Incoming economic “hard” data won’t reflect increasing signs of disinflation. Visibility on “I” matters more than “e”

Incoming economic “hard” data (over next few weeks) may not necessarily confirm the increasing signs of softening of inflation

There will be several incoming “hard” data points that will impact market views on inflation and economy and therefore impact Fed policy. Paramount remains inflation pressures and while many “soft” (surveys and market implied) and leading indicators (commodities, etc) have softened sharply, the actual data needs to be seen to assuage inflation concerns:

• Friday is the June jobs report and Street consensus is NFP +237k
• Consensus avg hourly earnings +0.3% m/m
• Next week June CPI and +0.6% m/m is consensus (see below)

But in a sense, these “hard” data prints seem somewhat lagging with the visible data we are seeing. To recap, commodities both energy and food are down sharply, even rents are cooling (see below) and market expectations are falling as well.

The S&P 500 closed at 3,903 and while this remains a depressed level, this is an improvement compared to levels seen in the past month:

• S&P 500 closed
• 3,900 post-May CPI “massacre” (June 10th)
• 3,790 post-June FOMC (June 15th)
• Still below technically important 3,946 (June 28th)
• June NFP July 8th
• June CPI July 13th

While there are a few important “hard” data points in the coming week or so, what is encouraging is that the S&P 500 has recovered its losses stemming from the May CPI massacre and moved higher from the June FOMC meeting.

As an aside, job postings for June dropped sharply as shown by this indeed.com labs data. The May JOLTS figures were reported on Wednesday, but as seen below, June saw a pronounced weakening. This could be showing up in the June payrolls report.

…Huge drop in market expectations for CPI since May CPI report

Earlier this week, we highlighted the drop in 5Y5Y inflation expectations to below 2%, the key level for the Fed. But even near term inflation forecasts have fallen sharply. Below is the inflation swaps for near expirations:

• these approximate month over month CPI expectations (even though actual contracts are 3M rolling)
• in past 3 weeks, there has been a huge drop in monthly inflation forecasts July through December
• sort of hard to see, but compare the plots of the gray line (3 weeks ago) versus blue line (now)
• this drop, in our view, reflects the cumulative declines in energy commodities, food and durable goods prices

Can inflation accelerate if inflation expectations and inflation leading indicators are tanking?

Over the past year, the market’s view on inflation has shifted from “transitory” to that of a more pernicious sticky inflation (“structural”) and this prompted the Fed to pursue a hawkish course. And this in turn has put a lot of pressure on asset prices. And in this context, not surprisingly markets remain in the “structural” camp until inflationary pressures ease. Even as incoming data has shown an increasingly less inflationary picture, inflation is still seen as sticky and a pronounced and persistent downturn in inflation readings is what will convince markets (and the Fed).

Over the past two weeks, there are increasing signs these inflationary pressures are indeed abating meaningfully. While it might take some time before these show up in the official data, the signs are harder for markets to ignore:

• Oil and energy commodities are down sharply in the past two weeks

• RBOB gasoline futures are down -24% from all-time highs, although retail gasoline only down -4%
• More stories of retailers slashing inventories and even not wanting to take customer returns
• As Mark Newton, Head of Technical Strategy for FSinsight notes, inflation breakevens 5Y5Y (5-yr forward, 5-yr inflation) are now below 2% for the first time since the start of 2022
• Collectively, this is painting a strengthening picture that inflationary pressures in the US might be more “transitory” than markets believe.
• At a minimum, this argues Fed has far less “wood to chop” to contain inflation

This comes back to our view that “i” (inflation) is more important than “e” (earnings risk) at the moment. Why? Inflation is a far harder problem to contain, while earnings risk can be mitigated by a change in Fed policy. And in our view the most important takeaways are:

• Oil and gasoline are easing, which in turn, should lower consumer expectations on inflation
• In just two weeks, markets now see Fed hike cycle peaking Feb 23 (vs May 23) and at 3.3% (-60bp)
• Directionally, both are major incremental positives.

There is a lot of incoming data on the labor market this week, which will naturally shape market expectations about inflation risks and the economy:

• ISM Services 7/6 10am ET (Street 54)
• JOLTS May 7/6 10am ET (10.9 million)
• June Jobs report 7/8 8:30am ET

Insights on the labor market are important, because the tightness of labor markets remains a focus for the Fed. As we noted in prior commentaries, some leading indicators like job openings (indeed labs), or mortgage applications (impact on financial jobs) or start-up layoffs (layoffs.fyi) and even jobless claims have all shown that labor markets are softening directionally.

Inflation breakevens 5Y5Y are now back to “2%” target (of Fed) — strengthening camp “transitory”

Mark Newton, Head of Technical Strategy, noted Tuesday that “a new disinflationary trend could be taking hold”:

• Mark is referring to 5Y5Y, or market expected 5-yr inflation 5 years from now
• This figure fell to 2% Tuesday, the first time since the start of 2022
• But think about this
• If a “disinflation” trend is underway now
• This argues inflation was indeed “transitory”

And as we can see below, 5Y5Y inflation breakevens have tanked since April 22, 2022. This has fallen from 2.7% (a worrying level for Fed) to 2% which is the level targeted by the Fed.

• in fact, this is lower than the levels seen in 2018 (see below)

OIL: Below $100 and within $5 of the price pre-Russia-Ukraine war… what happens with a cease fire?

Can inflation really accelerate if oil prices are declining? The reason we ask is WTI fell to $97 on Tuesday:

• WTI crude was $92-$93 prior to the start of Russia-Ukraine war
• WTI surged to >$130 in the past 4 months
• WTI is down -21% in the past month to $97
• This is within $5 of the price prior to the invasion

That is a major roundtrip. We are not bearish on oil prices, but this drop in prices will have a visible impact on:

• headline inflation in July CPI
• in turn, this should lead to lower gasoline prices
• which impact consumer expectations around inflation

So all in all, an important development.

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