Sive Morten
Special Consultant to the FPA
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Fundamentals
So, the epic event of this week is no doubts the CPI report. The majority has treated results as positive. Indeed, numbers show inflation decreasing. But the most important thing was to assess the impact of less aggressive rate change. If you remember, Fed has raised rate only for 0.5% and many experts worry that it could push inflation rate up again. But, it seems it was harmless for CPI numbers, and supposedly this also has added more optimism. Still, it is not everything as simple as it stands in report.
CPI breakdown
Here is the major components of report. Mostly analysts were watching on few components. Nominal inflation remains at 6.5%, showing drop for 0.1%. Many analysts talks about shelter component, arguing that it is lagging behind real inflation and keep going lower, but now it is artificially keeps inflation at high levels. If you take a look at data excluding shelter - US shows even deflation and this sparks a furore when data has been released. Many analysts now are sure that inflation in reality even lower than it was showing in report and shelter effect is temporal and economy stands at the edge of the recovery. We disagree. Not about shelter component, but about recovery. You can't judge on economy conditions just based on single CPI report. Besides, it is interesting what PPI data we will get next week.
By our view most reliable analysis has to be made on core Inflation. Core inflation in the US increased by 0.3% mom, and the main contribution to the growth of inflation is provided by rent, which contributed 0.26% to core inflation, respectively, all other categories of goods and services have practically not changed in price. Over the year, rent increased by 7.5% and contributed 2.47 percentage points to the total inflation, which amounted to 6.42%.
The growth rate for food is still high - 11.8% YoY and not so far from the peak rate of 13.5%. Food and beverages: plus 0.044 percentage points of the contribution for the month and 1.48 percentage points for the year. However, the fall in wholesale prices for agricultural products may slow down price growth in 2023.
As we've mentioned medical care up from 7.6 to 8% and all other services ex. rent and shelter were up to 7.4% from 7.3%
What are prices rising for? For services with low added value, where salaries are low and there is a high shortage of personnel. This is public catering, where there is practically no slowdown – growth by 8.3% yoy, culture, sports and entertainment with an acceleration in price growth of over 5% (a record!), other goods and household services are growing by 7% without slowing down.
That's being said In 2023, high inflation will persist in services.
Another important conclusion that we could make is converging of CPI and core CPI. It means that energy (and some others) inflation outbreaks are gradually fading by different reasons - normalizing of logistics, global economy slowdown and decreasing of demand etc., and nominal inflation is coming to the core inflation, which reflects the structural component. We expect that core inflation remains more or less stable around 5% for long term, just because it has non-monetary nature and can't be decreased by rate hike.
Speaking about economy growth - review our last FX market report where we've discussed job market and showed that its conditions doesn't correspond to growth economy situation. Those who are so positive should take a look at small business sentiment chart, that absolutely doesn't take an idea of positive and coming US economy growth - United States Nfib Business Optimism Index very close to 10 years bottom:
Another really scaring moment is massive drop of industrial production in Turkey. As it is export-oriented economy, the drop of production tells that they have problems with export. Second - huge drop of import and especially export from China:
China Exports YoY
China Import YoY
This looks painful, especially because this is annual data.
Here is how world's famous economist, M. Hazin explains this phenomenon:
Let's add another fly in the ointment to the barrel of honey, which is demonstrated by official "expert" publications. For the first time in many months, the number of initial claims in December decreased to 205,000 (in November it was 206,000), despite the fact that the forecast was negative (215K). But we have noted many times that labor statistics in the United States, more precisely, its main indicators, are subject to serious distortions. But no one publicly discusses the indicator of the length of the working week, in connection with which he can be trusted more.
The length of the working week in December (seasonally adjusted, data from January 6) decreased to 34.3 hours compared to 34.4 in November. At the same time, forecasts were promising growth to 34.5. Normally, employers tend to increase the load on existing staff rather than recruit new ones, therefore, at the beginning of the period of economic growth (which, as Fed officials hint, is about to begin or even has already begun), the length of the working week should increase. If it falls, it means that stagnation continues, and quite strong, since the length of the working week is a very conservative indicator.
Further, many interpret the decline in inflation as a positive signal, the reaction of the economy to the monetary policy of the authorities. And indeed, the effect is clearly visible in the graph below for the EU:
The trouble is such a positive effect, both in the US and in the EU, is associated with a drop in aggregate demand (sales volume). Sellers of any product in such a situation begin to reduce prices in order to maintain sales volumes. For the EU, this is even more important because serious de-industrialization is beginning in the region. When large consumers fall out, it is inevitably necessary to reduce margins (recall that intermediaries receive the main profit from gas sales in the EU).
ICE Natural Gas EU prices (MW/h):
At the same time, the cost of credit is growing, this is very clearly seen on card loans in the USA:
And anyway, the wage real growth is lagging behind CPI numbers. The decline of households prosperity continues. And this is one of the big reasons why Fed will hike again on 1st of February meeting.
Here, by the way, the same law is perfectly working but in the opposite direction: an increase in demand causes an increase in prices (that is, an increase in interest on a loan). Accordingly, very soon, in a few months this will inevitable give a new wave of falling demand, since part of the money that households spend on purchases today, they will be forced to give as payment for a loan:
Since the authorities do not recognize the economic downturn in either the US or the EU, they cannot explain the fall in inflation by a decrease in demand. We estimate the real decline in GDP in the United States by the end of 2022 at 7-8%, and for this reason the monetary component of inflation should be reduced not only because of the tightening, but also because of a direct and obvious drop in demand.
At the same time, the structural component of inflation (associated with an increase in the cost of production of goods and services) does not depend on a drop in demand in any way. Because it is no matter how much demand drops - you anywhere will not sell with a loss. You have to get profit on your business - this is a market economy. For example, in some spheres with big added value, such as gas re-sale, the price drop is possible, as re-sellers get tens or even hundreds of percents.
But with low added value industries, such as trade and service, this is almost impossible. Accordingly, it is possible to hope for a serious drop in inflation from current values only in a situation of a sharp decline in demand (i.e. GDP), since in this case the structure of demand will change greatly towards the cheapest products. And sector of cheap goods will grow due to the collapse of more expensive (and high-quality) goods and services. That is the core of structural crisis - total restructure of economy model - the production cycle, logistics, goods nomenclature, markets orientation etc.
Finally, we should mention some tricky political moments. They are not dominant but still, have played some role I suppose.
If inflation would had risen relative to November, it would have been necessary to sharply raise the rate, which would have jeopardized the financial markets (they do not like" rate increases), and would have given "trump" (!!! LOL) cards to the Republicans, who took control of the House. And Biden's announcement that he wants to run for the presidency again would not look very successful.
In other words, he immediately "excused himself" from possible accusations of political bias. But let's face it: it is very likely that the indicators for consumer inflation were specially embellished, proceeding precisely from political expediency! Note that there is no data on PPI inflation yet, they will be next week. Maybe they will somehow clarify the situation. But the overall picture in the US economy is not rosy at all.
Conclusion
First is - hopefully you enjoy that this report is shorter than usual (LOL)
Seriously speaking, we do not take an idea of mass celebration and inspiration around stable CPI numbers. We suggest that markets follow to wishful thinking as everybody were waiting fruits of rate hike for too long and are tired from crisis looming. Other words, it seems more like some psychological factor and reaction rather then real matching to the data. Markets reaction looks too optimistic.
Additionally, we should mention the purely calculation effect here. First is next month CPI will calculate on different basis, formulae will change. Second - as we will go further into 2023 as more high inflation months will exclude from YoY moving data, which will lead to decreasing effect of nominal number of CPI index. For example, recent data doesn't include already December 2021, where was big jump in inflation, which makes CPI smoother and closer to an average annual level.
If rally doesn't exhaust in near term, then it will be painful collapse in near future, when Fed steps and statistics put everything in its proper place. Mismatches are massive and well visible, so it becomes even more surprising of current market reaction. Job market performance doesn't correspond to the growth pattern of economy, sentiment is strongly negative in all countries and all spheres - just take a look PMI and Sentiment indicators. Inflation remains stable, with rising of Core inflation after the year of interest rate hiking.
We consider current EUR rally as temporal, on a background weak economy, rising political tensions, exhausting of Fed reserves and coming unavoidable collapse of stock markets - demand for safe haven, which is a US dollar by far, should be triggered sooner rather than later. Although we do not exclude that EUR could reach next strong resistance level of 1.10-1.1050 in near term.
So, the epic event of this week is no doubts the CPI report. The majority has treated results as positive. Indeed, numbers show inflation decreasing. But the most important thing was to assess the impact of less aggressive rate change. If you remember, Fed has raised rate only for 0.5% and many experts worry that it could push inflation rate up again. But, it seems it was harmless for CPI numbers, and supposedly this also has added more optimism. Still, it is not everything as simple as it stands in report.
CPI breakdown
Here is the major components of report. Mostly analysts were watching on few components. Nominal inflation remains at 6.5%, showing drop for 0.1%. Many analysts talks about shelter component, arguing that it is lagging behind real inflation and keep going lower, but now it is artificially keeps inflation at high levels. If you take a look at data excluding shelter - US shows even deflation and this sparks a furore when data has been released. Many analysts now are sure that inflation in reality even lower than it was showing in report and shelter effect is temporal and economy stands at the edge of the recovery. We disagree. Not about shelter component, but about recovery. You can't judge on economy conditions just based on single CPI report. Besides, it is interesting what PPI data we will get next week.
By our view most reliable analysis has to be made on core Inflation. Core inflation in the US increased by 0.3% mom, and the main contribution to the growth of inflation is provided by rent, which contributed 0.26% to core inflation, respectively, all other categories of goods and services have practically not changed in price. Over the year, rent increased by 7.5% and contributed 2.47 percentage points to the total inflation, which amounted to 6.42%.
The growth rate for food is still high - 11.8% YoY and not so far from the peak rate of 13.5%. Food and beverages: plus 0.044 percentage points of the contribution for the month and 1.48 percentage points for the year. However, the fall in wholesale prices for agricultural products may slow down price growth in 2023.
As we've mentioned medical care up from 7.6 to 8% and all other services ex. rent and shelter were up to 7.4% from 7.3%
What are prices rising for? For services with low added value, where salaries are low and there is a high shortage of personnel. This is public catering, where there is practically no slowdown – growth by 8.3% yoy, culture, sports and entertainment with an acceleration in price growth of over 5% (a record!), other goods and household services are growing by 7% without slowing down.
That's being said In 2023, high inflation will persist in services.
Another important conclusion that we could make is converging of CPI and core CPI. It means that energy (and some others) inflation outbreaks are gradually fading by different reasons - normalizing of logistics, global economy slowdown and decreasing of demand etc., and nominal inflation is coming to the core inflation, which reflects the structural component. We expect that core inflation remains more or less stable around 5% for long term, just because it has non-monetary nature and can't be decreased by rate hike.
Speaking about economy growth - review our last FX market report where we've discussed job market and showed that its conditions doesn't correspond to growth economy situation. Those who are so positive should take a look at small business sentiment chart, that absolutely doesn't take an idea of positive and coming US economy growth - United States Nfib Business Optimism Index very close to 10 years bottom:
Another really scaring moment is massive drop of industrial production in Turkey. As it is export-oriented economy, the drop of production tells that they have problems with export. Second - huge drop of import and especially export from China:
China Exports YoY
China Import YoY
This looks painful, especially because this is annual data.
Here is how world's famous economist, M. Hazin explains this phenomenon:
Let's add another fly in the ointment to the barrel of honey, which is demonstrated by official "expert" publications. For the first time in many months, the number of initial claims in December decreased to 205,000 (in November it was 206,000), despite the fact that the forecast was negative (215K). But we have noted many times that labor statistics in the United States, more precisely, its main indicators, are subject to serious distortions. But no one publicly discusses the indicator of the length of the working week, in connection with which he can be trusted more.
The length of the working week in December (seasonally adjusted, data from January 6) decreased to 34.3 hours compared to 34.4 in November. At the same time, forecasts were promising growth to 34.5. Normally, employers tend to increase the load on existing staff rather than recruit new ones, therefore, at the beginning of the period of economic growth (which, as Fed officials hint, is about to begin or even has already begun), the length of the working week should increase. If it falls, it means that stagnation continues, and quite strong, since the length of the working week is a very conservative indicator.
Further, many interpret the decline in inflation as a positive signal, the reaction of the economy to the monetary policy of the authorities. And indeed, the effect is clearly visible in the graph below for the EU:
The trouble is such a positive effect, both in the US and in the EU, is associated with a drop in aggregate demand (sales volume). Sellers of any product in such a situation begin to reduce prices in order to maintain sales volumes. For the EU, this is even more important because serious de-industrialization is beginning in the region. When large consumers fall out, it is inevitably necessary to reduce margins (recall that intermediaries receive the main profit from gas sales in the EU).
ICE Natural Gas EU prices (MW/h):
At the same time, the cost of credit is growing, this is very clearly seen on card loans in the USA:
And anyway, the wage real growth is lagging behind CPI numbers. The decline of households prosperity continues. And this is one of the big reasons why Fed will hike again on 1st of February meeting.
Here, by the way, the same law is perfectly working but in the opposite direction: an increase in demand causes an increase in prices (that is, an increase in interest on a loan). Accordingly, very soon, in a few months this will inevitable give a new wave of falling demand, since part of the money that households spend on purchases today, they will be forced to give as payment for a loan:
Since the authorities do not recognize the economic downturn in either the US or the EU, they cannot explain the fall in inflation by a decrease in demand. We estimate the real decline in GDP in the United States by the end of 2022 at 7-8%, and for this reason the monetary component of inflation should be reduced not only because of the tightening, but also because of a direct and obvious drop in demand.
At the same time, the structural component of inflation (associated with an increase in the cost of production of goods and services) does not depend on a drop in demand in any way. Because it is no matter how much demand drops - you anywhere will not sell with a loss. You have to get profit on your business - this is a market economy. For example, in some spheres with big added value, such as gas re-sale, the price drop is possible, as re-sellers get tens or even hundreds of percents.
But with low added value industries, such as trade and service, this is almost impossible. Accordingly, it is possible to hope for a serious drop in inflation from current values only in a situation of a sharp decline in demand (i.e. GDP), since in this case the structure of demand will change greatly towards the cheapest products. And sector of cheap goods will grow due to the collapse of more expensive (and high-quality) goods and services. That is the core of structural crisis - total restructure of economy model - the production cycle, logistics, goods nomenclature, markets orientation etc.
Finally, we should mention some tricky political moments. They are not dominant but still, have played some role I suppose.
If inflation would had risen relative to November, it would have been necessary to sharply raise the rate, which would have jeopardized the financial markets (they do not like" rate increases), and would have given "trump" (!!! LOL) cards to the Republicans, who took control of the House. And Biden's announcement that he wants to run for the presidency again would not look very successful.
In other words, he immediately "excused himself" from possible accusations of political bias. But let's face it: it is very likely that the indicators for consumer inflation were specially embellished, proceeding precisely from political expediency! Note that there is no data on PPI inflation yet, they will be next week. Maybe they will somehow clarify the situation. But the overall picture in the US economy is not rosy at all.
Conclusion
First is - hopefully you enjoy that this report is shorter than usual (LOL)
Seriously speaking, we do not take an idea of mass celebration and inspiration around stable CPI numbers. We suggest that markets follow to wishful thinking as everybody were waiting fruits of rate hike for too long and are tired from crisis looming. Other words, it seems more like some psychological factor and reaction rather then real matching to the data. Markets reaction looks too optimistic.
Additionally, we should mention the purely calculation effect here. First is next month CPI will calculate on different basis, formulae will change. Second - as we will go further into 2023 as more high inflation months will exclude from YoY moving data, which will lead to decreasing effect of nominal number of CPI index. For example, recent data doesn't include already December 2021, where was big jump in inflation, which makes CPI smoother and closer to an average annual level.
If rally doesn't exhaust in near term, then it will be painful collapse in near future, when Fed steps and statistics put everything in its proper place. Mismatches are massive and well visible, so it becomes even more surprising of current market reaction. Job market performance doesn't correspond to the growth pattern of economy, sentiment is strongly negative in all countries and all spheres - just take a look PMI and Sentiment indicators. Inflation remains stable, with rising of Core inflation after the year of interest rate hiking.
We consider current EUR rally as temporal, on a background weak economy, rising political tensions, exhausting of Fed reserves and coming unavoidable collapse of stock markets - demand for safe haven, which is a US dollar by far, should be triggered sooner rather than later. Although we do not exclude that EUR could reach next strong resistance level of 1.10-1.1050 in near term.
