Sive Morten
Special Consultant to the FPA
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Fundamentals
This week, no doubts, CPI report has become a major driver. Markets were so inspired with decrease that it has provided positive impulse right to the end of the week. Not only on stock market but on bonds, Gold, FX and others. At the same time a lot of political events stand now in the US and J. Biden government authorized few legal acts that confirm our suggestion - Democrats pull out all the stops. Events of this week confirm our long-term view adjustment with expectations of softer Fed policy.
Market overview
Wall Street equities rallied and the dollar tumbled after signs of sharply decelerating U.S. inflation prompted bets that the Federal Reserve would raise interest rates at a slower pace than previously expected. Treasury yields mostly pulled back from an earlier plunge as investors digested data showing that consumer prices did not rise in July as the cost of gasoline fell, delivering the first notable sign of relief for Americans who have watched inflation soar over the past two years. Traders priced in a 50 basis points rate hike next month, compared with the 75 bps increase that had been expected before inflation report.
During Wednesday's session, Chicago Fed President Charles Evans said inflation is still "unacceptably" high, and the Fed will likely need to lift its policy rate to 3.25%-3.50% this year and to 3.75%-4.00% by the end of next year.
Minneapolis Federal Reserve Bank President Neel Kashkari said that while the cooling in price pressures in July was "welcome," the Fed is "far, far away from declaring victory" and needs to raise the policy rate much higher than its current 2.25%-2.50% range.
The Fed has indicated that several monthly declines in CPI growth will be needed before it lets up on the aggressive monetary policy tightening it has delivered to tame inflation currently running at four-decade highs.
U.S. Treasury yields were down as traders weighed a likely moderation of the Fed's monetary policy stance. Benchmark 10-year note yields dipped to 2.8385%, after reaching 2.902% on Thursday, the highest since July 22.
Data over the last two weeks bolstered hopes that the Fed can achieve a soft landing for the economy. While last week’s strong jobs report allayed fears of recession, inflation numbers this week showed the largest month-on-month deceleration of consumer price increases since 1973. The shift in market mood was reflected in data released by BoFA Global Research on Friday: tech stocks saw their largest inflows in around two months over the past week, while Treasury Inflation-Protected Securities, or TIPS, which are used to hedge against inflation, notched their fifth straight week of outflows.
Investors next week will be watching retail sales and housing data. Earnings reports are also due from a number of top retailers, including Walmart and Home Depot, that will give fresh insight into the health of the consumer. Seasonality may also play a role. September - when the Fed holds its next monetary policy meeting - has been the worst month for stocks, with the S&P 500 losing an average 1.04% since 1928, Refinitiv data showed.
Walmart and Target which report second-quarter earnings on Tuesday and Wednesday, respectively, have recently cut forecasts and warned inflation was squeezing margins and forcing consumers to reduce discretionary purchases. Retailers' outlook for consumer behavior will be key for investors looking to assess the pace of inflation. U.S. consumer prices were unchanged last month, the largest month-on-month deceleration of price increases since 1973.
Other big retailers reporting include Home Depot on Tuesday and Lowe's the following day, while U.S. retail sales data, set for Wednesday, will give a broad picture of how the consumer is faring.
The question on stock market performance is very tricky, as current S&P shape accurately repeats the one of 2008 crisis, dotcom bubble crush and 1930-1937 crisis of Great Depression.
Besides, one of the largest BlackRock Inc. shareholders, Laurence Fink has sold ~ 8% of company shares. Why, if it is cloudless stock market future on the horizon? Last time he has sold shares on 30th of January 2020 - at the eve of CV-19 collapse...
The cooling U.S. housing market gets a couple of gut checks in the coming week as well. July data on housing starts is due on Tuesday, after new U.S. home-building activity fell to a nine-month low in June. Data on U.S. existing home sales for last month is released on Thursday after such sales fell for a fifth straight month in June to the lowest level in two years.
CPI COMPONENTS ANALYSIS
To get clear understanding on what has happened and is it really we should be inspired with recent numbers - we have to take a look at the CPI major components. It is not necessary to be a prophet to understand that drop mostly has happened because of hydrocarbons and gasoline price drop. But it doesn't resolve all the problems. Yes, energy has dropped for 4.6% and gasoline in particular - 7.7%. It takes 5.33% share in CPI index value.
At the same time, Food is rising for 10.9% YoY (with 13% growth for food at home), and core inflation without energy stands for 6.6% (YoY). At the same time we see stable growth in rent, medical services, and this growth is constant. By taking a look at the components we could acknowledge that inflation is coming to average level of 6-7%. This is precisely the one that Credit Suisse Zoltan Pozsar has mentioned in its analysis:
The CPI decrease that we see is an exhausting of two components in commodities part - war premium and general slowdown of global economy. War premium were standing very high in Electricity, gas, oil, grain wheat and other components. But now it is gradually exhausting. Additionally decreasing of global demand on other commodities and partially on hydrocarbons (or, anticipation of this decreasing), pushes prices lower/keep it stable, making CPI slowdown a bit. Thus, we could say that the CPI structure is becoming smoother. At the same time, all other components keep growing.
There are two other thoughts on CPI. We need to track a dynamic for a few months to make final conclusion, because CPI seasonally is decreasing on summer and because it is not correct to make conclusion by just a single outbreak.
Besides, labour cost indicator, which is a leading one to CPI/PPI should keep us in tension as it shows growth for 10.6%:
And weekly claims keep going higher:
As a result, the real wage, with adjustment to inflation has dropped significantly:
Also we've mentioned epic drop in the US Productivity. In a IQ 2022 it has dropped for 7.6%, in IIQ for -4.6%, which is the largest drop in 75 years. Productivity has minor impact on the markets in short-term, but longer term effect is important. The higher productivity is, the more wage you could pay and the more people could consume without triggering inflation. Rising of labor cost together with productivity drop creates additional inflationary pressure.
All in all, inflation will drop not because of oversupply or price decreasing but because of households' wealth deterioration, as people just can't pay for it. Previously we already have shown you that the gasoline consumption is dropping, despite the "High season" on summer, which is the reason of inflation drop, but not because the gasoline becomes cheaper.
Besides, US is burning its strategic oil reserves, trying to saturate the market. Thus, it is still the question of gasoline price drop... maybe Democrats are preparing to November elections, trying to use all tools to create the visuality of improvements - consume crude oil reserves, printing money to support stock market and keep rates stable? With market economy, the cheap US gasoline/oil should start flow to Europe where it is still expensive. Why it is not flowing there? This also suggests that we see administrative intruding in economy, where price is artificially damped inside the country for some time.
Conclusion:
Hypothetically, if Fed would keep rising rates, leading them to 5%, at least, inflation would have to stabilize first around 5-6% and then gradually decrease, leading economy to the health condition. But in particular example, we see multiple deviations from the theoretical scenario. Keeping aside high US debt and its service expenses, difficulties with debt replacement etc., we see that average structural inflation rate is coming to 6%. The process of "war premium" exhausting in commodity prices should continue. But problems come from another side. First is Fed doesn't intend to rise rate so high. Now consensus suggests it around 3.5-4% at best case. Second problem is more significant - Fed doesn't intend to contract money supply to hold inflation and turns to opposite, a kind of QE but in a bit different way.
Couple of weeks ago when we've estimated that Fed is defeated by inflation, we've suggested that it should start using Treasury money for bonds buying. The most recent data confirms this idea - Fed balance has increased for ~5 Bln while Treasury deposit has dropped for the same sum.
Previously we've mentioned that US Treasury already double the limit of borrowing until September. This is new liquidity injection for 440 Bln. Democrats have approved different programmes - semiconductor, tax reducing, eco energy etc. for ~760 Bln. This is additional 1 Trln inflows until the end of the year. Besides we have doubts that energy prices have decreased naturally. But, even with this suggestion, and suggestion that inflation in long-term will gravitate to 6-7% level - this basic level of structural inflation will keep rising because of reasons that we've mentioned here.
We expect that CPI/PPI numbers will bring a lot of chaos in investors' minds in nearest 3-5 months. Because of artificial manipulation of oil and gasoline prices and natural rebalancing of the components of the index. It will give us higher volatility in numbers.
Finally we have to remember that CPI is not the reason for the crisis, it is just a reflection, the indicator, that is changing under impact of the US economy fundamentals, which do not show any signs of improvements yet, whatever sphere you take a look - production, services, manufacturing, consumption, PMI, savings, sentiment etc. Deterioration on real estate market continues. People are loosing wealth and this makes them to take more loans while they are relatively cheap. Consumer loans rise for 12% this year - the fastest pace in last 15 years (ex. mortgage loans). But as loan rates lag behind inflation - this should hurt banks' profit margin later and increase defaults and provisions that sooner or later but make negative impact on banking sector. Who will pay for this consumption?
As situation in Europe stands even worse (Food inflation in Germany also around 14.6%) and will become worse more as we're coming to winter, we do not see reasons yet to change our long-term expectations of dollar domination over EUR and change our 0.9 EUR/USD target. Still, the one thing that we have to acknowledge though, that USD appreciation could become slower and more choppy, as closer we're coming to November elections. Rising domestic political confrontation hardly brings stability and improve situation.
This week, no doubts, CPI report has become a major driver. Markets were so inspired with decrease that it has provided positive impulse right to the end of the week. Not only on stock market but on bonds, Gold, FX and others. At the same time a lot of political events stand now in the US and J. Biden government authorized few legal acts that confirm our suggestion - Democrats pull out all the stops. Events of this week confirm our long-term view adjustment with expectations of softer Fed policy.
Market overview
Wall Street equities rallied and the dollar tumbled after signs of sharply decelerating U.S. inflation prompted bets that the Federal Reserve would raise interest rates at a slower pace than previously expected. Treasury yields mostly pulled back from an earlier plunge as investors digested data showing that consumer prices did not rise in July as the cost of gasoline fell, delivering the first notable sign of relief for Americans who have watched inflation soar over the past two years. Traders priced in a 50 basis points rate hike next month, compared with the 75 bps increase that had been expected before inflation report.
During Wednesday's session, Chicago Fed President Charles Evans said inflation is still "unacceptably" high, and the Fed will likely need to lift its policy rate to 3.25%-3.50% this year and to 3.75%-4.00% by the end of next year.
Minneapolis Federal Reserve Bank President Neel Kashkari said that while the cooling in price pressures in July was "welcome," the Fed is "far, far away from declaring victory" and needs to raise the policy rate much higher than its current 2.25%-2.50% range.
The Fed has indicated that several monthly declines in CPI growth will be needed before it lets up on the aggressive monetary policy tightening it has delivered to tame inflation currently running at four-decade highs.
U.S. Treasury yields were down as traders weighed a likely moderation of the Fed's monetary policy stance. Benchmark 10-year note yields dipped to 2.8385%, after reaching 2.902% on Thursday, the highest since July 22.
"With inflation coming down, consumer confidence is going to be coming back, and employment is still strong, you could see a situation where the market has stabilized and the economic numbers continue to slow based on the lag effect of the Fed tightening that has already happened," said Thomas Hayes, chairman at Great Hill Capital.
Data over the last two weeks bolstered hopes that the Fed can achieve a soft landing for the economy. While last week’s strong jobs report allayed fears of recession, inflation numbers this week showed the largest month-on-month deceleration of consumer price increases since 1973. The shift in market mood was reflected in data released by BoFA Global Research on Friday: tech stocks saw their largest inflows in around two months over the past week, while Treasury Inflation-Protected Securities, or TIPS, which are used to hedge against inflation, notched their fifth straight week of outflows.
“If in fact a soft landing is possible, then you’d want to see the kind of data inputs that we have seen thus far," said Art Hogan, chief market strategist at B. Riley Wealth. "Strong jobs number and declining inflation would both be important inputs into that theory.”
Investors next week will be watching retail sales and housing data. Earnings reports are also due from a number of top retailers, including Walmart and Home Depot, that will give fresh insight into the health of the consumer. Seasonality may also play a role. September - when the Fed holds its next monetary policy meeting - has been the worst month for stocks, with the S&P 500 losing an average 1.04% since 1928, Refinitiv data showed.
Walmart and Target which report second-quarter earnings on Tuesday and Wednesday, respectively, have recently cut forecasts and warned inflation was squeezing margins and forcing consumers to reduce discretionary purchases. Retailers' outlook for consumer behavior will be key for investors looking to assess the pace of inflation. U.S. consumer prices were unchanged last month, the largest month-on-month deceleration of price increases since 1973.
Other big retailers reporting include Home Depot on Tuesday and Lowe's the following day, while U.S. retail sales data, set for Wednesday, will give a broad picture of how the consumer is faring.
The question on stock market performance is very tricky, as current S&P shape accurately repeats the one of 2008 crisis, dotcom bubble crush and 1930-1937 crisis of Great Depression.
Besides, one of the largest BlackRock Inc. shareholders, Laurence Fink has sold ~ 8% of company shares. Why, if it is cloudless stock market future on the horizon? Last time he has sold shares on 30th of January 2020 - at the eve of CV-19 collapse...
The cooling U.S. housing market gets a couple of gut checks in the coming week as well. July data on housing starts is due on Tuesday, after new U.S. home-building activity fell to a nine-month low in June. Data on U.S. existing home sales for last month is released on Thursday after such sales fell for a fifth straight month in June to the lowest level in two years.
CPI COMPONENTS ANALYSIS
To get clear understanding on what has happened and is it really we should be inspired with recent numbers - we have to take a look at the CPI major components. It is not necessary to be a prophet to understand that drop mostly has happened because of hydrocarbons and gasoline price drop. But it doesn't resolve all the problems. Yes, energy has dropped for 4.6% and gasoline in particular - 7.7%. It takes 5.33% share in CPI index value.
At the same time, Food is rising for 10.9% YoY (with 13% growth for food at home), and core inflation without energy stands for 6.6% (YoY). At the same time we see stable growth in rent, medical services, and this growth is constant. By taking a look at the components we could acknowledge that inflation is coming to average level of 6-7%. This is precisely the one that Credit Suisse Zoltan Pozsar has mentioned in its analysis:
The result is that inflation is now a structural problem, rather than a cyclical one. Supply disruptions have arisen from the changes in Russia and China, along with tighter labor markets due to immigration restrictions and a reduction in mobility caused by the coronavirus pandemic, Pozsar said. There’s now a risk the Federal Reserve under Chair Jerome Powell has to raise interest rates to 5% or 6% and keep them there(!!!) to create a substantial and sustained reduction of aggregate demand to match the tighter supply profile, he said.
The CPI decrease that we see is an exhausting of two components in commodities part - war premium and general slowdown of global economy. War premium were standing very high in Electricity, gas, oil, grain wheat and other components. But now it is gradually exhausting. Additionally decreasing of global demand on other commodities and partially on hydrocarbons (or, anticipation of this decreasing), pushes prices lower/keep it stable, making CPI slowdown a bit. Thus, we could say that the CPI structure is becoming smoother. At the same time, all other components keep growing.
There are two other thoughts on CPI. We need to track a dynamic for a few months to make final conclusion, because CPI seasonally is decreasing on summer and because it is not correct to make conclusion by just a single outbreak.
Besides, labour cost indicator, which is a leading one to CPI/PPI should keep us in tension as it shows growth for 10.6%:
And weekly claims keep going higher:
As a result, the real wage, with adjustment to inflation has dropped significantly:
Also we've mentioned epic drop in the US Productivity. In a IQ 2022 it has dropped for 7.6%, in IIQ for -4.6%, which is the largest drop in 75 years. Productivity has minor impact on the markets in short-term, but longer term effect is important. The higher productivity is, the more wage you could pay and the more people could consume without triggering inflation. Rising of labor cost together with productivity drop creates additional inflationary pressure.
All in all, inflation will drop not because of oversupply or price decreasing but because of households' wealth deterioration, as people just can't pay for it. Previously we already have shown you that the gasoline consumption is dropping, despite the "High season" on summer, which is the reason of inflation drop, but not because the gasoline becomes cheaper.
Besides, US is burning its strategic oil reserves, trying to saturate the market. Thus, it is still the question of gasoline price drop... maybe Democrats are preparing to November elections, trying to use all tools to create the visuality of improvements - consume crude oil reserves, printing money to support stock market and keep rates stable? With market economy, the cheap US gasoline/oil should start flow to Europe where it is still expensive. Why it is not flowing there? This also suggests that we see administrative intruding in economy, where price is artificially damped inside the country for some time.
Conclusion:
Hypothetically, if Fed would keep rising rates, leading them to 5%, at least, inflation would have to stabilize first around 5-6% and then gradually decrease, leading economy to the health condition. But in particular example, we see multiple deviations from the theoretical scenario. Keeping aside high US debt and its service expenses, difficulties with debt replacement etc., we see that average structural inflation rate is coming to 6%. The process of "war premium" exhausting in commodity prices should continue. But problems come from another side. First is Fed doesn't intend to rise rate so high. Now consensus suggests it around 3.5-4% at best case. Second problem is more significant - Fed doesn't intend to contract money supply to hold inflation and turns to opposite, a kind of QE but in a bit different way.
Couple of weeks ago when we've estimated that Fed is defeated by inflation, we've suggested that it should start using Treasury money for bonds buying. The most recent data confirms this idea - Fed balance has increased for ~5 Bln while Treasury deposit has dropped for the same sum.
Previously we've mentioned that US Treasury already double the limit of borrowing until September. This is new liquidity injection for 440 Bln. Democrats have approved different programmes - semiconductor, tax reducing, eco energy etc. for ~760 Bln. This is additional 1 Trln inflows until the end of the year. Besides we have doubts that energy prices have decreased naturally. But, even with this suggestion, and suggestion that inflation in long-term will gravitate to 6-7% level - this basic level of structural inflation will keep rising because of reasons that we've mentioned here.
We expect that CPI/PPI numbers will bring a lot of chaos in investors' minds in nearest 3-5 months. Because of artificial manipulation of oil and gasoline prices and natural rebalancing of the components of the index. It will give us higher volatility in numbers.
Finally we have to remember that CPI is not the reason for the crisis, it is just a reflection, the indicator, that is changing under impact of the US economy fundamentals, which do not show any signs of improvements yet, whatever sphere you take a look - production, services, manufacturing, consumption, PMI, savings, sentiment etc. Deterioration on real estate market continues. People are loosing wealth and this makes them to take more loans while they are relatively cheap. Consumer loans rise for 12% this year - the fastest pace in last 15 years (ex. mortgage loans). But as loan rates lag behind inflation - this should hurt banks' profit margin later and increase defaults and provisions that sooner or later but make negative impact on banking sector. Who will pay for this consumption?
As situation in Europe stands even worse (Food inflation in Germany also around 14.6%) and will become worse more as we're coming to winter, we do not see reasons yet to change our long-term expectations of dollar domination over EUR and change our 0.9 EUR/USD target. Still, the one thing that we have to acknowledge though, that USD appreciation could become slower and more choppy, as closer we're coming to November elections. Rising domestic political confrontation hardly brings stability and improve situation.