Nov's PCE inflation release will highlight why 2023 is more opportunities, and less crisis. We see downside surprises to PCE inflation = less hawkish path forward for Fed

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Equities are struggling in December, capping what has proven to be a horrible year for equities. In our view, US core inflation has apexed (mid-2022) and now running at closer to 2%. But due to lags in how price-level series works (inflation is a price level), inflation will not be officially “2%” (year over year) until Sept 2023.

• If inflation, on a forward basis, is running at 2%. Will markets and Fed wait until Sept 2023 to say inflation is running at 2%? Fed previously said “3 consecutive months” of improvement is a sign of progress. Annualized Core PCE inflation after Nov is released on 12/23:

• See the trend? The 3M annualized Core PCE inflation rate is down to 3%. It was >6% at the start of 2022 and ~8% in June 2022. So this is an utter collapse in the rate of inflation. And as we highlighted in prior commentaries, we see this as repeatable.
• The YE 2022 Core PCE inflation of 4.1% is 70bp below the YE 2022 4.8% Core PCE inflation forecast of Fed’s Dec SEP (Summary of Economic Projections) by FOMC members. Think about that. 70bp.
• What if the Fed staffers made an inadvertent error? The Haver Analytics website is still not providing updated economic data after suffering from a ransomware attack on or before 12/13 (see link if you don’t believe us –> Haver site). We previously wrote that the Dec SEP forecast for 2022 CorePCE inflation of 4.8% seems unachievably high. And this is higher than the 4.5% Sep SEP forecast by +30bp. This higher “jump-off” also drove higher PCE inflation forecasts for 2023 and also the higher Fed terminal rate.
• I spoke to a European client this week who himself noted he could not see the updated “eco data” because of the Haver outage. So, it is not just the Fed.
• What are we getting at?
• Friday could be an important day for markets. It is a day where markets and view of Fed projections is “course corrected” — if Nov Core PCE comes in at any figure below 0.4%, the Fed’s figure 2022 inflatin is far too high. And this means their 2023 inflation forecasts are too high as well.
• Atlanta Fed InflationNOW is looking for +0.26% (InflationNow forecast) and we forecast Nov Core PCE staggeringly low 0.10-0.15%. Street consensus is +0.20%.
• Additionally, there could be a positive surprise from U Mich inflation perception survey as Dec Final is set to be released as well. Street is looking for 1-yr ahead to remain 4.6% but we believe it could fall to 4.3% or lower (see below). Two positive inflation surprises.
• More importantly, if inflation is indeed tracking closer to 2% (and won’t be evident in YoY until Sept 2023), then the Fed itself is likely to course correct dovishly in 2023. To me, this would be positive for risk assets.
• Expectations remain low for 2023. Only 3 of 25 Street Strategists see S&P 500 gaining more than 4% in 2023, underperforming cash. And Goldman’s client survey shows “short S&P 500” is viewed as the most attractive risk/reward trade in 2023 with 19% selecting this of 10 possible trades.
• We think the odds of stocks gaining 15% to 20% are quite high for 2023. This has to do with the expected collapse of volatility (see below), the breaking of inflation, the re-rating of P/E multiples and the fact that stocks rarely post two consecutive annual declines.
• In fact, 3 of the top 5 best ever gains in the S&P 500 followed a year of a market decline: 1954, 1958 and 1995. By the way, 2019 was a +29% year following a troubled 2018. So you get the picture. 4% return in 2023 seems low, unless we have an expansion of the inflation crisis.

Key inflation data in the next few weeks…

In the next few weeks, we get 3 key inflation data points:

• 12/23: Nov Core PCE inflation –> TO BE GOODFundstrat 0.15% vs Street 0.20% vs InflationNOW 0.26%
• 12/23: Dec U Mich 1-yr inflation –> TO BE GOODFundstrat 4.4% vs Street 4.6%
• 1/12/23: Dec Core CPI –> TO BE GOODFundstrat 0.15% vs No Consensus

Nov Core PCE inflation forecast at +0.10% and implies +4.55% YoY, lowest since Oct 2021

The Core PCE inflation (deflator) MoM is forecast at +0.10% and this would lead to 4.55% YoY.

• as highlighted, if this is 4.55% YoY, this is already WAY below Fed YE2022 forecast of 4.8%
• and if Dec is another +0.10%, then 2022 Core PCE will be 4.14%, 65bp BELOW Fed’s 4.8% forecast.
• as noted in prior commentaries, to get to 4.8%, Dec would have to be +0.75%, a massive acceleration of inflation.

…Haver still down

And Haver Analytics Website is still down. This is a widely used database and I know a client who told me as such. He was unable to pull up recent data due to the Haver outage.

Inflation has been below 3% since September 2022…

Inflation is a price-level index so the level in any month is serially connected to the prior month:

• the “slope” or rate of inflation has been 3% since Sept 2023, or 4 months now

But as the lines below show, the YoY %-change is not yet showing this. The Core PCE inflation YoY is 5% (as of October):

• even if inflation runs at 2% throughout 2023
• the YoY will not fall to 2% until September 2023
• the 6M annualized will show 2% by March 2023
• The 3M annualized will show 2% by December 2022
• Which metric do you think actually best shows the trend in inflation?
• To me, it is clearly the 3M annualized.

CPI: YoY Inflation takes time to fall because it requires dropping prior “high” months

As shown below, for YoY Core PCE inflation to fall, it is a matter of “dropping” the higher monthly prints.

• recall, Core PCE Inflation is a price-level index which means this is dependent on the cumulative price changes in 12 months.
• so YoY takes time to fall
• and as shown below, over the next few months, the “big” monthly gains are getting dropped
• But January, Core PCE inflation could have something with a “3” in front of it.

Why are we confident inflation is falling? Core inflation ex-housing has been DEFLATING for two months now…

Foremost, core inflation is arguably in deflation now:

• Core inflation ex-Housing has been negative two consecutive months
• see below

And Housing is set to rollover as Cleveland Fed “Rent Repeat Index” shows this is coming

The Cleveland Fed released its new “repeat rent” indices (white paper here). And as shown below:

• this figure has tanked
• at 6%, this is closing in on pre-pandemic inflation rates of 4%
• it was >12% earlier in 2022

Our team has shown this leads CPI shelter by about 6 months (4 months per Cleveland Fed).

• if this is correct, we will see tremendous disinflationary pushes by shelter CPI

And Shelter CPI has already peaked, or it appears to have peaked as shown below. But this would remove a tremendous inflationary force from CPI.

• again, does Fed need to be this tight?
• even if one says it is the labor market, it is generally correct
• but if wages are growing but inflation is 2%, is that such a bad thing?

U Mich Consumer Inflation Year Ahead just tracks gasoline which has been plunging

Gasoline price have been in a free fall since mid 2022 and as shown below are now nearing early 2021 levels.

• we expect this to drive a sharp drop in U Mich inflation expectations
• Mid-Dec came in at 4.6%
• On 12/23, Dec final will be released and we expect this to fall to 4.4% or lower
• This is below Street of 4.6%
• This shows consumers are expecting a decline in inflation.

Ultimately, as we highlight below, the drivers of 2022 inflation are largely blunted or reversing.

STRATEGY: 2023 is more opportunity and less crisis

As outlined in our 2023 Outlook, we see 2023 as a year of less crisis and more opportunity. This reminds us of the Japanese word for crisis:

• in kanji, crisis is two words
• “danger” and
• “opportunity”
• we see 2023 as the opportunity

3 of the top 5 years for market gains happen after a negative year

Look below:

• stocks rarely post two consecutive years of declines
• 18 of 21 instances stocks are higher
• 3 of the 5 best years for market returns happen after a negative year
• so, expectations seem too low

Strategists are only seeing flat markets in 2023, expect for 3 looking for 4% or more.

And Goldman Survey shows shorting equities is the most popular trade among clients.

STRATEGY: If Fed framework shifts = lower volatility = higher stock gains

The VIX averaged >25 in 2022. This is an extraordinarily high level. There are only a few years where VIX averaged greater than 2022 levels:

• 2008, 2009, 2020, 2002 and 2001

And shown below, on average, when VIX >25 in a year, the following year sees a huge drop:

• average decline is 20%

Inflation drop is catalyst for Fed which is catalyst for VIX

We think this drop in inflation towards 2% annualized will shift the Fed to “predictable” mode and therefore lead to lower volatility:

• thus, Fed is the catalyst
• we think both Bond VIX (MOVE) and equity VIX drop
• and as scatters below show, a drop in volatility is good for equity gains

Why? Lower volatility means investors will assign higher terminal multiples. And thus, P/E can expand. Think about it. In a world of high volatility, P/E would be lower.

If VIX falls 20%, equity gains average +20%, suggesting stocks could do very well in 2023

As shown below, whenever VIX falls, equities do well:

• There are 19 years when VIX 12M avg fell vs prior year
• Of these 18 times, equities posted positive gains
• There is an obviously positive relationship
• But if VIX falls 20% (expected after surging >25), equity gains are far higher averaging 20%

STRATEGY: Earnings yield (inverse of P/E) surged ~2.5% in past year, a historic move and supports view equities can rally 20% in 2023

2022 has been a year of multiple crises, from inflation to Russia-Ukraine War to China zero-COVID to FTX fraud:

• so it is possible the Fed got “dad-gummed” by a ransonware attack?
• yes
• as bizarre as it sounds

And this has contributed to a surge in the attractiveness of equity valuations. As one of our data scientists, Matt Cerminaro, points out:

• the 438 day change in earnings yield has exceeded 2.25%
• and this type of surge has not been that common in the past 40 years
• as shown below, this has happened at key times in equities
• August 82 (bottom)
• March 6, 2009 (bottom)
• March 24, 2020 (bottom)
• and other key times
• So it shows the level of decline seen in equity valuations in 2022

Forward returns tend to be quite solid as well.

• 12-month average return is ~26%
• 17 of 17 instances are positive 12-months later
• This lines up with our view that S&P 500 can rise 20% in 2023

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