I’ll start by providing the link to that WSJ article I cited yesterday in the note on inflation, //www.wsj.com/articles/health-insurance-inflation-is-poised-to-drop-sharply-11666655474. So, health insurance overstated health care costs over the past year and now is about to understate it.
We always wish investing can be easy but unfortunately it’s not. Yesterday’s slight moderation in inflation was welcome relief as was the bond market rally that came with it that drove an incredible day for stocks. But we have to think deeper here and not automatically believe that all will be fine and the bear market is over if only inflation further drops from here. While that would of course be a good thing, the 5 yr TIPS market on Wednesday was pricing in a 2.53% inflation rate over the coming 5 years, thus already discounting a sharply lower inflation rate from now.
With respect to the Fed, if it is one thing we’re learning is that they REALLY want negative REAL interest rates to go away. Thus, lets assume they stop hiking at around 4.5% (give or take), that implies the inflation to fall to around 4.5% from the 7.7% headline and 6.3% core seen yesterday (PCE will of course be lower than that in a few weeks). So even with a much lower inflation rate from here, the fed funds rate will still remain very high (at least relatively speaking over the past 15 years). What will a world of zero to positive REAL interest rates look like? Over time that would be a great thing but the higher cost of capital for now will still be a challenge to a credit dependent US economy and still high valuations where the S&P 500 is back to trading at almost 18x earnings and the price to sales ratio at 2.32 is still above the March 2000 PEAK of 2.28.
With regards to earnings, higher inflation has been the MAIN driver of revenue growth for corporate America as seen over the past month. In fact, without inflation many companies would have seen a drop in revenues. So any decline in inflation would negatively impact sales (somewhat offset by maybe lower prices bringing back more demand but only somewhat) and with wage growth rising at DOUBLE the pace pre-Covid, profit margins are at serious further risk. Companies will get some relief on the raw material/shipping/supply costs but wages are their biggest costs. Now we’re already seeing a pick up in layoffs for tech companies and that will relieve their own labor costs but many other parts of the labor market will still see higher than usual wage gains.
Finally, I heard someone on tv yesterday say that ‘inflation is over.’ While I for sure hope so and believe that inflation is definitely heading lower from here but think that it will still remain double the pre-covid pace when all is said and done and that energy prices will go higher from here (especially on a full China reopening), I include below a chart of the y/o/y change in CPI in the 1970’s and I wonder how many times people in 1971 and 1972 said it was over or how many people in 1975 and 1976 said it was over.
If there is someone else who loved the less than expected CPI figure, drop in rates and dollar hammering it was BoJ Governor Haruhiko Kuroda who can enjoy his weekend with the yen below 140 instead of teasing 150. The dollar by the way is getting smacked again today after yesterday’s biggest drop I’ve seen in a long time. You’ve heard me argue for a while that the only thing helping the US dollar (I think) was solely interest rate differentials and the aggressive Fed. Giving me evidence of that has been the great performance in the Mexican peso and Brazilian real over the past two years that were supported by central banks there who started hiking rates in 2021. Well, the Mexican central bank yesterday raised its overnight rate to 10% as expected, up 75 bps and the Mexican peso rallied to the highest level vs the US dollar since March 2020, giving some of that back today.
Back to Japan, the 10 yr JGB yield fell 1 bp to .24% and the 40 yr yield dropped by 9 bps to 1.67%. This as the Japanese reported a 9.1% y/o/y PPI in October, 3 tenths more than expected, although down from 10.2% seen in September.
Mexican Peso (the lower it goes, the higher its value vs the dollar)
The National Association of Realtors yesterday came out with their Q3 home price report and said prices rose 8.6% y/o/y, a needed and not unexpected downshift from 14.2% in Q2. They said the “monthly mortgage payment on a typical existing single family home with a 20% down payment was $1,840, up 50% y/o/y.” Absorb this stat too, “The median income needed to buy a typical home has risen to $88,300 – that’s almost $40,000 more than it was prior to the start of the pandemic, back in 2019.” So to my point at the beginning of this piece, a higher rate environment for longer has a major impact on the interest rate sensitive parts of the economy.