Cooling "soft data" argues Fed playbook soon change to more predictable. In 1982, took only 4 mos to erase entire Volcker "bear market"

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Fed speak post-June CPI shows the Fed playbook seems to be changing

Most investors, based upon my conversations, remain skeptical that markets can find any footing, particularly in the face of continuing bad CPI reports. But I think investors are overlooking that Fed reaction to “hot” inflation prints is actually changing.

Last week, after the horrific June CPI report, several Fed members spoke and pushed back against the market’s knee-jerk reaction to expect 100bp hike. SF Fed Reserve Bank Mary Daly and other Fed members made similar comments:



This is a reminder the Fed isn’t only reading CPI reports. They are incorporating many leading contemporaneous and leading measures into their thinking about inflation trends. A simple graphic below shows there are many leading indicators that can inform the Fed:

• “soft surveys” are important such as U Mich consumer expectations
• the high reading in mid-June triggered the Fed to move towards a 75bp hike
• the Fed, like economists, all know many leading indicators might soften on inflation
• but there are serious lags before this shows up in weaker CPI
• the current issue is the high-side reading on “rent” and “owner’s equivalent rent” because this is pushing up core

And as shown below, the trend in many leading and soft indicators have rolled over materially in July:

• leading and soft indicators are showing inflation weakening in July
• but this will not be reflected in CPI for many months
• for YoY, it may be 6-12 months before we see this in the “hard data” CPI

We think markets will price in the cooling inflation well before this shows up in the CPI data.



Volcker shifted away from “anti-inflation” tactics in October 1982, even as CPI remained at 6%

Many investors, in my conversations, argue the Fed will not stop its aggressive policies until inflation is well on its way to 2%. And this is conceptually true, but it is the details that matter:

• we believe the more important distinction is the “predictable path” away from “expeditious”
• meaning, Fed reaction is away from “hawkish” reaction to data
• but Fed could be hiking, but in a predictable way, still allows asset prices to rise
• thus, we don’t think CPI needs to closing in on 2% before equities reprice

In fact, as shown below, Volcker shifted away from “anti-inflation” tactics on October 10, 1982:

• Volcker implemented (and evolved) anti-inflation tactics starting Oct 6, 1979
• The “anti-inflation” approach essentially ended 36 months later
• Inflation started at 11% at the start of this period
• rose to 14% by 1980 and even in April 1981, Volcker fought bond markets which thought rates could fall
• by the time Volcker said enough is enough, CPI was still 6%
• but 12 months later fell to 2% in 1983



Gasoline and Food inflation averaged 17% and 8% into the period before Volcker took measures

The history around Volcker is well known, so I don’t want to rehash everything. But some context is important. Inflationary pressures in Food and gasoline were building for sometime before 1979:

• food prices were inflation at 8% or higher starting in 1968
• by 1979, food inflation was 8% for 11 years
• gasoline prices started volatile surges from 1972
• by 1979, the US was dealing with 17% gasoline inflation for 7 years
• see the context?
• the US today has seen elevated inflation for just little over 1 year
• Volcker was dealing with entrenched inflation for 7 to 11X longer periods



Getting “soft data” down to goals seemed to matter more than CPI

It seems like “soft data” like surveys seemed to be a better measure of how Volcker ended the anti-inflation program.

• the anti-inflation program kicked off when U Mich consumer inflation hit all-time highs
• 10% for 1-year and 9% 5-10 year
• Volcker abandoned these measures in October 1982
• when U Mich inflation expectations collapsed
• to 3% for 1-year and 5% 5-10 year

We think this applies to 2022:

• when soft data confirms inflation is well on its way to 2%
• we think market reaction will reflect this
• much of the soft data is pointing to far weaker inflation



STRATEGY: Equities bottomed August 12, 1982, or 2 months before Fed shift

The most interesting takeaway from 1982 is the equity market during this time:

• S&P 500 peaked November 28, 1980 as interest rates were soaring
• this drove P/E compression as 10-year reached 14%
• S&P 500 bottomed on August 12, 1982 as 10-year fell back and reached 10%
• The total drawdown was 27%
• The strong rally in equities started 2 months before Volcker abandoned “anti-inflation” measures
• S&P 500 recovered the entire bear market within 4 months

The context to today is important:

• In 2022, S&P 500 total drawdown was 24%, or nearing the Volcker bear market drawdown
• Headline/Core CPI is 9%/6% compared to >14% in 1980
• Inflation has been elevated for ~15 months, compared to 15 years prior to Volcker

And unlike 1980s, inflation expectations are pretty well anchored.



This is our context today. We think multiple leading indicators point to softening inflation picture.



STRATEGY: Will the Fed actually wait until CPI YoY declines to 2%? When month over month will show persistent declines?

This gets us back to a key conceptual question. We realize the Fed needs to fight inflation.

• many clients say Fed won’t stop until CPI YoY is back towards 2%
• this seems somewhat illogical since there is a huge time element involved in YoY
• and raising rates until YoY gets towards 2% is obvious overkill
• more logical is for CPI to show substantial progress,
• along with leading indicators affirming this
• how long this takes is unknown, but soft indicators show a pace that if reflect in CPI
• would show substantial decline in CPI



S&P 500 and Russell 2000 earnings are up +40%/+72% since 2019, while index only +17%/+4%

2Q2022 earnings season is underway. And while there are going to be disappointments, a lot of bad news is priced in. And as we have stated in other notes, we believe “i” matters more than “e” since this cycle slowdown is engineered by the Fed. As shown below, some perspective is helpful:

• Russell 2000 is only up 4% since the end of 2019
• But revenues are +27% higher and EPS +72% higher
• Thus, the carnage in 2022 has discounted a lot of bad news

Even the S&P 500 shows this impact to a lesser extent:

• S&P 500 is up +17% since end of 2019
• Revenues are +17%
• Earnings +40%

So the S&P 500 is already discounting a massive hit to earnings.

GRANNY SHOTS: 33 names, 8 stocks added in last rebalance. YTD outperformance +349bp

Our reviewed Granny Shots of 33 stocks is below. Recall, our July rebalance additions are:

• META -2.52% ,
• AZO 1.79% ,
• GPC 0.90% ,
• ABT -0.24% ,
• BIIB 3.16% ,
• ISRG -1.89% ,
• MRNA 3.45% ,
• REGN 1.05%

33 GRANNY SHOTS: Updated list is below

The list on the table below is sorted by the most attractive (most frequently cited) to least. To be a “Granny shot” the stock needs to appear on at least two portfolios:

• AAPL 2.52%  in 5 of 6 portfolios
• GOOGL -3.39%  MSFT -1.06%  in 4 of 6 portfolios
• AMZN 0.91%  META -2.52%  in at least 2
• This reinforces our favorable view of FANG in 2H2022

33 Granny Shot Ideas:

Consumer Discretionary: AMZN 0.91% , AZO 1.79% , GPC 0.90% , GRMN 1.21% , TSLA 15.34%

Information Technology: AAPL 2.52% , AMD 1.90% , AVGO -0.41% , CSCO -0.17% , KLAC 1.09% , MSFT -1.06% , NVDA 0.47% , PYPL 1.71% , QCOM 2.14%

Communication Services: GOOGL -3.39% , META -2.52%

Energy: CVX 0.27% , DVN 0.70% , XOM

Financials: ALL -0.29% , AXP 1.39%

Real Estate: AMT 1.92% , CCI 1.86% , EXR 2.93%

Health Care: ABT -0.24% , BIIB 3.16% , ISRG -1.89% , MRNA 3.45% , REGN 1.05%

Consumer Staples: BF/B, MNST 1.42% , PG 0.23% , PM 0.61%

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

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