By the time you get this report we will have an all-important inflation data point with CPI for May. I have no prediction, but a few analysts like JP Morgan’s team came out yesterday predicting a horrible number. Stocks dropped throughout the day.
Most expect the CPI number to show a continued, albeit slow, decline for inflation. Anything weak or strong on either side of the pricing fear debate will determine how we finish the week. So far it has been another slightly negative, mini-consolidation of the massive gains off our lows from late-May. That 10% S&P pop (after a 21% decline from January) has led to a very tight trading range, albeit with a 3% downward bias. All of this occurred while 10-year Treasury yields jumped nearly 30bps back to 3.05%, oil jumped 15%, and retailers offered downbeat reports as inventories spiked higher in certain categories due to a slowing U.S. consumer.
Housing inflation is a lagging piece of CPI and just started hitting implied rent calculations which make up 1/3 of CPI. Even though home prices have peaked, the rent metric for CPI will keep rising. Goods deflation is already here, but services inflation will continue throughout the summer. Fertilizer, shipping costs, freight rates, used cars and even grain prices are showing noteworthy drops from their highs. By year end, as supply chains continue to repair themselves, we should see a clear decline in new car prices, car parts, rental cars, sport and recreational vehicles, sporting equipment, clothing, household goods, furniture and appliances. Target and others have all said that huge discounts are coming in order to move inventory. Last year’s freighter jams at ports wreaked havoc on many products, but are leading to an abundance of supply as purchasing demands are changing just when inventories get back to normal. We own too much stuff as it is, and now is the time for most to spend on experiences instead. Inflation is and should be coming down.
The big influence here is tied to M2 – which is a broad measure of money supply that includes cash, checking deposits and other “near money” items. The supply of money normally expands after economic contractions have already begun to hurt consumers. This stems from Governments attempting to juice a slowing economy via direct intervention. Below you can see how sizable this jump was during the pandemic at the far-right side of the chart:
Last year, while the Government was handing out money to anyone with a pulse, and in 2020 to any business with a P.O. Box, M2 exploded nearly 25%. This directly led to the inflation that we see today. The U.S. printed more than most countries and that’s why our CPI is higher than most developed nations. As with Fed rate hikes/cuts, it takes about a year for inflation to fully show up in an economy. GDP in 2021 was tremendous as a result of 2020 handouts. Now M2 money supply is down to low-single digits. Better late than never, but this will directly slow our economy going into 2023, not today.
On the surface, slowing inflation should be a layup. Interest rates are already halting housing purchases. Mortgage applications are at their lowest point since 2020. Wage gains peaked a few months ago. Semi shortages are abating, allowing for more products to finally get finished. Container spot rates for cargo from China to the West Coast are down over 40%. We went from a truck driver shortage to an excess. Job gains are surely sliding back to population growth rates of ~100k per month instead of the 400k we’ve averaged for some time now.
However, the Russian invasion is displacing the most important commodity inputs of oil and gas, not to mention the abundant market share that Russia and Ukraine had for wheat. There are no alternatives for manufacturers, truck drivers, airplanes, plastics, electricity and thousands of other end products. No amount of Fed or Government intervention will get the millions of barrels we need in a growing economy. The only thing they can control is to make sure the economy isn’t growing by tightening the money spigot. A pretty sad state of affairs to say the least. The consumer will spend less next year than in 2021 if they have their way.
This has been and will be the battle over the slow trading summer months.
I see 2 prime bull/bear scenarios as everyone heads to their vacation spots and awaits the next two Fed meetings, further inflation data and a hopeful resolution in Ukraine before the Summer ends:
• Bullish: With peak inflation, we also have peak Fed hawkishness. Two rate hikes were taken off the table a month ago but are now back on. All we really know is that the June and July meetings are 50bps events. In a few months’ time we could realize the cycle will end sooner than many thought. Interest rates are done spiking higher and can settle in the same range of the past decade at ~2% – 3.5%. Stocks did quite well then and held an ~18 P/E. As more goods flow into the U.S., inflation gets back to 4% by year-end and the Fed slows down their tightening cycle. Further, China is reopening and finally back to stimulating their economy. The Russia/Ukraine war has the potential to end soon, helping the critical oil price get back to sub $100. U.S. consumers are still flush with savings and are fully employed. The worst of margin compression is behind us. A 20% decline in stocks takes out a lot of pent-up bearishness, leaving only buyers left. The P/E decline from 22x to 16x also includes a positive EPS bent. Corporations are buying back stock at record levels. Insiders are also purchasing more company stock than before.
• Bearish: Oil prices push peak inflation further down the road. CPI barely budges and the Fed has to quickly get above “neutral”, raising rates by 50bps increments 4-5 times this year. This creates an inverted yield curve which always precedes a recession. Russia sanctions remain throughout 2023 and inflation doesn’t subside while oil skyrockets to $250/barrel. A true stagflation environment as GDP goes negative but consumer prices keep rising. The Fed has already tightened more in 2 months than prior multi-year cycles that led to recessions. Consumer spending slows, layoffs rise and wages collapse. P/E’s head to 12x, where many bear markets go. The Fed can’t offer any reprieve as inflation stays elevated. The low-end consumer can barely afford life’s necessities. Stock and home prices decline, forcing even more retirees back to work while job openings dry up.
Frankly, either side of the aisle has a coin flip chance of happening at this point. Obviously, something in the middle could also happen, but the diverging economic paths are quite unusual for investors. My favored economists, with very successful long-term track records, are also on different pages with their outlooks. Some quite bullish, others super bearish. We haven’t had a more confusing macro-outlook in years. When this happens, it’s best to sit back and wait. Long-term investing success occurs when you can make an educated entry point into a world-class company that is trading at a discount to its fair value. Some stocks are already there today but could get even cheaper from here. This bear market rally had a nice run…today’s data could determine if it heads up another 5% or we retest May’s lows. Fingers crossed.
Enjoy the Summer months and extended vacations. There will be clearer skies ahead.
Kate Upton turns 30 today. President Obama’s youngest daughter Sasha is 21, and comedian Bill Burr turns 54.
James Vogt, 610-260-2214