about face was likely due to the recognition of such.

· We’ve remarked in past blogs about the easing in the supply chain. Capital Economics developed a “shortage indicator” which is shown as the blue line in the chart below. The black line is the “core goods” Y/Y level of inflation. If the relationship holds, the disinflation noted above will continue.

· One of the Fed’s worries has to do with inflation expectations becoming unanchored, because if people expect inflation, they won’t fight it. However, that has not happened. The chart shows that inflation expectations have fallen significantly ever since the Fed started its tightening phase. Expectations are now well anchored below 3%.

Incoming Data

· China’s CPI rose +2.8% Y/Y in September; the CPI ex-food was up just +1.5%. PPI in China was -0.1% M/M and +0.9% Y/Y. That, plus the stronger dollar, means that import prices into the U.S. will continue to be disinflationary.

· U.S. PPI (headline) rose +0.4% M/M in September (+7.2% Y/Y vs. +7.3% in August). But “core” PPI was -0.6% M/M and over the past three months has fallen at an annual rate of -6.3%.

· The oil price (WTI) closed the week at $85.55/bbl., down from $92.64 a week earlier (October 7). This in the face of OPEC’s promised November cut of 2 million bpd. Apparently, demand is falling faster than the planned cuts.

· Mortgage applications continue to fall: -2% W/W (October 7) on top of a fall of -14.2% the prior week. Housing has clearly entered a Recession; we will soon be seeing falling home prices.

· The University of Michigan’s Consumer Sentiment Index for October rose to 59.8 from 58.6. This was mainly due to a fall in gasoline prices. As you can see from the chart, this index is still probing historic lows.

· A further analysis of last week’s employment report (the Household Survey) indicates that the “strength” assigned to the +204K employment growth was less than meets the eye.

  • Self-employment rose +272K while wage and salaried workers fell -146K.
  • Multiple job holders are up +10% Y/Y. This means that full-time employment has fallen making it necessary for people needing full-time income to hold more than one part-time job.
  • Employment in the 55+ age cohort grew +355K (early retirees now going back to work). This means that for the rest of the age cohorts, 16-55 year-olds, employment actually fell -151K.

Final Thoughts – What Else Will the Fed Break

Nearly every Fed tightening cycle results in unexpected economic drama in some important economic sector. The Great Recession had the financial crisis (Lehmann Brothers bankruptcy, and significant banking sector capital issues from holding AAA graded mortgages that weren’t worth the paper they were printed on).

Over the past two weeks, we’ve seen the near bankruptcy of several U.K. pension funds. During the years of low interest rates, in order to generate enough cash to make required payments to pensioners without delving into principal, U.K. pension funds leveraged (borrowed money) to buy enough bonds to make those payments. Many borrowed in dollars. The rapid rise in interest rates (engineered by the Fed) put bonds into the worst bear market in modern history. And the rapid fall in the value of the British pound (from $1.22 in early August to as low as $1.03 near September’s end) compounded the problem. The value of the bonds in those pension funds were hit hard, and margin calls put them in danger of bankruptcy. Only the fast action by the BoE in supporting the value of the pound prevented a calamity.

As in nature, there is always more than one cockroach! We don’t have any special knowledge, but believe that if the Fed continues its uber-aggressive tightening, there will be other fallout.

The chart above shows the rise in distress in the corporate bond space. Problems could arise there. The chart below shows the rapid rise in total consumer credit as U.S. households borrow on their credit cards in order to (temporarily) maintain their living standards as inflation has risen faster than their incomes. Rising delinquencies could play havoc, especially in the shadow banking space.

As indicated, we don’t know what/when/or where something significant will break. But using history as a guide and after years of ultra-easy money and near zero interest rates, the rapid move of interest rates to levels not seen in decades and with more to come, it is likely that something vital will break. When that happens, the Fed will have little choice but to “pivot.” Bonds, at current levels, look to be a buy.

(Joshua Barone contributed to this blog)

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