FOMO can quickly turn to fear

The inflation genie likes it out of the bottle. The Fed has a dual mandate, but right now, for the first time since the 1980s, the market cares about inflation more than jobs. CPI came in uncomfortably strong for January. Why? Housing is the main reason. The thorniest item in the inflation basket is owner’s equivalent rent, which jumped to 6.9% year-over-year, vs. 4.4% for residential rent. Keeping rates high would only seem to make matters worse, though, if the problem is an insufficient supply of houses. Producer prices and import prices rose uncomfortably as well, further dashing hopes for a May rate cut. Meanwhile the other sticky inflation component—wages. The Employment Cost Index rose at a 3.5% annualized rate in the fourth quarter. Renaissance Macro points out that this is the lowest number since mid-2021, and, taken together with labor productivity growth about 1.5%, this suggests that inflation is on track to meet the Fed’s target. For Yardeni, there is no sign of a second wave of inflation. Excluding shelter, he notes, CPI is right in the Fed’s target range. Meantime, with the economic bust in China, commodities are soft, which helps keep inflation at bay. But, in whack-a-mole fashion, a recent concern is gasoline futures, which have risen 12% over the past 10 weeks. The CPI and the PCE provide very different inflation rates right now, with core CPI at a 3.7% annualized rate over the past 6 months vs. core PCE at 1.9%. Indeed, while core PCE, the Fed’s preferred measure, suggests the Fed is on track to meet its target, other measures of inflation, such as median, trimmed-mean and sticky CPI tell a different story. These are up in the 4-6% range still, with Gavekal arguing that untamed inflation is the main risk over the next year or two, not recession.

Meanwhile, consumers are in a fine mood. The January retail sales report was a dud. Weak in itself, it brought with it downward revisions to November and December’s numbers. Weather may have been the culprit, with an assist from soft commodity prices (since sales are in nominal terms). For Renaissance Macro, these factors, together with quirks of seasonality, mean there is little reason to worry too much about the report. BAC, emphasizing the downward revisions to November and December data that accompanied the weak January number, mentions the soft handoff that last quarter gave to this one. It’s not all grim, though. Tight inventories give a cushion to the news. Then, too, if a recession were in the offing, we’d expect to see higher gas prices than we do at present. Furthermore, the Consumer Health Index rose in December on the strength of real wage growth and improved household balance sheets. Per the New York Fed’s consumer expectations survey, a growing percentage of consumers (34%, best since Sept. 2020) expect to be better off in one year, while a decreasing percentage (11%) expect to be laid off in the next year. (Until I lose my job, you’ll see me at the mall!) Consumer free cash flow—a measure of disposable income after accounting for food, energy and debt servicing—has been rising of late. (You know, I haven’t bought a new pair of shoes in months.) Before recessions, it usually falls. With elevated mortgage rates disrupting the real estate market, housing remains a sector to watch. Evercore ISI's homebuilders survey fell when mortgage rates went above 7.75%. Unless we revisit those levels, Evercore thinks homebuilders will be fine. Home prices rose faster post-pandemic than they did during the housing bubble of 2002-2006. The cause then was strong demand; this time, it’s limited supply that’s to blame. Currently, housing starts are just below long-term demographic demand. Authorized but unstarted building permits are quite high, so maybe there’s hope for those who have been frozen out from the market.

FOMO in stocks but fear in bonds? The solid recovery from Tuesday’s CPI-driven selloff, with small caps in particular re-asserting themselves, reveals a market able to shrug off interest-rate worries—for now, anyway. Breadth continues to haunt the market, with half of the S&P 500 down for the year despite the rally to yet another record high this week. Maybe there’s a glimmer of hope there, with FactSet saying that fourth quarter earnings look set to grow faster for the “S&P 493” than for the Magnificent Seven. Earnings season has indeed been strong, with 10 of 11 sectors beating estimates. For Strategas, there is simply too much uninvested cash to see selloffs turn into something worse. Even bond fund flows have been very strong so far this year—about $9 billion per week, which is well above average. Piper Sandler, noting that bonds and stocks haven’t been this negatively correlated in a quarter century, says that the biggest upside and downside risk to equities comes from the bond market. We’re back well above 4% on the 10-year Treasury, a mark that has spelled trouble for the equity market in recent months. We were reminded this week of what can happen in a momentum-driven market when data disappoints. As Evercore ISI put it, the market’s response to the CPI report was FOMO turned to Fear. The good news is that rate cuts are now better priced. Some even said the Fed’s next move would be to hike. No way. It’s an election year!

Positives

• Consumers in a fine mood The University of Michigan’s consumer sentiment survey rose in February to levels 30% above those seen last November, though still 6% below the historical average. The survey also indicated inflation expectations remain little changed, at 3% one year from now.
• Mid-Atlantic momentum The New York and Philadelphia Fed’s manufacturing indexes both rebounded sharply from last month’s swoon, with new orders faring particularly well. They remain in contractionary territory, however, and in New York capex and hiring intentions both edged lower.
• Knock on wood Homebuilder sentiment as measured by the NAHB rose more than expected in February. While lower mortgage rates have clearly helped in recent months, the survey has not yet retraced the damage done by last year’s spike in rates.

Negatives

• Where did that genie go? Inflation jumped unexpectedly in January, with headline CPI rising 0.3% on the month and 3.1% on the year. Housing costs accounted for much of the increase. Producer prices also rose 0.3% in January, vs. expectations of a 0.1% increase. Hospital care and portfolio management (given the gains in equity prices) were among the leading causes of the rise.
• The weather ate my garden gnome Retail sales fell 0.8% in January from the month before, vs. expectations of a 0.3% decrease. Building materials and garden stores saw a 4.1% drop; winter weather was blamed.
• Factories’ whistle fainter Industrial production fell 0.1% in January on top of a downwardly revised December. Auto manufacturing, which may still be rebounding from the UAW strike, was a rare bright spot; aside from autos and parts, production fell 0.6%. Capacity utilization in factories fell to 76.6% in January, the lowest level since April 2021.

What Else

Magnificent Inc. At a market cap of about $13 trillion, the Magnificent Seven would be the second-largest national stock market in the world after the U.S. as a whole. On a P/E basis, they’re pricey. But is that the only way to appraise them? Seen in terms of earnings growth, they look rather reasonable, with PEG ratios in-line with the broader market.

Small cap rebound? 22V Research notes that the number of unprofitable S&P 600 vs. S&P 500 companies is in the 89th percentile. What could change that? An improving economy could help small-company profits, potentially benefiting investors tempted by small caps’ valuations.  

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