Issue 93: Is US Inflation Dead?

This Week’s Highlights

• June CPI could bring September cut
  Last Thursday’s data showed headline prices actually fell for US consumers in June—a first since early 2020—further fueling optimism the Fed has navigated America’s economy to a rare soft landing and prompting traders to place bets the US central bank will ease at its September meeting.
• May 7 stocks suffer big-tech rotation
  On the same day softening US inflation boosted investor sentiment, mega-cap tech stocks in the US posted their worst decline in over a year, as investors apparently shifted their bets to small-caps, perhaps more sensitive to a Fed pivot and majorly lagging the Mag 7 in recent years.
• China posts record trade surplus
  Chinese exports surged to US$308 billion in June, their third consecutive monthly rise, as the nation’s trade surplus hit an all-time high of US$99 billion for the month. Despite such impressive growth in output, an unexpected fall in China’s imports revealed the country’s fragile recovery.​​​​​​

The CIO’s Take:

• Since early this year, our base case has been for one or two rate cuts—more hawkish than even the Fed was when 2024 kicked off. That said, we must admit that a September start to easing became more likely as June marked the third month in a row of comforting inflation data. With chances of a soft landing rising, it makes sense to add risk.
• Many prudent investors have watched with frustration as efficiently diversified portfolios lost out to those heavy on exposure to just a handful of Mag 7 names. Last Thursday’s rotation toward smaller firms with higher sensitivity to rates validates our expectation that imbalances in valuation and concentration will eventually correct.
• Given our models’ active allocation to mainland Chinese stocks, we follow developments in the world’s second-largest economy very closely. Though we’re happy to see stellar export growth offsetting soft domestic demand—and while we think the market is insanely cheap—we believe more fiscal support is needed to catalyze recovery.

Is US Inflation Dead?

Headline CPI actually drops in June
Thursday’s report on US consumer prices from the Bureau of Labor Statistics (BLS) was a high-stakes release, with many expecting a Q3 rate cut could hinge on whether June data confirmed the favorable trend established by cooling inflation in April and May. Those holding their breath were able to exhale with relief, as headline CPI actually declined by 0.1% month-over-month, versus a consensus among economists that prices would rise by 0.1%. That’s even better than May’s flat CPI print, and marks the first drop in prices since the early days of the pandemic (see below).

That small monthly drop implied a bigger move down in year-over-year CPI, which fell from 3.3% in May to 3% in June, a tick below what economists expected. Energy was a meaningful contributor, with gas prices slipping 3.8% from May. Even so, core inflation likewise surprised to the downside, rising just 0.1% in June, versus a consensus increase of 0.2%. There was even good news on sticky shelter prices, which posted their smallest month-over-month increase in three years, rising 0.2%—though we must note that still corresponds to a 5.2% year-over-year move.

Chances of September cut on the rise
​​​The rosy inflation report had some calling for a July cut from the Fed, though it won’t surprise readers to hear we don’t see things happening quite that fast. We do believe this report meaningfully increases the chances easing begins in September. CME Group reports traders’ bets currently imply a 90% likelihood of a September cut, up from 70% just before the CPI release and a mere 60% at the beginning of July. At this point, we expect the Fed to message a September cut at the July FOMC. Even so, data from now until September will matter as much as ever.

Risk of overshoot moves to the fore
The Fed has talked about “two-sided risk” facing the US economy: In chair Jay Powell’s words, the bank may “loosen policy too late or too little” on the one hand, versus “too much or too soon” on the other. While both risks seem to have reduced in the last few months, we see risk of a hard landing, given signs the economy is cooling, as becoming the more pronounced of the two. And what of risk on the inflation front? Friday’s report on producer prices showed PPI—thought to presage moves in consumer prices—rising 0.2% in June, against expectations of a mere 0.1% increase.

Thursday’s Tech Rout

Mag 7 technology stocks have a very bad day
It will come as a surprise to many investors that despite what pretty much everyone saw as good news on inflation out of the BLS, last Thursday’s trading brought a sharp move down in tech stocks. AI darling Nvidia slumped by over –5%, while Tesla shares slid more than –8%, breaking a streak of eleven up days in a row. Overall, the Magnificent 7 basket sagged by –3.5% in its worst single-day performance since December 2022, which weighed on the widely followed NASDAQ and S&P 500 benchmarks, down –0.9% and –2%, respectively, on the day.

Small-cap shares moved sharply higher
In Tesla’s case, the precipitous fall was easily attributable to a report of delays in the launch of its robotaxi, though it’s harder to point to specific news in other names that might account for such a sharp loss in value. One clue comes in spotting stocks that didn’t suffer on Thursday: constituents of the Dow, for example, which rose by a modest 0.1%, and especially stocks in the Russell 2000, up a whopping 3.6% for the day. And those 493 stocks in the S&P 500 outside of the Mag 7? They were up 0.5% last Thursday, a far cry from performance since the beginning of Q2 (see below).

More ‘rotation’ needed to correct imbalance
Judging by the scores we’ve just rattled off, it seems Thursday’s trading was less a sell-off of stocks and more a rotation: out of tech and into a broader set of stocks representing a larger swath of the real economy. Looking again at the chart above, while there was some talk of the current bull market’s breadth improving in Q1, it’s clear that trend reversed sharply beginning early in the second quarter, with Thursday’s move a step back in the direction of parity between mega-cap tech stocks and the rest of the market.

Could be a preview of what’s to come
There are fundamental reasons one might expect breadth to gradually improve, making Thursday a preview of coming trends. For one thing, ‘old economy’ firms overrepresented in the Dow and among small caps—including, for instance, homebuilders and others in the property sector—are generally more sensitive to interest rates, making them a better bet as Fed cuts near. Moreover, those Magnificent 7 stocks falling hard on Thursday were coming off record highs: prices that reflect fairly lofty valuations, much more vulnerable to sudden shifts in sentiment.

China Trade Data

Exports post record growth in June
The second quarter was a challenging one for Chinese stocks, as domestic consumers and foreign investors began to strongly doubt this year’s policy-driven recovery in the nation’s economy, which has been battered by the prolonged effects of pandemic-era disruptions and a property market rocked by a years-long deleveraging process. China’s June trade data, released last Friday, offered a more positive sign, with exports growing for the third month in a row, leaping 8.6%, higher than economists’ 8% consensus forecast and May’s 7.6% rise. So, is this good news? Well…

Nuanced trade dynamics at play
Strong export growth has certainly helped to offset China’s weak domestic economy. Indeed, much of the fiscal stimulus we’ve seen so far from Beijing has been to boost manufacturing, and that’s showing up in a flood of higher-value goods into foreign markets—think electronics, EV, and green energy tech. It’s the very success of this drive to boost exports that’s got some of China’s biggest trading partners, including the US and Europe, crying for trade protections. In fact, pundits believe part of the June jump in exports is front-loading of orders to get ahead of expected tariffs.

Imports paint a less positive picture
An even more apparent problem is visible in China’s net trade surplus—the difference between exports and imports—which totaled US$99 billion in the month of June alone, a record-high sum (see below). Rising exports contributed, of course, but another part of the equation is imports, which unexpectedly fell in June: an indication of how weak China’s domestic consumers are at the moment. With exports sensitive to trade frictions and potential weakening in the US economy, slumping imports highlight a real vulnerability for a recovery dependent on foreign demand.

Markets crave bigger policy support
As we mentioned above, China’s success in exports has been helped by policy support, and we believe that’s a big part of the solution to its broader economic problems, with more fiscal stimulus needed to successfully kickstart growth in domestic demand. In that vein, we note that China’s delayed ‘Third Plenum’ meeting of top party officials convenes this week, and while we don’t expect any bombshell announcements at the event, we will be watching for more subtle hints that Beijing recognizes the challenge and could get more active on the demand side in the second half.