The best case scenario for yesterday was “horrible CPI miss and stocks rally”
I was at two finance investor gatherings last night (midtown 5 minutes apart) and there was naturally a lot of discussion about what would be the best “case” outcome for yesterday’s CPI (Sept) report. No surprise, the views ranged from “CPI below expectations and we rally” etc but the most cogent was made by a family office investor:
- best case is “way hotter CPI print and stocks tank at open then reverse into close”
- an example as Mark Newton, Head of Technical Strategy, likes to say “markets bottom on bad news”
Well, this is what happened.
- futures strengthened overnight on UK Truss news
- Sept CPI reported 8:30am ET and far stronger than expected
- futures quickly fall 4%
- markets open down 2.5% and rally from open
The chart below sums up the price action yesterday. Markets managed to reverse the selling over the past 3 days. But have not recovered losses experienced over the past 6 trading session.
- that would require a recovery to S&P 500 ~3,800
As we highlighted earlier this week, the probabilities slightly favored a rally given investor positioning into this CPI report. As shown below:
- when financial conditions (Goldman Sachs Financial Conditions Index) tighten into CPI day
- markets have rallied ala Feb CPI, March CPI, April CPI and June CPI days (2-week lag, so actual date is month later)
TAKEAWAY: Fed speak post this CPI is key…
Immediately following yesterday’s Sept CPI report, June Fed funds futures surged ~+0.4%, or nearly 2 hikes, to 4.92%.
- investors saw “hot” CPI leading to a higher terminal rate ~5.0%
- Fed’s dot plot is 4.6%, implying market suggesting Fed terminal rate needs to be 0.40% higher
- but as the day has progressed, this figure has backed off somewhat to 4.8%
Therefore, in coming weeks, markets will focus on Fed speak post this CPI report. The next FOMC meeting is 11/2 and given the associated blackout period, the next scheduled speech is Fed Gov Chris Waller on 10/14 (on central bank digital currencies).
SEP CPI: Stronger as goods still inflating, labor-driven services rising and housing still strong
The Sept CPI report came in stronger than expected with key items:
- Headline YoY +8.2% vs +8.1% consensus and +8.3% August
- Headline MoM +0.4% vs +0.2% consensus and +0.1% August
- Over the past few weeks, Fed officials have been consistent in their messaging about “staying the course” and this strong CPI report doesn’t necessarily change the path of rates.
But as highlighted above, the rise in Fed futures and US Treasury yields show that investors saw this as an upside surprise and are pricing in more Fed tightening and higher interest rates ahead.
STICKY CPI: Services aka sticky components still too strong, but growing gap versus soft data
The perspective of a macro client of Fundstrat best explains the factors behind a strong CPI:
- Shelter strengthened in Sept (rent +0.84% vs +0.74% Aug and OER +0.81% vs +0.71% in Aug)
- Wage-sensitive too strong — daycare (+2.0%), auto repair (+1.9%), medical care (+1.0%) and even car insurance (+1.6%) due to higher parts costs
- Goods inflation has too many offsets as lower used cars and apparel offset by new cars, pet products and food prices still strong
- The Atlanta “sticky CPI” captures this as the 3-month annualized “sticky CPI” still running at 7% (lower chart)
CPI: Auto related was 4 of top 10 contributors to CPI gains in September
Our data science team, led by “tireless Ken,” compiled the 175 components of CPI and their respective contribution to the month-over-month rise:
- Top of the list is “shelter” representing +0.25% of the +0.39% CPI rise or 64% of the gain
- Auto-related represented 4 of the top 10 categories (leased cars, insurance, new cars and car repair) totaling +0.14% of the +0.39% rise, or 36% of the CPI gain
- I think many investors would be surprised to see a continuing high contribution from cars but this again speaks to the large gap between “soft” data and what shows up in CPI
UNDERLYING INFLATION GAUGE: Fed measure shows Sept trend inflation 4.41%, -0.10bp from August
The NY Fed publishes the Underlying Inflation Gauge (UIG) on CPI day. The white paper explains the NY Fed believes this is a better measure of trend inflation compared to the BLS “core CPI”:
- the UIG Full data set peaked in March 2022 at 4.88%
- the Sept UIG is 4.41%, still above Fed’s 2% target
- this is down -10bp from the prior month August of 4.51%
- but this is a “better place” compared to core CPI 6.6%
REGIONAL CPI: Inflation strongest in Pacific, Mountain and South Atlantic
And the regional CPIs show that 3 regions have >3% annualized inflation. These are circled in red.
And looking at the details, there are a few contributing factors:
- Shelter is a top factor in Mountain and South Atlantic
- Motor / auto related and fuel are other factors
- and Apparel is top 10 in both Mountain and South Atlantic. Recall, Apparel was a top contributor to Northeast last month
CPI DIFFUSION: 53% of CPI components are off their peak, up from 47% last month
Our data science team also compiled what percent of CPI components price level are off their highs.
- this figure is now 53%, up from 47% last month
- on a weighted component basis, this is now 31%, up from 26% last month and approaching the 39% 10-yr average
- so, while wage-driven components and shelter components are sticky, many other components are cooling.
SOFT VS HARD “GAP”: Why is CPI still strong when leading indicators and UIG falling?
We have written about the numerous reasons CPI should be cooling, particularly since so many leading indicators point to lower inflation:
- take a look at the 50 leading indicators below, roughly half are in outright declines YoY
- ISMs both manufacturing and services, NFIB, consumer surveys show this and even commodities
- but the natural question is why there is a differential between these soft indicators and hard data
- the gap between the “soft” data and “hard” data can arguably be explained by a few things
- time “gap” as there is a natural lag between when leading indicators versus official data capturing. Shelter and OER (owners equivalent rent) are examples where “new rents” lead these components by months
- time “lag” as many components might stall in price but YoY declines take longer to form
- wage factor as ISM prices survey is about prices received, but many CPI components are wage driven
- collectively, this means there can be lags but the broader picture is cooling inflation
INFLATION DASHBOARD: 27 of 50 items are negative YoY
Various inflation drivers. Sorted by date of “inflation YoY peak”
SOFT VS HARD “GAP”: Used cars remains an example of CPI “GAP” still growing
There is also another lag in the CPI report itself. This is a “gap” between the soft (leading) and hard (actual CPI) report. Eventually, these link up. 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
SOFT VS HARD “YoY Takes time”: The “lag” between prices flattening and “YoY showing decline”
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
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 0.15% ) vs large-caps (SPY 0.54% )
- HY bonds (HYG 0.21% ) vs investment grade bonds (LQD 0.49% )
- 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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