December 19, 2022Scroll down
Markets cheered a softer-than-expected US inflation print last Tuesday, as CPI registering its lowest increase in almost a year. The YoY rate of change in CPI index fell from +7.7% in October to +7.1% in November, with data showing a broad-based deceleration in rising prices. The MoM rate of change slowed to +0.1%, compared to +0.4% increase in October. Digging deeper, shelter costs were the main driver of the MoM increase in services, despite the fact that home prices have dropped significantly as mortgage rates spiked in 2022. Given the lagging nature of housing prices, a lower housing price will pull inflation down in the coming year. Some volatile components—airfares and hotel prices, for example, both included in the services statistics—plunged in November, but could easily rebound next month as the holiday season descends on consumers. Meanwhile, oil prices have been held down by the combination of the Chinese government’s “Zero Covid” policy and US releases of crude oil from the Strategic Petroleum Reserve. Both of those deflationary elements are poised to reverse.
Taking a broader view, the present moderation in inflation only modestly reduces recession risk, two data points do not make up a trend, and though CPI might have peaked, inflation is still well above the Fed’s target rate. Consequently, the Fed is clearly afraid of letting go too early and allowing inflation to make a resurgence, knowing full well that a second round of hikes after easing had started would shake the confidence of investors, consumers, and businesses to its core. Marginal improvement suggests that a pivot could come faster, but the market seemed to have pricing a pivot far earlier than is realistic to begin with, so this does little to change our view that investors seem overly optimistic about mid-2023 rate cuts.
No surprise that the Fed downshifted to a 50 basis-point hike
As if the CPI on Tuesday wasn’t momentous enough, last week’s calendar also included an FOMC meeting on Wednesday, which saw the Fed decide on a fully anticipated half-point hike. The current median forecast for the Fed funds rate at the end of 2023 is 5.1%, with a majority of policymakers expecting the rate to surpass 5.25% next year. Most Fed officials believe that the ongoing inflationary shock will last three years, through 2025. Unemployment is expected to rise to 4.6% at end of 2023 and stay there through 2024, up from the current 3.7% level. In fact, policymakers are sounding more pessimistic in their economic outlook: GDP growth is seen slowing to 0.5% in 2023, compared with a 1.2% growth forecast in September. Europe’s ECB followed the Fed with a 50bps hike, with President Lagarde delivering what might have been her most hawkish press conference to date. While investors bid stocks up in the immediate aftermath of the Fed meeting, US stocks plunged and the dollar rallied the day after as wishful thinking gave way to sober assessment of economic prospects and central bank resolve.
Rate hike felt tame, but FOMC meeting anything but dovish
Along those lines, two consecutive soft CPI prints seem to have made no difference to the Fed and Powell’s narrative. Policymakers appear more determined than ever to push on with restrictive policy, flying in the face of a soft landing long priced in by investors. Chairman Powell has said repeatedly that it will take substantially more evidence for the Fed to conclude that inflation is falling enough to make it comfortable letting its guard down. Those watching CPI should take note of three categories the Fed has highlighted as a focus in parsing inflationary data: goods, shelter, and non-shelter core services. Powell emphasized that the bank’s most decisive battle will be in the last category. All three categories are closely tied to action in the labor market. Since labor supply is more or less fixed in the short run, labor demand will need to fall for things to look better on this front.
What’s the implications for markets?
As mentioned, markets have been rather optimistic despite the Fed’s outsized rate hikes, seeming to overlook comments in FOMC statements and policymaker quotes emphasizing a “higher for longer” commitment in the fight against inflation. As data on inflation show a clear improvement, this hasn’t shaken the Fed’s resolve, making it unlikely we will see a pivot in coming quarters merely because inflation is “on the right track”. Meanwhile, data continue to suggest an impending recession, which has gradually pushed investors’ focus from Fed policy to economic growth, about which optimism is clearly declining. Presently, we observe an interesting disconnect in markets: pricing of risk—such as equity valuations and credit spreads—indicate something close to a soft landing, while the yield curve and Fed Funds futures predict easing by mid-2023. But, for that pivot to come, it seems there would need to be some economic calamity that would force the Fed’s hand, and that would clearly be a disaster for investors in risk assets. As such, we remain cautious going into year-end.
Economic strength will likely give way
What might lead investors to finally capitulate and give us a more attractive entry point? Keep an eye on corporate earnings. With a CPI report and FOMC meeting on the calendar, it would have been easy to miss last week’s November retail sales, which fell 0.6% from the prior month, marking the biggest decline this year and shifting spending toward services. Several factory activity gauges were already showing contraction. Of course, we have long commented that a recession—and falling corporate earnings—remain the inevitable second shoe to drop in the current cycle. Interestingly, despite rapidly rising costs, FactSet estimates US companies’ profit margins will stay elevated at 12.3% in 2023, the second-widest level since 2008. To some degree, inflation has sustained high profit margins, as corporations pass costs on to consumers. During earnings calls, we hear executives continue to reassure analysts that prices can go even higher, supporting rosy earnings forecasts. In the meantime, most firms have seen fixed costs spike, such that even a mild contraction in revenue could easily compress margins significantly. Tighter labor markets, higher borrowing costs, and discounted inventories add to the risk of earnings disappointment in coming months. Ultimately, as American consumers spend through what remains of their pandemic savings and have to forego that $6.75 holiday Peppermint Mocha at Starbucks, slowdown seems to us a foregone conclusion.