Week ended August 12, 2022
Disinflation at last, markets rejoice
SUMMARY OF MARKETS
All it took for US equity markets to regain their footing and power ahead was a better-than-expected (meaning “lower-than-expected”) CPI read on Wednesday before the US market opened. Following a 1.0% increase in headline CPI in May and a 1.3% increase in June, July’s nil change was most welcomed by equity investors, pushing the S&P 500 to a 2.1% gain on the day (CPI discussed further below here). The euphoria that the Federal Reserve might back down was not as enthusiastically shared in the bond market, where intermediate and longer-term yields barely moved that day even though inflation might finally be moving in the right direction. The following day, PPI was released, confirming that inflation might have indeed peaked in the US as the indicator declined 0.5% in July (MoM), following increases in May (+0.8% ) and June (+1.0%).
Keep in mind though that even with the relatively good news – which certainly must bring some relief to the Federal Reserve – inflation in the US remains highly elevated, and there is a lot of work to be done to bring inflation back to the Fed’s target of 2%. The break-even rate is still nearly 3% two years out, raising doubts that inflation can get back to the Fed’s target anytime soon. If you want to give the Fed accolades, I suggest you don’t, at least not yet! As has been the case throughout the course of the pandemic, a majority of global inflation has come from a combination of higher energy / commodity prices and supply-chain disruptions (i.e. supply-push factors), arguably not factors that the Fed can control anyway. However, it is now these same factors – especially lower commodity prices – that are contributing to disinflation at the headline level. Core CPI (ex-energy and ex-food) actually continued to increase, up 0.3% in July (YoY up 5.9%). The trend in CPI and PPI in July probably means that the likelihood of a September Fed Funds increase of 50bps vs 75bps is an even-money bet, when a few weeks ago some pundits were even saying a 100bps might make sense. There will be another set of inflation data and a jobs report released in early September, prior to the next FOMC meeting on September 20-21, which will be very influential in determining the next move by the Fed. It feels to me like the bond market – with yields barely budging WoW – is right and the equity market is wrong, but let’s see. Certainly, the Biden Administration and his Democratic party must be relieved to get good economic news going into the mid-term elections, as US job creation remains strong, inflation looks to have peaked, and the price of gasoline is back below $4/gallon according to AAA (here).
The euphoria in US equity markets spilled over into global equity markets, too, with all of the global equity indices I track better on the week. Mimicking the “feel good” in US equities, corporate credit spreads raced in across the credit spectrum, with USD high yield spreads now having improved 180bps (4.21% Thurs close) since the spread nearly touched 6% just six weeks ago. US Treasury yields barely budged compared to the week before, having gyrated throughout the week. The US Dollar was down again albeit modestly WoW, I suppose because investors are moving back into riskier assets / currencies as confidence returns and sentiment improves. I find this somewhat strange because the outlook for the US economy remains so much better than the outlook for Europe and the UK. Perhaps slight USD weakness can be attributed to the fact that neither the Eurozone nor the UK have reached peak inflation, and the severity of central bank actions in these jurisdictions is therefore sure to be more intense (than the Fed) in the coming months. Or at least, this could be the narrative. The price of oil (+3.2% WoW) and gold (+2.6% WoW) were also better on the week. Improving sentiment for risk assets also filtered into the cryptocurrency market, with Bitcoin up 4.8% WoW (Friday end of day $24,403). The worst of the crypto winter does indeed appear to have past now, with #BTC up around 27% from its worst day in early July.
ECONOMIC AND GEOPOLITICAL NEWS THAT MATTERED THIS WEEK
On Wednesday, the Bureau of Labor Statistics(“BLS”) released CPI for July (here). The news was good, with headline inflation coming it at nil for July (MoM), and core inflation (ex-energy and ex-food) coming in at 0.3% for July (MoM). Inflation YoY fell from 9.1% in June to 8.5% in July. Energy was the largest contributor to moderating inflation, with fuel oil down 11.0% in July and gasoline down 7.7%. Airline fares also declined markedly, down 7.8% in July. New vehicles and shelter costs (rents and owners’ rent equivalent) were the largest contributors to CPI, up 0.6% and 0.7% in July, respectively. The BLS report has much more granular information. Below is the monthly CPI chart for inflation over the last year showing changes month to month.
On Thursday, the BLS released PPI for July (here), which confirmed that inflation could have indeed peaked in the US. PPI fell 0.5% in July, following increases of 0.8% in May and 1.0% in June. YoY PPI fell to 9.8%, the lowest since October 2021. As with CPI, the decrease in energy prices was the major reason that PPI was lower in July. It is interesting to note that price trajectory of shipping and transportation costs – which peaked at 5.6% in February – have declined sharply over the last several months (0.4% in July).
S&P 500 earnings
Nearly all of the S&P 500 companies have reported earnings for the quarter ended June 30, 2022. As I have mentioned on several occasions, the results have been closer-to-consensus than the prior few quarters, although still beating analysts’ expectations on average more often than not. In other words, earnings have been good enough this round given beaten down expectations. The outlook for S&P 500 earnings for 2023 and 2024 is fairly robust too given the current economic uncertainties, which you can see in the “Earnings Scorecard” from Refinitiv Lipper for the week ended August 12th here. The chart below, extracted from the report, shows the trajectory of trailing and forward P/E for the S&P 500 during 2022, noting the steady climb back up of this much-watched valuation ratio off of its mid-year low.
Corporate bonds (credit)
Safe haven and other assets