Welcome to Inflation Week. In the US, the week ahead will be punctuated by widespread school closures on Tuesday for midterm elections, by what could well be another drawn-out vote-counting process, and by Veterans Day (Armistice Day in the UK) on Friday. The big moment for financial markets, however, will unambiguously be Thursday's release of US CPI data for October. Will they give the Federal Reserve any reason to relent?
In theory, last Friday's non-farm payroll report for October should have brought the central bankers a little closer to easing, because the unemployment rate rose. This may be bad news for American workers, but good news for investors hoping the Fed will ease its monetary tightening given its "singular focus on destroying labor demand and fear of wage inflation," said Bryce Doty, senior vice president at Sit Investment Associates. But the unemployment rate remains historically low, and it's hard to see anything like the kind of clear weakening trend that the Fed must want:
US Unemployment: It's Still Really Low
The rate of unemployment is barely below its average for this century
For Lisa Erickson, senior vice president and head of public markets group at US Bank Wealth Management, the jobs report probably won't diminish the Fed's hawkishness:
What we see is just that general sentiment for hope that we can maybe hit a soft landing that the labor market is staying sufficiently robust to cushion the impact of the Fed, because certainly the jobs report would not give necessarily the Fed a reason to pause.
Low unemployment ought to be reason for cheer, although if the midterm polls are even close to accurate, most Americans don't feel it. However, there are some reasons for at least guarded optimism on the inflation front. Here they are, in no particular order:
The New York Fed goes through a lot of complicated math to calculate an "underlying" rate of inflation. The version that includes both the prices in the CPI and other macro variables has distinctly turned downward. As the chart shows, core CPI tends to follow the underlying rate with a lag of a few months. So this suggests a turn in inflation is approaching:
Underlying Reasons for Optimism on Inflation
The NY Fed's underlying measure has turned down - Core CPI will likely follow
Joe Lavorgna, chief US economist at SMBC Capital Markets, says this looks like an "inflation inflection point":
The growth rate of the series has slowed from a 4.9% rate experienced from March 2022 to May 2022. Meanwhile, the core CPI rose 6.6% in September from a year earlier, matching its cyclical high set in the previous month. The current 2.2% spread between the two series is the largest since September 2009. The last time this happened, core CPI collapsed within nine months. The upshot is that investors and monetary policymakers alike should proceed more cautiously going forward.
When supply managers are polled on their experiences, the most important series for inflation concerns their answers on what is happening to the prices they're paying. Here, there is good news. The ISM Prices Paid index for manufacturing last month dipped below 50, taken as the dividing line between expansion and recession. The supply shocks driven by the pandemic really do look now as though they have worked their way through the US manufacturing complex. The equivalent index for services prices ticked up slightly, so this is not an unalloyed positive, but again it looks as though the peak is in:
Less Pressure in the Pipeline
Most manufacturers say prices aren't increasing; services prices are stickier
What the CEOs Are Telling Us
Earnings seasons these days have a fascinating final stage when different investment firms put the transcripts from all the CEO and CFO calls through their machine processing systems to identify patterns. And so far, the algorithms are finding reasons for cheerfulness. First, the numbers talking of lower input prices, for commodities and raw materials, is rising as a proportion of the total. As counted by BofA Global Research, more executives are reporting lower materials costs than in any quarter since they started counting in 2017:
The transcripts also offered at least some evidence that the labor market isn't as tight as it was, at least as it affects the bottom lines. A year ago, companies were complaining of having to offer signing bonuses in order to attract staff. This has dropped very significantly — still above the average for the years before the pandemic, but within the range:
None of this proves anything beyond reasonable doubt, but the evidence is growing that the pandemic shock is diminishing without creating a lasting shock to wages.
The prices of commodity futures don't affect core inflation, but they have a mighty effect on headline measures of inflation, and on the cost of living. And at last, the "base effects" are making 12-month comparisons look less scary. The year-on-year inflation rate of the Bloomberg Commodities index, a broad benchmark that includes industrial and precious metals, energy, and agricultural commodities, briefly dipped below 10% last week for the first time since early in 2021:
Single-Figure Commodity Price Inflation!
It didn't last long, but base effects are beginning to have an impact
It since popped up a little again, and obviously there are huge geopolitical risks. Many scenarios that are easy to imagine but horrible to contemplate would allow prices to rise significantly from here.
For at least two decades, China has been the world's buyer of last resort, the ultimate demand that undergirds prices in the rest of the world. This didn't cause inflation (except in asset prices), largely because the country also provided the world's labor of last resort; price rises were contained as cheap Chinese labor hit the global market. For a while, as their wages steadily rose, this effect went into reverse. But at this point, the Covid Zero policy is actually helping the Fed by keeping demand in check.
Friday trading was also roiled by another round of unconfirmed reports that China had decided to start rolling back the policy, which entails widespread lockdowns and slows economic activity. But Saturday brought an official statement that appears to refute those reports.
"Previous practices have proved that our prevention and control plans and a series of strategic measures are completely correct," Hu Xiang, an official at National Health Commission's disease prevention and control bureau, said on Saturday, at a briefing in which he promised to follow Covid Zero "unswervingly." He added: "The policies are also the most economical and effective."
This might well be good news for China's population, given that the vaccination rate for the elderly is persistently low. There's also an argument that lockdowns aren't good news, but at this point there's not much point in continuing the debate. In economic terms, this is bad news for much of the rest of the world as it damages risk assets (even though Chinese stocks managed to continue rallying in early Monday trading); but it's arguably good news for central banks as China continues to offer a deflationary force, rather than an inflationary one.
Add to this an optimistic gloss on the latest "Fedspeak," and you have another reason to be cheerful. Chair Jerome Powell offered up the most emphatically hawkish performance he could muster last Wednesday, and the market reacted accordingly.
But once he had established that the "terminal" rate at which the Fed stops hiking is probably higher than most in the market think, other senior Fed figures are beginning to ease that rhetoric a little. The central bank has finally acknowledged that policy acts with a lag — which is a significant change to its messaging, even though it must surely have been aware of this all along — with Boston Fed President Susan Collins on Friday saying policy is entering a new phase that could require smaller rate hikes, and her Richmond counterpart Thomas Barkin telling CNBC that the central bank may slow its pace of increases. He also thought that they may need to raise rates above 5%.
After Powell successfully reset expectations, the Fed is now trying to grant itself more optionality to respond to trouble as it sees fit. And it might just use that leeway to cut rates. So cheer up.
Panic No More
The slew of news in recent weeks has left Wall Street with plenty to obsess over, from Powell sounding unequivocally hawkish to the confusingly mixed signals sent by the nation's labor market. For every new development, markets have whipsawed in opposite directions, sometimes in a matter of minutes.
But for those who want a rigorous check on sentiment, perhaps this key indicator monitored by Citigroup strategists may help: the Levkovich Index. It was originated by the late Tobias Levkovich, Citi's chief US equity strategist for many years, and has a strong record as a contrarian indicator. To compose the gauge, Levkovich put together different measures of positioning to produce what he called the panic/euphoria index. Buying when the market is in "panic" is a good idea, while there are problems ahead if the market is in "euphoria." The gauge moved out of panic, rising to -0.12 from -0.18 last week, strategists led by Scott Chronert wrote Friday. Panic territory is defined as -0.17 and lower while euphoria is 0.38 and higher. This is what it looks like at present:
At the current level, the market just moved out of panic and implies a 90% probability of positive return over the next 12 months — higher than random outcomes — though with less attractive risk/reward. This is a pattern that recurs when going through data that should tell us about sentiment; people appear to be scared, but less so than they were a few weeks ago. This is the S&P 500 put/call ratio, showing use of options that pay off if stocks fall relative to those that pay off with a rise. Sentiment is still bad, but not flashing a compelling buy:
Putting Fears Aside
Buying of options to insure against falling stocks has slipped in recent weeks
Looking at the degree to which investors appear to have weighted themselves into equities rather than other assets, as measured by the asset allocation team at Deutsche Bank AG, the pattern appears again. Equities have been as underweighted recently as at the very tense moments when US sovereign debt was downgraded in 2011, and when the Chinese yuan devalued in late 2015 — although not touching the levels reached during the brief Covid crisis in March 2020. Now, it looks as though positioning has improved a bit — still suggesting a decent time to buy, but not a compelling contrarian buying opportunity:
Is this because people are already as pessimistic as they can get? That's possible. Looking at the 60/40 portfolio (a mythical benchmark of 60% S&P 500 and 40% the Bloomberg bond aggregate, the following chart produced by Jim Bianco of Bianco Research shows that by the end of October this was on course to be the worst year since the inception of the data in 1988. The period includes the disastrous equity crashes that started in 2000 and 2007, but the fall of bond prices this year has added up to more punishing losses even than in those crisis years:
In short, there are a lot of people licking some very painful wounds at this moment, and perhaps more ready than usual to grasp at straws. That might help to explain some otherwise very strange and volatile trading in equities after Friday's nonfarm payrolls. Average hourly earnings accelerated. The unemployment rate did, indeed, edge higher by 0.2 percentage points to 3.7%, more than forecast — but as we've seen, that scarcely suggests sudden labor market weakness.
The strong session for equities, with the S&P 500 gaining more than 1%, was puzzling to Victoria Greene, founding partner and chief investment officer at G Squared Private Wealth:
Jobs data supports hawkish Fed! Technically the unemployment rate rose, but we added 261,000 which was above expectations, so this is not a dovish economic data point.
Her best suggestion was that market reaction had been colored by the day's other huge news story, the cold-blooded and ruthless firing of half of Twitter Inc.'s staff by its new chief executive Elon Musk, which itself follows other high-profile layoff announcements:
You are seeing a lot of pressures to reduce costs and margins, so possibly the market is reading into that, and seeing a lag between announcements, trajectory and backward-looking data.
When you reach the point when something like the mass firing at Twitter is cause for optimism, it's a fair bet that the moment of maximum panic has been passed.
Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.