Often times, stock and bond markets react in ways that are very counterintuitive. Robust quarterly earnings updates bring about aggressive selling. Horrible reports precede stocks rising. The discounting nature of our capital markets means today’s headlines are less important than what investors and institutions expect a year from now. Such was the case yesterday with another unusual response to inflation data that came out prior to the opening bell.
As we are all aware, we’re stuck in the middle of a very tight supply/demand equation in numerous sectors. Last year’s shutdown is bringing a massive wave of pent-up demand for goods and services. While supplies slowly creep back into markets on the commodity side, they continue to tighten for services. Gone are lumber concerns, with prices collapsing 35% in just four weeks. China is pulling out all the stops after seeing their price index spike higher, and is now attempting to put price caps on basic materials, namely coal, as producers can’t afford to keep eating these costs. Many commodity supplies are ramping back up. Transitory inflation here looks to be coming to fruition.
On the other end of the inflation curve is services. Stop by any restaurant, concert or airport and you’re going to see long lines, the lack of labor is real. We now have more available job openings than people on unemployment. While we slowly expand our comfort zones outside the home and into favored hot spots, we’re met with higher prices. It remains to be seen how much of this will be transitory.
Yesterday we received another update on the inflation front which came in even hotter than already elevated expectations. For May CPI, headline and core readings came in at +0.6% and +0.7%. This comes after April’s report showed +0.8% and +0.9%. As a reminder, +0.1% to +0.2% is “normal” for a monthly price increase to consumers. Not only that, but these metrics were all above estimates. Initial pre-market reactions were predictable. Interest rates rose 4-5bps. Growth stocks suffered. Inflation beneficiaries rose. By the time markets opened, everything reversed course, and then some. Technology stocks jumped higher, while Financial and Industrial stocks dropped. The S&P 500 made another new high. Interest rates also joined the confusing party. The 10-year Treasury initially rose 5bps but ended down 4bps to close at 1.46%, our lowest close since early March. After two months of the hottest inflation readings in decades, the 10-year is now down 25bps! As with any reaction, the excuses are numerous.
Digging further into May’s CPI report, a lot of spikes were similar to last month, contained to reopening sectors or those with near-term supply issues, both of which will be fixed over time. Used car and truck prices led the way with a 7.3% rise. This follows a 10% increase last month and accounted for a third of the headline gains. Once our current automotive semi-supply imbalance is fixed, more cars will be arriving. Many manufacturers are already ramping factories back up, so this could be fixed soon. Airfares were the #2 leading piece, similar to April. If United Airlines is any indication with their new 100 737 Max order, this too will prove transitory. About the only real input to worry about from a long-term inflation standpoint is accelerating rents. CPI for rents increased by 0.3% month over month. This implies an annual rate of 3.6%. Since this category is 40% of CPI calculations, future gains will have to be monitored.
So, what happened to cause a complete 180 degree turn from what would normally occur after a robust report like this? Take your pick! Inflation was already expected and May is supposed to be the highest CPI reading this year. Comparisons get easier going forward, meaning inflation peaked last month. We’re past that news cycle. There are a few possible explanations for this market reaction:
Higher inflation leads to tapering. The last time we tapered (slowed monthly bond purchases) it led to slower growth, lower inflation and the 10-year Treasury dropping from 3.0% to 1.5%. Pulling the punch bowl is deflationary in nature.
Or, peaking inflation is coinciding with peaking growth. Q2 GDP will be the high for this cycle, everything slows from here. A consolidation of recent gains in both stocks and bond yields is prudent as investors assess the natural run rate for our economy.
Or, this continued supply demand imbalance could pressure the folks in Washington to slow their never-ending spending habits. Do we really need another $2, $3 or $4 trillion in stimulus when current income levels are forcing supplies to be dwindled across the globe? How much money printing is too much? If our infrastructure or jobs bill comes in lower than expected, it adds to the “inflation is peaking” theme.
Whatever the case, under the surface we’re already seeing signs of a transition from a low quality, highly levered, cyclical leadership back to the stable growth sectors. Cyclical leaders like Caterpillar, Freeport-McMoran, Sherwin-Williams, UPS or most home builders are down 5% – 15% in just a few weeks. Inflation and higher interest rate winners like Citigroup, Bank of America or Travelers are also down ~5%. On the other hand, high flyers from the past few years like Salesforce, Adobe#, ServiceNow and even Zoom are up 10%+ in a similar timeframe.
It is too early to tell if the value vs. growth debate is reverting back in favor of growth again. Over the past decade growth stocks have massively outpaced value. We’ve undergone a massive technological revolution dating back to the ramp up in Amazon Web Services. Cloud computing is still not finished. We’re also entering the next wave of amazing advancements with 5G, Internet of Things, Artificial Intelligence and Big Data. It makes sense for “growth” to take the baton back at some point. Lower inflation next year, subdued interest rates and fair valuations means different leadership. That is not to say sell all value names, but certainly the easy money has been made. Companies with differentiating leadership products not dependent on higher inflation can still generate acceptable returns. At the end of the day, what happens in bond land will continue to affect what happens to stock leadership.
Actor, Shia LaBeouf is 35 today. Peter Dinklage, Game of Thrones legend, turns 52, while football great Joe Montana hits 65.
James Vogt, 610-260-2214