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The charts and themes from the past week that tell an interesting story in markets and investing…
1) Inflation is Slowing Fast
The overall US inflation rate (YoY % Change) moved down in December for the 6th consecutive month. At 6.5%, this is the lowest inflation rate since October 2021. Core inflation (which excludes food/energy) also moved down to 5.7%, its lowest level since December 2021.
US Producer Prices (PPI) increased 6.2% over the last year, the smallest YoY increase since March 2021. PPI peaked at 11.7% in March 2022.
While these declines in the year-over-year rate of inflation are significant, the more recent data illustrates the fact that inflation is slowing fast. Consumer prices have barely increased over the last six months (+0.2%) and have actually declined over the last two months (-0.4%).
Among the major components of CPI, the majority are showing a lower inflation rate in the last six months, with Shelter being the most notable exception. At 7.5%, this was the highest rate of Shelter inflation we’ve seen in the US since 1982.
But as I’ve noted, Shelter CPI continues to be a lagging indicator, with actual rents declining in each of the past three months (note: national average).
After wildly understating true housing inflation during the runup, Shelter CPI continues to play catch up (+14% since the start of 2020 vs. a 20.9% increase in rents and a 40.9% increase in home prices). But if rents and home prices continue their descent, it’s only a matter of time before Shelter CPI turns down. And when that happens, given the huge weighting of Shelter CPI in the overall index (33%), we could see the inflation rate really turn lower.
Outside of housing, we’re seeing continued improvement in other areas. Gas Utilities were up 19% year-over-year in the December CPI report, but the real-time data suggests this is likely to move sharply lower. Natural Gas futures are at their lowest levels since June 2021, down 69% from their peak last August.
And the downtrend in Used Car prices is accelerating, with the 14.9% YoY decline in the Manheim Index setting a new record.
Food inflation remained stubbornly high in the latest CPI report (+11.8% YoY), but the downturn in fertilizer prices (-50% from last year’s peak) is promising, suggesting an improvement over the coming months.
Finally, market-based inflation expectations are confirming the move lower, with 10-year breakevens down to 2.12%, their lowest level since February 2021.
2) Next Move: 25 Bps
With all signs pointing to lower inflation, perhaps it’s not surprising that the market is now expecting the Fed to hike only 25 bps when it meets on February 1.
The 1-Month Treasury Bill is already pricing in just that, an 8th rate hike to 4.50-4.75%. At 4.69%, this is the highest 1-month yield we’ve seen since August 2007. Incredibly, only a year ago the yield was just 0.05%.
Why is the Fed still hiking rates if all signs are pointing to lower inflation?
The following chart, which shows that inflation has outpaced wage growth for a record 21 consecutive months. This is a meaningful loss in prosperity for the American worker and the Fed wants to be sure that inflation comes down enough so that wages once again are outpacing prices.
And given the Fed’s dual mandate (maximum employment and price stability), inflation remains the higher concern. The U.S. Unemployment Rate moved down to 3.5% in December, which was back to pre-pandemic levels and tied for the lowest rate we’ve seen since 1969.
In addition to the upcoming rate hike on February 1, market participants should expect further declines in the Fed’s balance sheet. While the Fed’s assets have already been reduced by $476 billion from their peak last April, they remain over $4 trillion higher than where they entered 2020.
The Fed’s balance sheet is now 5.3% lower than its peak, and in prior balance sheet reductions we saw a much greater drawdown before a reversal in policy.
3) Will Rate Hikes Lead to a Recession?
Rising interest rates are certainly helping to lower inflation, but will they eventually push the economy into a recession? Based on the historical evidence, avoiding a downturn in the economy will prove to be difficult. In the past 50 years, every time the Fed responded to periods of high inflation with rate hikes, a recession soon followed.
The yield curve indeed seems to be saying that this time will not be different, with the inversion in 10-year and 3-month treasuries moving to the most extreme levels we’ve seen since March 1980.
The last 8 recessions in the U.S. were all preceded by an inversion in the yield curve, though the lead time shows considerable variation.
How will the Fed respond if signs of recession emerge?
Likely with looser monetary policy. The markets are already pricing that in, with rate cuts expected starting in November and continued cuts throughout 2024.
4) The Housing Recession Continues
While the debate over the path of the U.S. economy continues, the housing market recession is undeniable at this point.
US Building Permits hit a 31-month low in December, down 30% year-over-year.
Existing Home Sales fell for the 11th consecutive month, down 34% over the last year. This was the 2nd largest YoY decline on record (largest was last month).
We’re following the same pattern as the last housing bubble: first affordability collapses, then sales plummet, and then prices decline.
We’ve just started that last phase with the median existing home sale price down 11% from its peak. After the last housing bubble top, prices fell 33% nationally. The same decline today would only bring prices back to February 20220 levels, a reflection of the mania in the last phase of the current bubble: a 40% increase in 2 years.
Affordability continues to be the biggest issue confronting the market, with the median American household needing to spend 46.4% of their income to afford payments on a median-priced home in the US. This is the highest % on record with data going back to 2006.
This affordability picture can improve with any of the following: a) lower home prices, b) lower mortgage rates, or c) higher incomes.
Thus far we’ve seen all three, but not enough to make a meaningful difference. While mortgage rates have declined to 6.15% (from a peak of 7.08%), that still leaves the monthly payment 80% higher than two years ago. Needless to say, incomes are not up anywhere close to that amount, making housing unaffordable to the average American.
5) Slowdown in Tech
Earnings season has started and Netflix being the first big tech company to report. They showed a continued slowdown in revenues to 1.9% year-over-year, the lowest growth rate in company history.
Paid subscribers grew only 4% in 2022, following increases of 9% in 2021 and 22% in 2020.
When it comes to earnings, it’s not the news but the reaction that matters, for it can illustrate sentiment, what was priced in, and expectations for the future. Netflix stock lost over 75% of its value from its peak in late 2021 to its low in 2022. But in recent months, it had been moving higher, and this trend continued with the stock rising after earnings.
While it remains 48% below its 2021 high, it has now rallied 119% off its low.
6) Is the US Consumer Already Pulling Back?
There’s nothing more critical to the economy than the health of the U.S. consumer. For much of last year, the consumer appeared to be incredibly resilient. But if you look closely, there are come signs of weakness emerging.
On a nominal basis, retail sales are still up 5.2% over the prior year, but after adjusting for inflation the story changes. We’ve now seen three consecutive year-over-year declines in real retail sales, perhaps a reflection that the U.S. consumer is already pulling back.
While savings rates near record lows and borrowing levels stretched, this shouldn’t be a huge shock, but few seem to be pricing in a sustained move lower in retail sales.
One reason for optimism is the continues strength in the travel and leisure sector, with U.S. airline travelers rising above pre-pandemic levels in recent weeks. This has lead to surge in profits for airlines ($UAL +30% vs. 2019 levels).
Interestingly, after hitting record lows in 2022, consumer confidence is starting to rise a bit, in large part due to the decline in inflation. Whether it continues to rise will in large part be dependent not only on the path of inflation, but whether the economy falls into a traditional recession (where unemployment rises and consumer sentiment tends to fall).
7) Voting With Their Feet
The great migration out of states with higher taxes, more regulations, and a higher cost of living continues. The biggest net losers over the past year: New York and California. The biggest net winners: Texas and Florida.
An incredible stat: New York’s population is the same as it was 20 years ago while Florida’s population has increased by 6 million.
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And that’s it for this week. Have a great week everyone!
-Charlie
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Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. Read our full disclosures here.
