Inflation "past peak" thesis challenged with August CPI, but our view remains inflation set to fall

Inflation “past peak” thesis challenged with August CPI, but our view remains inflation set to fall

The upside August CPI report (higher inflation) roiled markets Tuesday, as economists and investors calibrated their expectations around the path of Fed policy into 2023:

• CPI (mom) +0.12% for August vs median forecast -0.1%, prior -0.02%
• Core CPI (mom) +0.57% for August vs. median forecast +0.3%, prior +0.31%
• the negative “shock” for markets was the strengthening of CPI around labor-intensive components such as food away from home, medical services, education
• while “goods deflation” was not reflected as apparel, vehicle maintenance and used cars showed strength
• Fed forecasts for YE inched up +25bp, with markets now seeing 75/75/50-ish for Sept, Nov and Dec
• and with this “upside shock” equities sold off sharply.

The “inflationistas” certainly gained arguments with Tuesday’s upside read in August CPI. But we think there is an over-reaction to the CPI report, as what appear to be inflationary pressures in labor contrast with recent soft business surveys around labor and pricing (see below). Here are our key takeaways:

• “clock is reset” on when inflation is improving, as August CPI is now viewed as a “bad report”
• market technicals have turned negative, as noted by Mark Newton, Head of Technical Strategy at Fundstrat, and thus stocks likely weaken over the next 3 weeks before reversing
• there might be an over-reaction to the “wage-pressure driven CPI rising” as both NFIB and ISM surveys counter this — another example where the “soft surveys” show trend change not yet reflected in the “hard” CPI reports
• moreover, arguably inflationary pressures appear to be cooling when looking at diffusion
• 47% of 175 CPI components have outright declined from their 18-month highs, the highest figure in 2022 and up from 38% low in 2022
• 6 of 9 regions, representing 73% of GDP, of the US saw outright “deflation” in August, expanding from 5 of 9 regions in the July CPI
• regionally, the upside print on CPI were the Northeast (middle atlantic + new england) where apparel (back to school season) and residential electricity costs (natural gas) were the upside surprise.
• overall, the notion that June 2022 was peak inflation remains intact
• moreover, leading indicators, including compensation costs, suggest inflationary pressures are easing faster than August CPI report suggests
• we will see the August PPI report on 9/14 (today) and the U Mich consumer inflation expectations later this week on 9/16

Food and Energy did not decline as much as expected in August…

August CPI simply showed that aggregate composition of CPI was simply not favorable, despite over-arching trends showing improving inflationary trends:

• used car prices were flat for August, despite tanking based upon Manheim indices
• apparel rose in August, contributing to an upside surprise
• in the Northeast region (see below), apparel prices rose +3% in the month, causing the overall surge in apparel prices
• natural gas prices also rose causing upside readings in home electricity
• labor intensive industries like food away from home and medical services saw increases
• overall, this was an unlucky report, and has changed market expectations for Fed
• as the clock is reset
• and many believe Fed needs to further extend the period of tightness
• but as our prior commentaries highlight, historically, inflation falls quickly once it has peaked
• the lags of components is contributing to this pace appearing to slow
• this applies to “core” as well since shelter lags the overall decline in home prices. And lower energy takes time to filter into lower services costs across the supply chain and services.

This table shows the Northeast/(Mid-Atlantic +New England) CPI composition, and as shown, apparel and electricity were the upside surprise.

ISM and NFIB surveys show inflationary pressures are easing for businesses, as well as compensation

Recall, the latest ISM surveys, both manufacturing and services show “prices paid” making rapid improvements:

• prices paid for manufacturing is down to 52.5, below the 75-year average of 62
• meaning, manufacturers prices paid is actually below long-term average
• prices paid for services is down to 71.5, falling from a recent peak to 85
• this is still above the 25-year average of 60.1 but shows rapid improvements

Similarly, Tuesday’s NFIB Small Business survey shows both inflationary and pricing pressures beginning to ease. And even compensation pressures are beginning to show improvement. In other words, the view that wage pressures are driving an acceleration of services CPI is counter to the “soft surveys” which show these impacts are beginning to ease.

47% of CPI components deflating from peak, the highest figure in 2022

Of the 175 CPI components, 47% are down from their 18-month price high. This is the largest share in 2022 and as shown below is rising:

• even on a “weighted basis” this figure is now 27%, again, the highest figure in 2022
• this diffusion shows the breadth of “deflation” is actually rising

6 of 9 regions, representing 73% of GDP, saw CPI “deflation” in August, up from 5 in July

The regional CPI map is shown below and again, shows August CPI month-over-month:

• 6 of 9 regions saw outright declines in CPI representing 73% of GDP
• in July, this was 5 of 9 regions, representing 49% of GDP
• this is a sizable rise in number of regions and share of GDP

But there were upside CPI prints in two regions: New England and Middle Atlantic. These are the Northeast regions and the delta (August CPI vs July CPI) is highlighted below:

• the upside reading in the regions, as noted above, stems from two factors
• apparel CPI (back to school) and electricity costs (natural gas)
• as highlighted by our data science team, natural gas is high in these regions

This table, compiled by our data science team led by tireless Ken, shows the composition of natural gas as a share of power generation:

• for Northeast states, these figures are sizable
• 91% for Rhode Island, etc

And as shown below, natural gas drives Energy services costs YoY. Natural gas prices surged in 2022 but the YoY pace is easing. This also suggests we could start to see an easing of this component later in the year.

CPI Energy: Led by Natural Gas

STRATEGY: Equities ping-pong post CPI, but overall we still see 2H rally

Equities saw a crushing decline Tuesday. And as the chart below highlights, seems to be conforming to a pattern:

• equities ping-pong after each CPI report
• Yesterday’s CPI was a negative surprise and thus, the sell-off is approaching important levels
• Mark Newton, Head of Technical Strategy, sees stocks weakening over the next 21 days into early October
• and Newton sees possibility of a downside move in S&P 500 to 3,650 to 3,750
• this 3,750 level would be near the trendline highlighted below

The trendline line from the above chart is connecting the 2020 lows to the June 2022 lows. And as shown below, touching 3,750 would be moving along this trendline. For reasons we discuss above, including the PPI report and U Mich surveys, we do not think stocks need to keep weakening.

Latest BofA Merrill Fund Manager Survey show investors highest underweight in equities ever

There are many investors who expect and are bracing for a recession. This is evident in our many conversations. And the rationale basically comes down to this:

• anytime Fed tightens this aggressively, the economy breaks

And while this is the basis for that view, the US economy has remained remarkably resilient. Perhaps this most importantly reflects that private households and corporates are not over-leveraged. In prior cycles, the private sector suffered from this credit contraction.

Still, as the latest BofA Merrill survey shows, investors have a record low allocation to equities.

• 52% of investors are underweight global equities
• this is lower than the ratio in October 2008
• while skeptics will say that stocks still fell further, that belies the fact October 2008 was the structural low
• Technology and Cyclicals bottomed in 2008

STRATEGY: 2H rally view intact

Given the list of market worries above, the natural question is how is there a positive thesis on equities into 2H2022? Here is our take:

• our continuing analysis shows leading indicators point to disinflationary/deflation
• US corporates remain impressively resilient, enduring the pandemic global shutdown with cost discipline
• and US corporates are weathering the inflation surge impressively as well
• the US economy has managed to absorb rapid Fed rate hikes so far
• and US economic relative positioning far stronger in 2022
• US net beneficiary of higher energy prices, absolute and relative (US exports oil)
• US is on-shoring assets = future competitive advantage
• US has labor issues, but this will be solved by either automation or rise in workforce participation
• investor sentiment is rock bottom and worse than GFC by some metrics
• fixed income markets show far less inflation in swaps, etc
• and while many believe “bonds are getting it wrong” including Fed officials
• the drop in energy and housing and other indicators are supportive of this lower inflation outlook
• hence, Fed could do far less tightening as the market is doing Fed’s work

Bottom line. We see 2H rally thesis intact.

STRATEGY: 2022 Bear market was 164 days, or 25% duration of prior bull

Our data science team put together the comparative duration of bull markets and bear markets, and the corresponding ratio:

• since 1942, there have been 14 such cycles
• median ratio of bear vs bull is 31%, meaning a bear market is roughly 1/3 duration
• since 1982, this ratio is only 15%

• in 2022, the preceding bull market was 651 days
• the current bear market was 164 (using 6/16)
• or 25% ratio

As seen below, this ratio is solidly within the ranges seen since 1982.

• many investors think “more time” is needed for this bear market
• but given the shortness of the preceding bull market 651 days versus 1,309 median
• the corresponding bear market should also be shorter

BUY THE DIP REGIME: Stocks already saw fundamental capitulation

And we want to revisit the chart below, which looks at the internals of the S&P 500 — the % stocks >20% off their highs, aka % stocks in a bear market.

• this figure surged to 73% on 6/17
• this was only exceeded 3 times in the past 30 years
• each of the 3 prior instances was the market bottom
• we think this is the 4th instance

BUY THE DIP: forward returns strong

And stocks have the best forward returns when this figure exceeds 54% as shown below:

• in 3M, 6M and 12M
• the best decile for returns
• is when this figure is oversold >54%
• hence, buy the dip regime is in force

We publish on a 3-day a week schedule:

Monday
SKIP TUESDAY
Wednesday
SKIP THURSDAY
Friday

 _____________________________

33 Granny Shot Ideas: We performed our quarterly rebalance on 7/12. Full stock list here –> Click here

______________________________