LEAD VS LAG: Case strengthening inflationary drivers peaked (“lead”), even if CPI remains elevated (“lag”) = market perception lagging
Inflation vs Recession = Markets focus of either “half-empty” views to “worser half-empty”
Incoming data this week has pointed to a pronounced softening of economic momentum globally, and this has pushed commodity prices lower and similarly pushed down interest rates. And this has shifted market focus:
- inflation vs recession
- two paths to ruin, either inflation wrecks the economy or a recession wrecks the economy
- weakening incoming economic data, at a minimum, reduces the “hawkish upside” risk from central banks
- but these are not the only two paths for markets, even if markets see these as most probable
- falling inflation is arguably more important anyways
- falling inflation would push Fed closer to a dovish pivot
- a recession would trigger a Fed pivot (to dove) and would support markets
A third option remains “soft landing” — in this version:
- inflationary pressures are cooling as supply chains ease
- Fed and other central banks have tightened sufficiently currently to further soften the labor market and housing
- thus, instead of a recession vs inflation debate, it should be “soft” vs “hard” landing
- and under “soft” there is a wider path for equity markets to recover
Taking a step back, the incoming data this week could be viewed as discouraging in this shortened week. Yet, as shown below, the S&P 500 has managed to climb 3.3% and even closed relatively strong Thursday, even as multiple Fed speakers, including Powell, continued to speak of the need to push Fed fund rates higher.
The relative strength of Nasdaq 100 and China equities argues for “soft landing” not recession
One argument in favor of “soft landing” or disinflation, is the relative strength shown by Nasdaq 100 (QQQ-2.08% ) and China equities (CS 300). As shown below, both have shown demonstrable strength:
- China has been outperforming since late April
- Nasdaq 100 since early June
Since April, inflationary fears have accelerated. And since early June, fears of a widening economic slowdown have strengthened. These two markets bear watching. After all:
- a recession would be a massive headwind for QQQ and China equities
- surging inflation would be a headwind for QQQ and China
- but a soft landing would arguably be a positive, since this would signal Fed potentially shifting dovish
Even Powell, in his testimony to Congress, made reference to the possibility of a “sharp decline in prices.” The context for this statement is that:
- in situations of unusually tight supply/demand
- prices move far more than suggested by typical models
- in excess demand, prices rise faster
- in easing supply (ala supply chains ease), the prices could move lower
This comment did not get wide coverage, but he made a similar statement during the Q&A of the June FOMC press conference (6/15). This speaks to the possible positive implications of supply chains easing.
Market-based inflation measures see ~9% CPI YoY through November…
Our data science team, led by tireless Ken, compiled market-based inflation expectations. They used inflation swap markets to get implied inflation forecasts for the next 12 months:
- Market-based measures see YoY CPI ~9% through November 2022
- This, in part, explains why markets see the Fed as far behind the curve
- And is also instructional, as we get a sense where expectations are calibrated
To the extent incoming inflation is softer than consensus, we could see these measures adjust downward sharply. This would be positive for risk assets.
And market-based measures are forecasting far more inflation than economists. For instance, JPMorgan Economists expect inflation to moderate towards a 7% pace by 3Q22 compared to the 9% seen in market forecasts.
Similarly, Goldman Sachs sees CPI YoY around 8% in 3Q2022 and falling towards 6.8% by 4Q2022 and PCE Core YoY falling to 4%. These are well below the levels forecasted by inflation swap markets.
Leading indicators of inflation are easing as well
Many commodities have already started to rollover. Commodities are a long lead to inflation:
- oil and gasoline and natural gas directly impact headline CPI (gasoline and nat gas)
- other commodities lead inflation as these are raw materials
- we have seen the downturn in industrial commodity prices – as shown below, falling 5% to 10% in the past month
- agricultural commodities have also rolled over hard as well, with steep declines
The cooling of inflationary food price pressures has been incrementally observable in the past few months. The time series below looks at the diffision of food prices declining month over month:
- the percentage of items with negative month over month changes has been rising
- this bottomed at 10% in February 2022
- and is now 17% currently as of May
- and as above has shown, commodity prices have since fallen in the month of June
One of our clients, FH, has shared the following email as well. He had spoken to a small restaurant owner. This restaurant owner had said prices have fallen:
- prices for chicken breast and romaine lettuce have fallen sharply
- this is a break of the pattern for much of the last two years
- this also corroborates the comments we heard from a seafood producers a few weeks ago
If one is wondering with what items (as of May) are seeing declining prices month over month, this is shown below. There are about 10 items with declining prices, these are shown below.
Figure: Themes in 2022 – “BEEF”
Per FSInsight
Figure: FSInsight Portfolio Strategy Summary – Relative to S&P 500
** Performance is calculated since strategy introduction, 1/10/2019
* Portfolio strategy introduced in December ’19 rebalance, replacing 2019 portfolio recommendation – “FANG in odd years”
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