The Macro Context
The recent data is showing that the US economy is sharply slowing. The Atlanta GDPNow for Q2 has been downgraded from over 4% to 1.8% in just a few weeks.
At the same time, inflation remains sticky well above the Fed’s 2% target. The May CPI inflation report is expected to confirm this, by showing a 0.3% MoM increase in the core CPI, which is equivalent to approximately 3.6% annual core CPI inflation.
Thus, the Fed should be seriously considering cutting the interest rates, as the economy is obviously heading toward a recession, possibly even in Q3. However, due to the sticky and elevated inflation, the Fed is unable to start cutting interest rates. As a result, the economy is likely to continue slowing until the growth turns negative and the unemployment rate starts spiking – that’s the hard landing scenario. In other words, the Fed will be forced to keep the policy restrictive until the recession comes due to the sticky and elevated inflation.
Thus, the S&P 500 (SP500) is facing a recessionary bear market. Given the elevated valuation, with the PE ratio at 22, and irrationally high earnings expectations, the S&P500 could be facing a deep 20%+ drawdown, which could be much deeper if the real estate bubble bursts with a systematic credit event.
The May CPI report: inflation elevated and sticky
The key part of the macro context puzzle is the sticky and elevated inflation, which prevents the Fed from preemptively cutting the interest rates and engineering a soft-landing (falling inflation without a recession).
As previously stated, the Fed’s inflation target is 2% as measured by the core PCE inflation, which is used for the GDP computation.
However, the market uses the CPI inflation measure for the inflation-adjusted transactions and even for the TIPS pricing. The core CPI inflation is usually about 0.5% higher than the core PCE inflation. Thus, the Fed would consider the core CPI at 2.5% as an acceptable level of price stability. An annual 2.5% core CPI inflation requires that monthly core CPI inflation comes on average at 0.2% MoM.
The Fed’s Inflation Nowcast predicts that the monthly core CPI for May and June will come at 0.3% MoM – that’s consistent with approximately 3.6% annual core CPI, and that’s well above the Fed’s target.
The monthly core CPI for April was also 0.3%, and even higher at 0.4% for January, February and March, as the chart below shows. Thus, it is obvious that the core CPI is running somewhere between 3.5% and 4%.
In fact, the quarterly annualized core CPI inflation is 3.85%, while the quarterly annualized core PCE inflation is 3.19%. These inflation readings are obviously well above the Fed’s target. More importantly, it appears that these monthly inflation readings have been fairly consistent since September 2023 – that means “inflation is elevated and sticky”. That’s the problem for the Fed, especially now that the economy is sharply slowing down.
The Fed needs to see the core CPI at 0.2% MoM for several months before starting to cut interest rates – and we are not even close to that point yet.
What’s keeping the core CPI elevated and sticky?
The main reason for the sticky and elevated core inflation is the Services ex-Energy inflation; which is heavily weighted in the total CPI, and has been increasing at 0.4-0.5% MoM over the last three months, and it’s up 5.3% YoY.
Within the Services ex-Energy inflation, the key is Shelter inflation, which has been increasing at 0.4% MoM over the last three months, and it’s up by 5.5% YoY.
Also, within this category, the transportation costs are sharply higher by 11% YoY, and this includes the auto insurance, and also the auto repair costs.
So, let’s focus on Shelter inflation. Many analysts, including the Fed, are suggesting that the Shelter inflation measure is not reflecting the current market rents, which are either falling or rising at a much lower rate. Thus, the Fed is confident that the Shelter inflation will eventually moderate.
However, the empirical evidence actually ties the OER Shelter rent to the housing prices, and housing prices are still rising. In fact, the house-to-rent ratio is near the record levels, and unless the house prices fall, rents will keep rising.
Thus, the key point is, as long as the housing prices remain high, the shelter inflation will remain sticky. At the same time, falling housing prices could trigger a deep recession, with a possible systematic credit event. That’s the choice the Fed is facing: allow shelter to remain elevated, or induce a housing correction and a recession – it’s a situation similar to the 2008 pre-financial crisis.
Other sources and measures of inflation
Inflation can also be measured in real-time with commodity prices, and recently metal prices have been soaring (copper, aluminium, silver, gold, platinum). Crude oil is currently falling due to Biden’s effort to de-escalate the geopolitical situation in the Middle East before the election. But, how long can that last? What happens after the election?
But more importantly, the containerized freight index has been spiking over the last few weeks, approaching the pandemic peak when ports were closed due to the Covid lockdowns. Why are freight costs spiking now? It is due to the geopolitical situation.
We are in the process of accelerated deglobalization, where the opposing blocks are competing in erecting the trade barriers. There are two active real proxy wars fought, with a brewing conflict in a few more places, most notable in Taiwan.
Deglobalization is stagflationary, and that’s exactly what the data has been showing – sticky and elevated inflation, and slowing growth.
Implications
The May core CPI is expected to come at 0.3% MoM, which is consistent with the approximately 3.6% annual inflation, and fits the recent trend of sticky and elevated inflation. Thus, the Fed is unable to start lowering interest rates and preventively respond to the sharply slowing economy to avoid a recession.
Thus, the economy is likely to enter a recession over the coming quarters, which implies that the S&P500 is facing a recessionary bear market. The potential housing market correction could even deepen the bear market drawdown.
Read the full article here