Markets on edge into Sept CPI report (10/13) but tightening FCI provides some positive "skew" into the report.

Equities have become incredibly fragile, as knock-on effects from central bank tightening further pressure equity risk premia higher (lower multiples). And investors generally fear that inflation is not falling at a pace fast enough to prevent more aggressive measures by the Fed. The most important economic report this week is the September CPI report (released Thursday 10/13). Inflation has proven to be difficult to forecast and given the negative “shock” from the August CPI (9/13), it would be difficult for any investor to have conviction going into this report.

• the WSJ article below (by Nick Timiraos) highlights that the Fed is grappling with the same issue
• “inflation… has consistently defied such forecasts”
• in short, the Fed and markets are “data dependent”

Today (10/12), there are some other important events like PPI and FOMC minutes, but the CPI report on 10/13 is the most important.

CALENDAR: Key economic data this week

DATA DEPENDENCY CPI: Has been the case for 2022

Look at the equity market reaction post-CPI in 2022 so far.

• Each CPI report has resulted in a substantial move in equities
• “good” reports/reactions, drove big rises (CPIs Feb, June, July reports)
• “bad” reports drove massive declines (CPIs Dec, Jan and Aug reports)

FINANCIAL CONDITIONS: When FCI tightens into CPI reports, equities tend to see gains

As we noted above, we do not have a sense for what Sept CPI will deliver (beat or miss). But we decided to look at financial conditions to see if there was a “skew” in how markets might react.

• The “good” reports/reactions were the CPIs Feb, June, July reports highlighted in “green”
• The lower half of the chart is Goldman Sachs FCI (financial conditions index), where rising is “tighter” conditions
• in each of the 4 instances (stocks up post-CPI), FCI tightened into those reports
• in the past few weeks, GS FCI has tightened dramatically

So the takeaway is that FCI tightening suggests there is a slight positive skew to Thursday’s CPI.

A similar pattern is seen when looking at the level of “oversold” conditions in equities. For this proxy, we use the “% stocks trading > 200D moving average” and this figure is the lower half of the chart (TRADPAUS on Bloomberg)

• The “good” reports/reactions were the CPIs Feb, June, July reports highlighted in “green”
• when stocks get more “oversold” into the CPI report, stocks tend to react positively to the report
• stocks have been getting more “oversold” into this CPI print

Thus, there is also a favorable “skew” from this

CPI: leading inflation indicators show inflation falling

Fed officials continue to make clear their view that inflation trends have not improved in a satisfactory way. Take a look at comments from Fed’s Mester and Kashkari.

Kashkari….

The fact that both the Fed and markets are data dependent means markets themselves will “pivot” before the Fed considers a need to “pivot” — this stems from the fact that all markets are now primarily respecting and reacting to “hard” inflation data like CPI.

• of the 50 or so components that are some sort of “leading indicator” for inflation
• more than half are showing negative YoY declines (see below)
• these are marked with “red”
• not all of these are directly calculated in CPI, such as “existing home sales” but have an ultimate influence on price, which in turn impacts “OER, owners equivalent rent” which in turn impacts CPI
• but as you can see from the table below, CPI Core YoY peaked in March 2022
• but many items (more than half) peaked well ahead of “core CPI”

This is a reason to expect future CPI to show improvements. Granted, wages and its impact on services remains a key focus.

INFLATION DASHBOARD: 27 of 50 items are negative YoY

Various inflation drivers. Sorted by date of “inflation YoY peak”

We listed some examples of items where the YoY is now becoming favorable. And as the table highlights, the “lag” between the peak in value to when the item becomes “negative YoY” is about 8 months:

• this is a reminder that CPI index itself will show a similar lag
• the price level might be slowing (rate of climb) but the YoY impact may not be seen for 8-9 months

A simple illustration is used car prices, using the Manheim Used Vehicle Index.

• this index peaked in Jan 2022
• but the YoY only showed a decline in Sept 2022
• an 8 month lag

There is also another lag in the CPI report itself. The process for CPI to compile prices indices. For instance, look at the comparison Manheim vs CPI used cars:

• CPI used cars YTD is “flat” with no change
• Manheim shows used car prices down 13% YTD
• but a similar lag was seen in 2021, where Manheim showed rises
• but CPI was showing falling car prices

INFLATION EXPECTATIONS: NYFRB Survey and NFIB Small-Biz Survey show this is falling

Another supportive data point remains that inflation expectations remain well anchored.

• the latest NY Fed survey of consumers show 1-year inflation expectations fell -0.3 to 5.4%, the lowest since Sept 2021
• on NFIB, the net percent planning to raise prices next 3 months fell to 31% (% higher less % lower) from 32% last month. While positive, the diffusion is falling

STRATEGY: Equities fragile as markets see increasing risk of an “accident” — yet divergences

Stocks continue to be caught in a vortex of pain. And Fed officials remain consistent in their rhetoric to continue to fight inflation. In our view, so many leading indicators show that inflation is slowing. While there remain stubborn components like shelter (which is a known lag) or the rise in medical costs, there is also a growing gap between what is apparent in many leading indicators and what is seen in the CPI reports. Ultimately, we see markets take a “step function” of relief when this gap begins to narrow.

• a hint of this was seen in the market reaction to the JOLTS report, where equities rallied 200 points on a positive surprise

In the meantime, there are some important market divergences that argue stocks should be seen as forming a bottoming process:

• high-yield spreads have not made new wides versus June, even as the S&P 500 has made a new low
• small-cap stocks have been outperforming large-caps and this is typically a positive sign for broader markets, as highlighted by Mark Newton, Head of Technical Strategy
• high-yield bonds are outperforming investment grade bonds, and this is also supportive of risk/reward for equities, another important divergence highlighted by Newton.

The HY spreads vs S&P 500 is shown below. And as shown, HY spreads did not make a new wide, despite S&P 500 falling.

But this was a similar setup in 2009.

• high yield did not make a new wide March 2009 vs Oct 2008
• but the S&P 500 made a closing low March 2009 vs Oct 2008
• this divergence proved to be important in 2009
• credit led equities in 2009
• is this the same case in 2022?

Our Head of Technical Strategy has also noted the outperformance of:

• small-caps (IWM 0.60% ) vs large-caps (SPY 0.44% )
• HY bonds (HYG -0.06% ) vs investment grade bonds (LQD 0.05% )
• small-caps began outperforming May 11, 2022
• small-caps have not violated their June lows
• HY began outperforming LQD on July 5, 2022

Both seem to suggest market internals are better than suggested by overall index performance.

As shown below, these relative performance divergences have been important for equities in the past 15 years.

• ultimately, these divergences highlight that investors should not become too pessimistic
• while Fed and the war on inflation remain the primary focus
• we think the tide will begin turning where inflation will show consistent progress
• and these divergences will prove to be meaningful

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