Inflation narrative now two-sided and central banks noticing, even as markets push back. We show 3 more drivers CPI services to ease

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Inflation narrative now two-sided and central banks noticing, even as markets push back

Equities have staged a pretty impressive rise in the past 2 weeks, gaining 10% and up 10 of the last 12 sessions. This even as corporate earnings have been OK (some big misses) and September CPI (released 10/13) was a massive disappointment. In conversation after conversation, many of our clients tell us “nothing has changed” and this is just another short bear market rally that will fail.

But we believe there are supportive drivers and substance for this change in market tone:

• inflation narrative has become more two-sided (vs “black hole of pain”)
• we highlight below 3 drivers why CPI services are set to materially ease soon
• global central banks are making modest dovish pivots: first, Fed hawks, now Bank of Canada and now ECB
• interest rates are finally easing and USD backing off
• investors remain stalwart in their bearishness evidenced by put premiums, sentiment, positioning and general feedback in our meetings
• the most watched report will likely be the 3Q22 ECI (employment cost index) as this is a definite measure of wage pressures. A reading below 1% (4% annualized) will be seen as positive
• even if Fed keeps terminal rate at 4.5%-5%, our report earlier this week shows this is consistent with a 19X P/E versus 15X-16X today. Upside to valuations if risk premium stabilizes
• Technicals are improving and Mark Newton, Head of Technical Strategy, sees risks of modest pullbacks but buyable into YE

SUMMARY: Could this rally turn into the most hated rally? Yes. As we discuss at the end of this report, there are multiple factors supporting why stocks should see a stronger rally than the 23 trading day/+16% rally seen in June.

• given the above, couldn’t a rally of 50 days/ +25% ensue?
• this would likely create FOMO
• but also push S&P 500 above the 200D moving average of 4,100-4,150
• thus, YE rally view remains intact

Central banks are speaking less “hawkish” but markets still very skeptical…

The recent actions by the ECB (yesterday) and Bank of Canada (Wednesday) further bolster the notion that global central banks are easing off the “hawkish freight train.” As noted two weeks ago, it appeared the Fed itself is in the process of reassessing the pace of hikes and the relatively “less hawkish” statements by the 3 most hawkish members suggested some dialogue is underway. The realization that monetary policy takes time to “bite” and, coupled with fact many leading indicators are showing vast declines, such as commodities (nat gas) and housing and even markets themselves (risk assets down) support the idea of moving at a slower pace.

Consensus view is inflation “too hot”… meaning, skew positive for downside surprise

In our multiple conversations with investors over the past week, investors are skeptical the global economy has made progress in the war against inflation. We don’t need to belabor this as we know anyone following markets see this. This is just one headline from a recent story.

And many on fintwit continue to share charts like this from @SoberLook.

And as finger pointing continues, there are those who blame corporate greed for inflation. This, in our view, is mostly misguided as supply/demand is driving higher prices. But there is a semblance of truth, to the extent that higher prices result from a seller “being able to pass along” higher prices.

INFLATION: More of a two-sided discussion today, even as markets see only higher inflation

One doesn’t have to look hard to find evidence of high inflation around the world. That is not the issue. The issue is whether inflation is set on a path to:

• accelerate = wage-price spiral = bad
• stays high = sticky and risk of above = bad
• peaking = bad now but better later = good
• set to fall = supply chain/ commodity slow = good

And in our informal twitter poll, fintwit shows that the vast majority see inflation as high.

• only 32% see inflation as “peaked and falling”

But this is where our research points in a different direction on inflation trends. CPI is high, but the drivers of inflation seem to be ebbing and it seems that more economists are also seeing this. We have highlighted multiple research reports in the past week from JPMorgan and Goldman Sachs, etc.

CPI SERVICES: Even some components of CPI services might be reversing soon

The heart of the inflation issue is containing services (as opposed to goods) inflation. That is, services are generally viewed as:

• “stickier” inflation
• driven more by wages, versus commodity prices or cost of goods
• but as we discuss below
• many components of CPI Services are actually driven by commodities and not by wages

The CPI Services basket is shown below:

• 54% of CPI services is shelter/rent and the notorious owner’s equivalent rent
• 6% is Energy services
• 40% is other services

As we highlight below, a few items are already seeing key components turn down. Recall, there is a key conceptual point to appreciate.

• the actual price trend of an item (“soft data”)
• the price trend as captured by CPI (“hard data”)
• how do these two items eventually sync up?

CPI SERVICES: 7 items comprise services outside of Shelter and Energy Services

CPI Services is not a complicated category, but we think investors overlook what the actual components are:

• Medical Services 28%
• Transport (rental, repair and insurance) 24%
• Communication + Education 22%
• Recreation 13%
• Household water/trash and sewer 4%
• Household operations 3%
• Other 6%

Transport + Medical services account for 88% of rise in CPI services (ex-housing & energy)

The biggies are really transport services and medical care, which together are 52% of this bucket.

• so in concept
• Fed is raising rates to slow the inflation in these 2 categories
• as shown below
• these 2 categories represent 88% of the rise in CPI services (ex-Housing & Energy)
• so these 2 are literally the drivers of services inflation

CPI TRANSPORT SERVICES: Rise is primarily supply chain, NOT WAGES

We have taken a snip of the BLS CPI report and added the “drivers of inflation” for prominent categories:

• vehicle repair and associated insurance are the bulk of the rise in this category (see red)
• as noted, this is mainly due to supply chain issues causing prices of auto parts to rise

Don’t believe it? Think it is wages? Look at wage growth of auto repair jobs vs CPI of auto repair

Think this is not really due to supply chains, but is due to wages? Take a look below:

• CPI auto repair is up +11% YoY
• AHE (avg hourly earnings) for auto repair works is +4.4% YoY
• AHE for glass repair is +1.8% YoY
• Get the picture?
• The difference is “parts” and this is what has surged.
• It’s the supply chain

And this goes back to our point on core CPI. Even used cars is set for a big payback:

• YoY CPI used cars is +7.2%
• YoY Manheim used cars is -10.4%
• one of these is right

CPI HEALTHCARE SERVICES: Medical Insurance primary driver

Below is the BLS table on CPI Medical Services.

• the YoY surge is +6.5%
• biggest driver is Health Insurance +28% YoY
• everything else is +4.5% ish
• just look at table below

And as we noted earlier this week, many economists see Health Insurance possibly falling as much as 40% over next 12 months, starting in October 2022.

Below is the monthly change in CPI Health Insurance. And it does seem like this monthly rate changes every 12 months (see dashed lines).

• if this falls at -40% annually
• this would be a huge subtraction from CPI services

CPI ENERGY SERVICES: Natural Gas is down YoY now… leads to lower CPI Energy Services

Another reason to expect CPI services to fall is the decline in natural gas prices.

• natural gas is down 40% from peak in USA
• and is down YoY
• same with European nat gas

As highlighted by our data science team, led by tireless Ken, this should lead to lower CPI Energy Services in the coming months:

• natural gas is 30% to 40% of the cost of the energy services business
• so it should exert influence
• since 1990, the relationship has been very tight

Energy Services is 1pp of the 8% YoY growth in CPI Services. So a slowing here is a major turning point.

• the chart below shows Energy services CPI impact is ACCELERATING
• but natural gas prices are falling

CPI: 50% of leading indicators see outright declines

This gets back to our view that the hard data will sync with the soft data by a drop in inflation trajectory.

STRATEGY: If Newton’s view that 1962 is the analog, markets rally into YE

Mark Newton, Head of Technical Strategy at Fundstrat, commented that he sees 1962 as a good analog for 2022. I mean the geopolitical landscape is similar and even political set up as well.

• the two charts line up surprisingly well
• if this plays out, YE rally is in store
• notice how the 1962 market rallied back to April/May levels ?
• That would be 4,400-4,500 for S&P 500
• well above where markets stand today

REAL RETURN: If S&P 500 rallies back to 4,400…Fed still wins as real returns -16%

This gets us to the notion of a rally in equities. While many cite Fed as pushing back on stocks recovering. Take a look below:

• S&P 500 is down -30%-ish in real terms (adjusted for inflation)
• If S&P 500 rallies to 4,400 to 4,600 in the near term
• This is still down -12% to -16% in real terms
• That is a dramatic wealth effect loss and tightening of financial conditions

Ingredients for a rally that should exceed the “June pivot” rally in duration and amplitude

All of this, in our view, are reasons that any equity rally should exceed that seen in July, which was the “false dawn of a Fed pivot”:

• that rally was 23 trading days and gained +16%
• at that time, only headline CPI peaked and many investors expected core CPI to keep strengthening
• labor markets were extremely tight in July with JOLTS/workers ~2.0
• that ratio is 1.67 today and falling
• more economists now forecast substantial declines in core CPI ahead
• today, multiple Fed members are openly discussing some type of “pause and look around” which is a dovish turn
• investor positioning is far more bearish now than anytime in 2022

Taken together:

• doesn’t it make sense a rally should exceed the “false dawn pivot”?
• consider a possible 30-50 day rally and 20-25%?
• 2022 mid-terms will be in the coming weeks, and Fundstrat’s Policy Strategist, Tom Block, believes Republicans will take the House and even possibly the Senate
• This would be considered disinflationary as well (rein in spending) driving possibly lower rates
• And voters likely see less risk of “higher inflation” (with Republicans) and thus reduce the risk of a wage-price spiral
• The fly in the ointment, however, is the continued surge in 10-yr yields

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