Broker Check

Inflation Down, Stocks Up, But the Fog Remains

| November 21, 2022

In our current range-bound trading environment, the market has been on the lookout for any reason to go up. Well, it found a new one in the latest consumer price index print that caused stocks to skyrocket on news of a weaker-than-expected increase in inflation. This sums up the situation well:

But we must remember the consumer price index (CPI) has also been the biggest factor in crushing equities and growth assets worldwide so it’s only fair the inverse was true as well, right? So, why was this CPI report so important?

Well, it dictates the Federal Reserve’s rate hiking path, which has been a top concern given Fed Chair Jerome Powell’s hawkish language of late. Remember, the Fed has highlighted how its primary objective is to stamp out inflation, along with its dual mandate regarding employment (more on that later).

In the most recent Fed meeting, our omniscient Chair Powell freaked out the market, causing people to believe in higher rates for longer periods to combat inflation. That’s obviously a bearish outlook for long duration assets. But the recent CPI print created a “net new” set of information (shiny object?) that allowed the market to recalibrate, at least in the short term.

This is why print versus expectations matters most with CPI data. To help illustrate this, see the heat map chart below that compares expectation versus print (green indicates lower-than-expected inflation and red is higher than expected):

As you can see, there have been only three instances since the beginning of 2021 in which the actual inflation reading was below expectation. While inflation is still well above the 2% target rate of the Fed, the inflation surprise was something to celebrate from a market perspective.

At the risk of putting you to sleep, let's dig a little bit into the actual inflation numbers.

Here’s a more detailed breakdown:

Two things stuck out to us.

First, there was a decrease in expectation, even though rent and shelter costs more broadly continue to remain exceptionally firm. The shelter aggregate rose 0.8%, tenant’s rent was up 0.7%, owner’s equivalent rent was up 0.6%, and lodging prices jumped 4.9%. Given the lag we see in rent measures when it comes to CPI, we can and should expect this to remain firmly elevated into next year.

We know rent and shelter costs in the CPI will be high for a while because of data lag. Inflation coming in below expectations means there were meaningful drops in prices elsewhere in the economy. That’s great news.

Second, if we exclude shelter, the CPI actually declined by 0.1%. That’s one of the softer monthly changes for this aggregate report in recent decades. Core goods prices dropped even more, seeing a 0.4% decline.

Optimistically, the question becomes, is this the first indication of many factors that boosted inflation over the past year starting to downshift or even reverse, not just pause?

Two areas we’d like to highlight are prices for vehicles and medical care services. The CPI for new and used vehicles declined 0.9% while costs for medical care dropped 0.5%. Those are positives that we think moved the market.

Then a week later this positive data was further supported by a surprisingly good Producer Price Index report that continued to show how peak inflation is likely behind us:

This all drove a quick new uptick in MAPsignals’ trusty Big Money Index (BMI), which measures “big money” investor activity. The arrow below indicates when the positive inflation news hit – notice the big ramp up right after:

So, how does this affect the markets? Remember, the bond market tail is wagging the equities market dog. After the inflation news, the tail (the 10-year Treasury yield) fell off a cliff, moving from around 4.2% to around 3.8%. That’s below the 4.0% threshold on our capitalized profits model discount rate, meaning stocks would have room to rise based on their discounted fair market value.

But why did the drop in the 10-year Treasury support the aggressive upward moves by long duration assets? We think that's where it gets interesting because it allows us to look further out on the hiking curve to see the significant change in the shape of the curve of expectations as a result.

Here is the expected curve prior to the CPI print:

After the print, the curve dipped dramatically:

In plain language, this means the market is now pricing in an implication that we're much closer to the end of the hiking cycle than we thought before the print. Hence, the decrease in the 10-year Treasury yield and bump in stocks.

Abundant Softening

Weirdly, a trend of weakening financial conditions, lower inflation, and a soft job market could be beneficial. This would ultimately lend credence to the pivot narrative that some optimists have been hoping would begin to be supported at Fed meetings. There’s additional data softness to support this position too.

For instance, capital markets are basically frozen. Typically around this time of year, there's a flurry of corporate purchasing. That is not the case this year. Activity has dropped 43% due to higher interest rates:

Even more interesting is the fact that initial public offerings of stocks have plummeted too. All of this is a grinding halt to economic activity.

Second, we’ve already seen significant softening in the labor market (hopefully the Fed has too), especially the tech industry. The chart below shows the occupations with the largest declines in job postings recently:

There’s also a litany of firms announcing layoffs. Just a few include Meta Platforms Inc. (META), Lyft Inc. (LYFT), Redfin Corporation (RDFN), Salesforce Inc. (CRM), Peloton Interactive Inc. (PTON), Coinbase Global Inc. (COIN), Shopify Inc. (SHOP), Netflix Inc. (NFLX), Robinhood Markets Inc. (HOOD), Microsoft Corporation (MSFT), Snap Inc. (SNAP), Tesla Inc. (TSLA), and Twilio Inc. (TWLO).

If you guide yourself strictly by the headlines, you’d never guess the labor market was as “tight” as the Fed seems to continually say it is. Clearly businesses have shifted their focuses from growth to efficiency.

Last, we started to get retail readings last week. We saw Target Corporation (TGT) get crushed again, just like last quarter.

More interestingly, Walmart Inc. (WMT) reported great earnings, but examining under the hood shows it was because of a significant increase in food sales (Walmart offers more food than Target) and shoppers with household incomes of more than $100,000. The latter point is a clear sign of shoppers moving down market (i.e., a softening economy).

Earnings Moving Markets

We've hammered home how important earnings would be this season and that is coming to fruition. As of this writing, FactSet has shown how S&P 500 companies reporting positive earnings surprises have seen a larger price increase than average the two days before earnings through the two days after:

It’s clear the market is rewarding positive earnings surprises…:

…and penalizing negative ones:

Last year was a record in total dollars used to buy back stocks. But 2022 looks to take the top spot (see the 2021 authorizations driving this year’s purchases below). It’s likely an effort to get ahead of the new 1% buyback excise tax being implemented by the current administration in January.

Buybacks are supportive of late-year rallies. A natural demand for shares returns in late October as reporting season ends. That’s when a buyback blackout beginning just before earnings are reported through two days after results are released comes to an end. The buybacks we’re seeing now are because of the blackout ending and last year’s authorizations noted above.

It’s all combining to hit a level of $1 trillion in buybacks in 2022. That would eclipse last year’s high of roughly $900 million.

Taken all together, that is ample market support. So, it’s not surprising to see significant “big money” buying, according to our friends at MAPsignals:

The buying covered multiple sectors, especially the ones with great earnings:

We’d personally prefer this recent stock market rally to continue through the end of the year and not have to worry about Chairman Powell until 2023. However, our preferences do not matter.

Powell could easily take all this craziness away by announcing a pause in rate hikes at the December meeting. Almost certainly the stock market would surge.

But how likely is such an announcement? While the long-term curve expectations have decreased, a rate hike freeze seems improbable based on the words coming out of the Fed lately.

Yes, the last few weeks have made us all feel good. Hopefully all this “positive” information we’ve laid out makes you feel good too. There are genuine reasons for positivity from an equity market perspective. But let’s be clear – the fog of inflation, rates hikes, recession, and economic pain persists nonetheless.

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Consumer Price Index is a measure of inflation compiled by the US Bureau of Labor Studies. Currencies investing are generally considered speculative because of the significant potential for investment loss. Their markets are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.