3 Reasons Why Stocks Might Be Strengthening, Bond Market Seems to Be “Changing Its Mind”

Portions of Episodic inflation are peaking…
I want to harken back to a phrase Tom Luddy, former Vice Chair of JPMorgan Asset Management, frequently repeats: “less bad is good” (when looking at trends). In other words, when inflation trends become “less bad” investors are likely to view this as a positive inflection.

Yesterday’s CPI report is an example of this. The CPI Core (ex-food and energy) was +0.3% month over month, improving over Feb’s +0.5% and the best reading since September 2021.

• the rate of change is slowing
• for reasons we discuss below, this 1st of 3 waves of episodic inflation is peaking

…Used car prices are rolling over now

The latest March Manheim Used Vehicle Index was published last week. The actual price level peaked in December and has been down 3 consecutive months. And this is slowing down the YoY growth rate of used car prices (down to a more “modest” +25%.)

• the immense supply chain crunch/chip shortage triggered a record rise in used and new car prices
• what might surprise investors is “used cars” alone accounted for +1.40% of the rise in CPI
• prior to 2020, “used cars” was essentially zero percent contributor to CPI
• “new cars” was another +0.40%
• so combined autos represented nearly 2.0% of CPI growth in 2021

I don’t think many pundits are aware of this. But without cars, CPI would have been 2.0% lower, so instead of 5-6%, it is really 3%-4% in 2021. And thus, a rolling over of car prices, as supply chains/chip shortages normalize, means a major “episodic” driver of CPI is diminishing. Recall, even Michael Feroli, JPMorgan’s Chief Economist, posited that used car prices could actually roundtrip to pre-2019 levels. (If he is correct, autos would SUBTRACT -2.0% in CPI in 2023… that is “deflation” not inflation.)

…Used cars could have -0.7% lower CPI impact by May, amplifying “less bad = good”

Our data science team, led by tireless Ken, also modeled the relationship between Manheim used car prices and “used car CPI” and the model is shown below:

• Manheim (grey) leads CPI (blue) used cars by two months
• Manheim is “advanced” 2 months
• if model is correct, “used car CPI” will fall -0.7% YoY
• This is a material downshift and amplifies the case that this episodic driver of inflation peaking

…while the trend in inflation is higher (3%-ish), episodic factors pushing it higher near term

We have illustrated this idea of “episodic” inflation as explained by Brian Rauscher, Head of Global Portfolio Strategy. There are successive waves of inflation driven by various factors:

• supply chain shortages, phase i
• revenge spend, second order effects, phase ii
• commodity surge, now parabolic due to Russia-Ukraine war, phase iii

This explains, in part, why inflation curve is in backwardation (see lines).

• inflation expected, using market-based measures
• sees higher inflation in the next 12 months
• cooling sharply thereafter

…others drivers of “goods inflation” rolling over as well

There are a few other charts I want to highlight showing how goods inflation, phase i, is probably peaking

• Freight rates -30% from Shanghai to major global cities (thanks John Spallanzani, shared by @Cquintanilla)
• Backlog of ships from LA/LB port is down to pre-September 2021 levels
• Cass Freight index (US goods) is negative YoY and leads CPI by 6 months

You get the picture. There are many signs that substantial portions of “goods inflation” has apexed.

STRATEGY: Tax day is 4/18 and given strong 2021 gains, means some selling pressure lifts…Earnings season starts next week…

Next week is when we see several key turning points in the market, which generally point to a positive risk/reward for stocks.

• April 18th is tax day. And our work shows that raising funds for “capital gains” is worse in year when S&P 500 gains were strong
• Mark Newton, FSInsight’s Head of Technical Strategy, also notes that near-term outlook is positive for stocks (original publication)
• Lastly, we believe 1Q2022 EPS season will show that companies margins are still expanding = positive

Stocks usually fall in the week before Tax day when markets are strong for the tax year

In 2021, the S&P 500 was up 27%, which as shown below, ranges as one of the strongest years since WWII (decile 2):

• since WWII, when markets are strong in a tax year
• stocks do poorly into Tax day
• Tax day is 4/18 in 2022
• Win-ratio is low
• Why? Investors need to pay capital gains
• They could be funding this via selling equities
• Hence, stocks would be under pressure this week
• This could turn next week, which is also when earning season starts

This week saw several major inflation prints. Strong March CPI yesterday (see our First Word on this), today March PPI +1% (ex-food, energy), both 40-year highs YoY. Yet, two things are happening this week:

• Odds of a Fed hike by YE 2022 have dropped from 9 to 8 in just the past 3 days
• Yield curve 10Y less 2Y is dramatically steepening
• And extra credit, equities managing to show surprising strength

As we have said previously, a lot of bad news seems to be priced in. And also, if T+2 applies, today is the last day for Americans to sell stocks in front of tax day (4/18).

• we believe capital gains taxes owed for 2021 will be the largest ever in history
• Crypto capital gains of at least $500 billion
• Several trillion for US equities
• Yup, that explains, in part, the selling pressure of the last two weeks

BOTTOM LINE: Investors tend to think the bond market makes views “cast in stone” — the hawkishness building in the past month has been due to mounting pressures. But this doesn’t mean the bond market can’t change its mind. This is what seems to be happening.

• this is positive for equities

Biggest PPI print in 40-years… is bad news baked in?

Fed hike odds have dropped from 9 to 8 in just the past two days… Dovish incrementally

The 10Y less 2Y curve steepened dramatically = strengthening economic outlook? maybe?

Figure: Themes in 2022 – “BEEF”

Per FSInsight

Figure: FSInsight Portfolio Strategy Summary – Relative to S&P 500

** Performance is calculated since strategy introduction, 1/10/2019