The "big news" in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.

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CATALYST WATCH: FRIDAY

U Mich Inflation 1-yr is reported 1/13 at 10am ET

  • we expect inflation expectations could fall below 4% (mid-month) vs 4.4% last month, validating the accelerating leg down in inflation

The “big news” in December CPI is 59% of components are now in deflation

Ultimately, the December CPI report is a net positive, in our view, as we think investors will increasingly come to the conclusion the Fed can declare “mission accomplished” on inflation. And this is setting up 2023 to be the opposite of 2022, where inflation expectations fall faster than EPS risk. Thus, we expect stocks to act far more resiliently in 2023 than consensus expects.

For the most part, investors are hesitant to believe equities can sustain any gains primarily because they believe the Fed will eventually want to quash any rise in stocks, and with an added dose of “EPS recession ahead.” But we believe conditions are becoming more conducive for the Fed to allow financial conditions (FCI) to ease, and in turn, the environment for equities will be sustainably firmer:

  • December Core CPI (1/12 at 8:30am ET) came in “soft” at +0.30% core MoM%, the 3rd consecutive month of soft inflation readings. The 3M annualized (SAAR) Core CPI is down to 3% and as we noted in prior reports, is more important than YoY rate (5.7%) because of the slowness of YoY% to reflect changes.
  • Disinflation (aka “deflation”) is accelerating. A whopping 59% of CPI components are now in outright deflation, a leap of 800bp in a single month (see below). The 50-year average is 50%, so the pace of items “deflating” is also well above the long-term average. We view this as repeatable low CPIs.
  • Applying same MoM% to Dec Core PCE (Fed preferred measures) implies Core PCE inflation likely comes in at 4.2%-4.3% YoY% when released on 1/27. This is 60bp lower than Fed’s Dec forecast for 2022 (aka SEP) at 4.8%. 60bp is whopping downside surprise vs Fed forecast.
  • The latest Atlanta Fed wage tracker was released and the YoY% fell to 5.5% in Dec, the lowest reading since Jan 2022. The YoY% dropped for both “job switchers” (7.7% vs 8.1% Nov) and “job stayers” (5.3% vs 5.5% Nov). Another data point corroborating that wage inflation has slowed sharply in the past few months.
  • Wage gains and job growth visibly slowed, developments favorable to the Fed perspective which has been targeting slowing wage pressures. Recall last week, total income (payrolls * avg hourly earnings) are now growing at a mere 3.6% or so, in line with levels needed to sustain 2% inflation.
  • The Fed narrative on inflation has focused on “core services ex-housing” as of particular concern, since this category (medical, entertainment, cell phones, education, auto repair) has a heavy wage component. For December, the inflation rate was 0.211% MoM%, the third consecutive soft reading. The 3M SAAR figure is down to 2.12%.
  • These economic reports arguably show the bond market got it right. Inflation is undershooting the Fed and consensus view and thus, explain the fact that UST 2-yr yields (4.145%) and UST 10-yr (3.444%), are far below the 5% Fed terminal rate.
  • For an equity investor, what is evident is inflation is falling faster than expected. And the Fed’s motivation to push for a “hardish” landing is diminishing given the softening of the labor market
  • In other words, this means there are more reasons for volatility to fall – Fed has less pressure to re-accelerate hikes, bonds already sniffing a “pause” than for EPS estimates to tank – weaker USD supportive and softish landing possible if labor is slowing.
  • As we noted in our 2023 outlook and in subsequent pieces, the key to 2023 is more dependent on the former. That a drop in VIX will be more influential for stock returns than EPS (see analysis below). And the VIX averaged 25 in 2022, and we think it could fall below 20 for most of 2023.
  • It already is happening. With yesterday’s CPI report, the VIX fell 9% to sub-19. Our past analysis shows that in the past, this implies stocks could gain >20% in 2023. And with the strength in first 5 days, this case seems stronger.
The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.

Is the Fed going to allow this easing of FCIs to persist?

Next FOMC meeting is not until 1/31-2/1, so there is time for markets to think about this. In our view, we think the Fed will eventually relent. But it would be because inflation itself is fading faster than expected. The drivers of inflation are slowing:

  • Supply chains are easing
  • Oil and gasoline prices are down sharply
  • Housing, a biggie, is rolling over hard
  • Labor markets and wage income visibly slowed and with higher income Tech layoffs underway, wage pressures are diminishing
  • Consumer inflation expectations have been steadily falling
  • Monetary policy works with unknown lags and a lot of tightening is in the pipeline
  • And if inflation is falling faster than expected, the balance of risks similarly is changing.

After all, the cost of pushing the US economy into eventual recession is not merely statistical. It would lead to millions of lost jobs, lost wealth and emotional carnage. So, the Fed would naturally need to balance risks if inflation is indeed undershooting. And Fed speak this week did not push back hard against stocks (Bullard Thursday) and the FCIs are generally a moving target anyways. There is no specific level for equities that accomplish Fed target, but they view monetary policy impacting asset prices more broadly.

The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.

By the way, Technology has increasing sensitivity to easing FCIs, meaning if financial conditions ease, Technology should rally the hardest.

The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.

And 2023 has been marked by a collapse in selling pressure, per Lowry Research. This is interesting because if this is sustained, it highlights that there has been an exhaustion of selling pressure.

The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.
Source: Lowry On Demand

FINAL BATTLEGROUND: Core Services… running at 2%, but why is Fed so focused on this?

The most recent Fed narrative has focused on containing inflation in “Core Services ex-Shelter” — this is a category the Fed views are particularly impacted by wages:

  • thus, targeting slowing employment
  • is designed to slow inflation here
  • this basket is 25% of overall CPI and as shown beow, is a mishmash of components
  • do these components have spillover risk to rest of economy? Like does recreation services create systematic inflation risk for economy? I don’t think so
  • moreover, the only component growing >5% annualized is “Household operations”
  • for the past 3 months, the inflation rate of this “core services ex-shelter” has only been 2.12%
  • the Fed needs to stop looking at YoY and look at 3M annualized
The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.
The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.

WAGES: Atlanta Fed wage tracker shows slowest wage gains in 13 months… mission accomplishing

On wages, the pace of wage gains as seen in surveys is slowing drastically. Below the latest Atlanta Fed Wage Tracker shows:

  • YoY down to 5.5%, the slowest pace since before Jan 2022, or 13 months
  • There has been a drastic deceleration for both job switchers and job stayers
  • along with the soft wages seen in Dec employment report, the labor market is going through a soft landing
The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.
The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.

STRATEGY: VIX matters far more for 2023 returns than EPS growth

Our data science team compiled the impact on 2023 equity returns from variables:

  • S&P 500 post-negative year (2022)
  • the varying impacts of
  • VIX or volatility
  • USD change
  • Interest rates
  • EPS growth
  • All of the 4 above, positive or negative YoY
  • Data is based on rolling quarters and summarized below

The surprising math and conclusions are as follows:

  • most impactful is VIX
  • Post-negative year (rolling LTM)
  • if VIX falls, equity gain is 22% (win ratio 83%, n=23)
  • if VIX rises, equity lose -23% (win ratio 14%, n=7)
  • I mean, this shows this all comes down to the VIX
  • EPS growth has little impact
  • If EPS growth is negative YoY (likely), median gain +14.8% (win-ratio 70% n=33)
  • If EPS growth is positive YoY, median gain is 15.5% (win-ratio is 78%)
  • Hardly a sizable bifurcation
The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.

As the scatter below highlights, we can see the sizable influence of the VIX. Even in all years, the VIX is a key factor:

  • in our view, if inflation falls sharply
  • and wage growth slows
  • Fed doesn’t have to cut, but this is a dovish development
  • we see VIX falling to sub-20
  • hence, >20% upside for stocks
The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.

And as shown below, EPS growth has a somewhat important correlation, but hardly as strong as VIX changes.

  • the difference in median gain is a mere 70bp (positive vs negative) post-negative year
  • the importance of EPS growth is stronger in other years
The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.

The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.
Source: Lowrys On Demand

STRATEGY: Financial conditions should ease in 2023, driving higher equity prices. Technology, Discretionary and Industrials levered to easing FCI

The “base” case for 2023 should be below. That stocks gained >1.4% in the first 5 trading days, and this portends strong gains for the full year:

  • Post-neg year + up >1.4% on first 5 days
  • Day 5 to first half median gain is 9.5%
  • Full year median gain is 26%, implies >4,800 S&P 500
  • 7 of 7 years saw gains.
The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.
Source: Fundstrat

Those 7 precedent years are shown below.

  • the range of full year gains is +13% to +38%
  • so, this is a VERY STRONG signal
  • the two most recent are 2012 and 2019
  • we think 2023 will track >20%
The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.

The path to higher equity prices is discussed above:

  • core inflation falling faster than Fed and consensus expects
  • wage inflation is already approaching 3.5% target of Fed (aggregate payrolls)
  • Fed could “dovishly” leg down its inflation view
  • allowing financial conditions to ease
  • bond market has already seen this and is well below Fed on terminal rate
The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.

BASE CASE: The “maths” for what to expect in 2023, post a “negative return” year (2022)

Question: how common is a “flat” year? Our team calculated the data and it is shown below:

  • since 1950, there are 19 instances of a negative S&P 500 return year. In the following year,
  • stocks are “flat” (+/- 5%) only 11% of the time (n=2)
  • stocks are up >20% 53% of the time (n=10)
  • yup, stocks are 5X more likely to rise 20% than be flat
  • and more than half of the instances are >20% gains

So, does a “flat year” still make sense?

The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.

As shown below, these probabilities are far higher than compared to typical years:

  • since 1950, based upon all 73 years
  • stocks are “flat” 16% of the time vs 11% post-negative years — BIG DIFFERENCE
  • stocks are up >20% 27% of the time vs 53% post-negative years — BIG DIFFERENCE
  • see the point? The odds of a >20% gain are double because of the decline in 2022
The big news in December CPI is 59% of components are now in deflation, a leap of 800bp in a single month (50-yr avg 50%). Reason to view this as repeatable low CPIs = easing FCI = falling VIX = rising stocks.

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37 Granny Shot Ideas: We performed our quarterly rebalance on 10/19. Full stock list here –> Click here

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