Investors have become "single issue" voters (inflation)... and Tech + small-caps quietly gaining

Financial markets have become a single-decision market — Inflation

The May CPI report (reported Friday), coupled with the U Mich Consumer Confidence survey, showed inflation remains sticky. And while there was some evidence, on the margin, of inflation pressures cooling (core CPI), financial markets saw both reports as upside reads to inflation.

• Equities sold off sharply as both inflation expectations and Fed funds YE 2022 forecasts moved up
• Inflation forwards (12M) moved up to 5.4%, but below the cycle high of ~6% on 3/24/2022
• Fed funds by YE 2022 move up 1.5 hikes to 3.3% (2.9% two days ago)

• Fed Funds are at cycle highs but inflation below peak
• One interpretation is that markets believe Fed needs to move faster even though inflationary pressures could be cooling. But the pace of cooling is just not sufficient.

The first 3 days of this coming week are the most consequential

Many of our clients, including macro PMs, note the nearly singular focus on inflation-impacts makes this market environment one of the most dependent they have ever seen. The market moves over the last few days exemplifies this. Over the coming week, there will be quite a lot of incoming data:

• May NFIB small biz optimism survey –> wages and inflation
• May PPI –> inflation
• June Empire Fed –> economy and inflation
• NAHB Housing Index –> housing
• FOMC –> biggest event, obviously

Investors losing patience, thus, pushing Fed to move more aggressively

The fact that market-based inflation has not moved to cycle highs, but Fed fund YE 2022 are at new highs, in our view, is a sign markets are losing patience with the Fed. That is:

• markets are fearful that the rate of inflation is not improving quickly enough
• markets are pushing the Fed to move more aggressively and hence, the rise in YE 2022 Fed Funds
• Fed funds by YE 2022 has risen by nearly 75bp in the past few weeks
• Progress is still measured by cooling labor markets, cooling inflation and reducing inflation expectation
• And this path does not have to lead to a recession (many are concerned)

In fact, as Goldman Sach’s economist note, the current combination of slowing economic activity and further Fed tightening can put the US onto a “narrow path” to a soft landing. Obviously, the key word is “narrow.”

There is considerable uncertainty and poor visibility. And in the absence of visibility, markets have become pessimistic. But as former Fed Chair Ben Bernanke points out, one of the important factors is improving supply-side inflation pressures.

• as we noted before, we are seeing signs this is improving.

To Bernanke’s point, nearly 2.0% of CPI for May came from categories with known supply chain constraints:

• used cars +0.6%
• new cars +0.5%
• furnishings +0.5%
• apparel +0.2%

In all of these cases, we know there are known improvements coming such as weaker prices on Manheim (used cars) and piling inventories. But the pace of these showing up in weaker CPI remain very slow.

4 “supply chain” categories added 2.0% to CPI in May YoY

CPI “used cars” still tracking Manheim with a 2-month lag…

Take a look at the Manheim used car index and the corresponding CPI “used cars.” Our data science team, led by tireless Ken, has argued Manheim leads CPI by two months:

• the May CPI affirms this as May CPI reflects the Manheim March improvements
• if this relationship holds, the “used car” CPI impact will drop sharply in June
• June CPI impact will drop to 0.35% from 0.64% in May
• July CPI impact will drop further to 0.21%
• Used car prices continue to fall, so this effect will amplify throughout the remainder of 2022

STRATEGY: Financial conditions are already tight and Tech and small-caps climbing out

As shown below, equity markets have pivoted on CPI reports in 2022. We have marked the date of the CPI reports and you can see how the S&P 500 has moved decisively around inflation reports.

• and as highlighted below, financial conditions (FCI) often signal the direction of stocks
• granted, there is some circularity as equities are a component of FCI
• but the general concept still holds
• it is not just “bad” or “good” inflation data, but how the market responds
• while last week’s reaction was negative, FCI did not really tighten sharply
• even as Fed Funds YE rate expectations moved up
• this is important, in my view

…and in the midst of this, Tech and small-caps modestly gaining traction

And as shown below, Tech and small-caps have been quietly outperforming:

• as our Head of Technical Analysis, Mark Newton, notes
• equal-weighted Tech bottomed in April
• and has been outperforming

The outperformance of Technology is justified, in our view. After all, think about the path out of inflation:

• wage pressures can only be alleviated by either a supply increase of labor or by replacing labor
• replacing labor is automation
• suppliers of automation are Technology and industrials
• both are de-rated so much, that one can argue a recession is priced in

In fact, as this comment below notes, the Nasdaq has already done a full 50% retrace of the gains post-COVID-19. In other words, a lot of bad news has been baked in.

STRATEGY: We lean relatively “bullish” into 2H2022 (but also 2Q22), but warn of jagged next few months… Stick with BEEF
To recap on equity strategy, we are leaning bullish into 2Q2022.

Stocks have continued to be treacherous in 2022. Investors are on a hair trigger.

– this is in context to a challenging 1H2022
– so jagged next 3 months

Broadly, our existing sector strategy of BEEF remains valid. Even in war. Even with inflation. In fact, the last few weeks are strengthening the case for our “BEEF” strategy. That is, BEEF is

– Bitcoin + Bitcoin Equities BITO -5.40%  GBTC -5.73%  BITW -9.69%
– Energy
– FAANG FNGS -2.37%  QQQ -2.14%

Combined, it can be shortened to BEEF.

Why is this making stronger BEEF?

– Energy supply is now a sovereign priority
– this helps Energy stocks

– Ukraine and Russia both want access to alternative currencies
– this strengthens case for Bitcoin and bitcoin equities

– if Global economy slows, growth stocks lead
– hence, FANG starts to lead FB AAPL -1.86%  AMZN 1.13%  NFLX -1.91%  GOOG -1.84%

All in all, one wants to be Overweight BEEF

_____________________________

31 Granny Shot Ideas: We performed our quarterly rebalance on 4/5. Full stock list here –> Click here

_____________________________

We publish on a 3-day a week schedule:

Monday
SKIP TUESDAY
Wednesday
SKIP THURSDAY
Friday