Less “I” on horizon. Markets can see through weaker “e” if “I” disinflating

Cooling of inflation (“i”) aka disinflation is Fed primary focus and in 1H2022, the sole focus of markets. Obviously, there remains the question of how quickly inflation can cool, and this lack of visibility unsettles markets. But as we discuss below, energy prices have dropped sharply in the past few weeks with Natural gas down -45% and oil -14% and we have heard that food suppliers are sitting on mounting food inventories. Thus, headline drivers of inflation (food + energy) could be cooling sharply.

But the converse of this “i” positives is the mounting concerns about S&P 500 EPS guidance in 2H. Our Head of global portfolio strategy, Brian Rauscher, has written extensively on this. Keep in mind:

• EPS risk as the “bullwhip” effect is going to cause wild swings in EPS
• nominal GDP, however, will continue to be strong given headline inflation
• markets, in our view, can more easily see through “e” than they can see through “i”
• thus, in 2H2022, the easing of “i” matters far more to markets than “e”

On Thursday this week, May Core PCE came in at +0.3% (+4.7% YoY), below Street’s +0.4% and another modest but encouraging downside read on inflation. PCE, or personal consumption expenditures, differs from CPI as the PCE measures the costs of goods and services consumed by households and not just the out of pocket costs. The Fed tends to favor the PCE as their preferred measure of inflation.

The chart of core PCE vs core CPI is shown below and the difference is 130bp. And the only reason we highlight this is that core PCE is closer (still a distance) to the Fed’s target of 2.0% and this will be important to keep in mind as we move through 2022.

Fed Chair Powell spoke at the European Central Bank Forum in Sintra (Portugal). And while his overall stance remains focused on inflation, one statement garnering particular attention is Powell’s comment on risk of “deanchoring” of inflation expectations. And there is a “time window” to achieve inflation tempering.

• market-based measures of inflation seem to be anchored
• while some business surveys show rising inflation expectations
• the larger risk is the public/consumer expectations
• much of this inflation perception stems from food/energy
• as discussed below, there are signs these are cooling

Market-based measures are well anchored

With recent softer inflation readings (and softer economic readings), market-based measures of inflation and Fed hikes have decreased notably in the past month:

• inflation 12M forward is down to 4.3% from 5.6% (month ago), or -130bp
• Implied Fed funds rate by YE2022 down 38bp, or -1.5 fewer hikes to 3.4% from 3.78%
• Fed funds is currently is 1.75% and should be 2.50% after July FOMC
• Suggesting post-July, there would be +0.9% of more hikes, or less than 4 hikes between July and YE 2022

…in just the past month, sharp drop in expected inflation in 2022

And when looking at futures markets, inflation forecasts for 2022 have dropped sharply in the past month:

• there are no longer >10% YoY inflation expected in near months
• YoY CPI is now similar to levels seen in April 2022

And the “difficult” months for inflation (month-over-month change) are seen to be June and July with >1% m/m gains. And then a sharp drop thereafter.

• thus, if market-based measures are correct
• the “i” will be cooling notably after July 2022

Increasing signs that inflationary pressures easing, except for tight labor

Over the past few weeks, there are increasingly convincing signs that inflationary pressures are easing. But we believe investors are ignoring signs that the incoming data is tracking closer to the “half-full” view — inflationary pressures are outright falling for many items and the lack of “unhealthy imbalances” means the risk to the cycle are lower. In fact, consider these latest developments collectively. These are not congruent with “inflation out of control”

• industrial metals declining
• agricultural commodities declining
• retailers sitting on record inventories
• housing inventory at multi-year highs
• discounts on new home listings

• regional PMIs showing “prices received” are declining sharply

For those in the half-empty camp (nearly entire consensus of investors), the pushback is two-fold: easing does not mean pace of inflation is falling AND economic growth risks are emerging. And to an extent, this is true. But these are arguably more congruent with a “bullwhip” effect and supply chains easing.

The MIT Beer Game has shown how easily the “bullwhip” effect of the supply chain can happen

My co-founder John Bai, a few months ago, talked about how the MIT Beer Game showed how vulnerable the supply chain is to wide swings, even with modest changes in demand. The upshot being huge volatility in double-ordering and massive inventory corrections. The MIT Beer Game is not “beer pong” but instead a game designed to illustrate the foibles and risks in the supply chain.

I have never played the “beer game” but have heard how this game/simulation is a great example of how small changes in the end market (consumer/retailer) create large swings across all areas of the supply chain. The total game takes 20-30 minutes to play, with 50 rounds of orders using chips/proxies passed around. Here is the basic rules of the game.

The overarching takeaway is the change in the end market creates a bullwhip effect across the supply chain. This is due to several factors:

• inventory management at each level of the supply chain
• incomplete information and communication across each level of the supply chain
• the natural delay between order and fulfillment means customers could end double-ordering or cutting orders, not congruent with actual demand
• those higher in the supply chain mistake these swings in demand as structural, not cyclical

Collectively, this is referred to as the “bullwhip” effect. I am not giving the greatest explanation, but hopefully, the basic point is clear.

Kearny (consulting agency) shows below how the changes in sales orders (bottom right chart) lead to an increasingly amplified volatile swing in orders across the supply chain. The greatest “bullwhip” is in the manufacturer.

And another illustration below shows how the step up in orders from the customer lead to a massive 100X increase in orders for the manufacturer.

• customer increased their orders from 400 to 1,000
• but the delays and interaction with inventory (need to replenish) ultimately swing the +600 increase in units
• to a +30,000 increase in units for the brewery

And as a consequence, the brewery ends up with a massive inventory surplus as shown below. Think about that. A simple +600 order could ultimately trigger a 2-year plus surplus at the manufacturer.

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