The Goldilocks scenario may not be dead but it developed a mean case of Covid yesterday when the government issued the January CPI report. Goldilocks had said inflation was dying, deflating. But yesterday’s release threw a big bucket of water on that conclusion. At first glance it might not have looked so bad. The month-over-month change was 0.3% instead of the 0.2% predicted. Year-over-year, the increase was 3.1% instead of the predicted 2.9%. Does that support a 1.5-2.0% decline in the leading stock market averages? The answer is an unqualified yes as we are about to explain.
Just look at the list of prices that increased by more that 6% annualized in the month of January. Laundry services, haircuts, residential phone bills, postage stamps, day care, pet services, cruise ship fares (up over 20% annualized alone!), hotels, parking, car insurance, vehicle repair, outpatient medical services, non-prescription drugs, trash collection, and, most important, owner equivalent rents. The last item, the single most important in the CPI calculation, rose at a pace greater than 7% based on higher year-over-year mortgage rates and higher home prices. Notice that the vast majority of the inflation in January was service related. It therefore bore a higher labor content than manufactured goods. Also remember that in January, including prior month adjustments, our economy added over 400,000 net new jobs. The tight link between jobs and inflation has been debunked a bit but the two are still connected.
The impact on the bond market was immediate with the 10-year Treasury yield now over 4.3%. But perhaps the most important impact that has pushed stock prices lower is the markets conclusion, reflected in the Fed Funds futures, that the logical first rate cut will come no sooner than May. Moreover, whereas a few months ago markets were expecting 7 cuts this year, as of yesterday, they were expecting just four cuts. And that is still higher than the Fed officials’ own prediction of just 3.
One month’s data shouldn’t be overemphasized. But where inflation was in steady decline for most of last year through October, the trend since then has been flat at best and, depending on how one interprets data, a bit of a reversal. Today’s CPI report creates a more disturbing October-January trend. Three months may not be a trend but it’s a reasonable start, one to reignite concerns that seemed to evaporate over the last 3 months. This is what has kept FOMC members so hesitant to consider lowering rates sooner rather than later. With that said, the Fed watches the PCE inflation data more than CPI. Those numbers haven’t been as hot lately as the CPI. Friday’s Producer Price Index (PPI) report should give a hint as to what to expect when the PCE number is released on February 29.
Sharp one day declines within a bull market have to be treated skeptically. Until we see today’s trading, we won’t know the true severity of yesterday’s action. Even a modest rally today would be encouraging. But a 15% surge since the start of November was predicated on inflation staying on a downward path, one that would induce multiple rate cuts this year. While stocks continued on a tear as the calendar marched into 2024, the 10-year Treasury yield has now risen 50 basis points. In terms of valuation and P/E ratios, that’s a big deal. Two-year Treasury yields have risen a similar amount. The curve remains inverted. Politically, I am sure Democrats would love to see the economy grow and the stock market set new records. But if inflation reignites, that would be crushing. The Fed will have plenty of cover to keep rates high for a much longer period than markets expect given robust job and GDP growth happening today.
While odds of a soft landing have clearly increased in recent months given the aforementioned strength in GDP and employment growth, a recession still isn’t out of the question, particularly if the fight against inflation proves tougher than anticipated.
All of this doesn’t suddenly mean the end of the bull run. But it does put it into a more logical context. The easy part of bringing inflation down from 7-9% to 3-4% is over. Getting it to 2% is going to take longer. What’s particularly disturbing is that our economy is much more service oriented than goods oriented. By their nature services have a higher labor component and wages continue to grow at 4%+. Furthermore, in some parts of the economy strong demand has brought much higher prices. As I mentioned at the start, look at the inflation rates for airline tickets, hotels, cruise ships, pet services, vehicle repair, and day care. And perversely, look at what’s happening to new home demand given the unwillingness of those holding 3% mortgages to sell.
As I mentioned Monday, markets were itching for a correction. I didn’t and couldn’t predict it might start the next day. But markets never move in a straight line for long. At best, I would expect increased volatility over the coming weeks as markets sort through data to determine/adjust the future path of inflation. Meanwhile, earnings are solid. What lies in front of us should be some sort of reversal from the 3-month rally. That most likely means a future buying opportunity after the recent rally eviscerated bargains. Without signs of a recession, any decline should be viewed within the context of a bull market. But if economic growth falters, job growth suddenly declines, inflation continues to reaccelerate or bond yields spike, any correction could become more serious. This is the perfect time, if you have sideline cash, to identify what you want to buy and establish entry points. That is what we are doing.
Today reporter Carl Bernstein is 80. Michael Bloomberg is 82.
James M. Meyer, CFA 610-260-2220