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When “Bad News” Becomes “Good News”

While Tuesday’s Producer Price Index (PPI) for April came in hotter than expected (+0.5%), markets took the bad data in stride, perhaps because the year/year change on the headline index was still only 2.2% (2.4% for the “core,” i.e., ex-food and energy). Another reason for the lack of market volatility from the release may have been the small increases in healthcare services (+0.2%) and in insurance rates (0.0%), two areas that have been “hot” lately. In fact, those two are the leading causes of the recent upsurge in the latest inflation data.

Then came Wednesday’s Consumer Price Index (CPI) release for April, and it showed up on the cooler side. Markets were prepped for a +0.4% month/month reading for the headline number, but it showed up as +0.3%, and to much celebration. (The year/year numbers were 3.4% for the headline (vs. 3.5% in March) and 3.6% for the core. Much of the rise in the CPI has been due to just a few areas, auto insurance being one of them (see chart). Health care services is another culprit.

Except for these, disinflation and deflation appear to have become the order of the day.

Our past blogs have highlighted the measurement issues in the CPI’s heavily weighted shelter component. To reiterate, the use of a long lag in that shelter sector in calculating the CPI has imparted a significant upward bias to the index. In fact, if we remove that shelter component from the “core,” the result would show a year/year inflation rate of just 2.1% (!), right in the Fed’s wheelhouse.

In addition, some goods prices have actually been deflating. New auto prices showed up at -0.4% in April and have been negative for three months in a row. Used car prices fell -1.4% in April and are down double digits from a year ago (see chart). As it was the poster child for the upsurge in consumer prices, used car prices now appear to be continuing that role as disinflation (deflation) sets in.

Appliance prices have fallen for three months running and furniture in two of the last three. On the services side, airfares fell nearly -1% in April while hotel/motel prices were down -0.3%.

Not much scary inflation in April!

And, no wonder. It appears that the U.S. consumer is finally tapped out. Those “excess savings” are now spent (chart), and the savings rate, now under 4%, is about half of its pre-pandemic norm. Additionally, credit card balances are at all-time highs and banks are rejecting applications for increased credit limits at record rates. The result is twofold: 1) delinquencies are rising and are now at 13 year highs (credit card, auto, and even mortgage) and 2) consumption is slowing.

We saw the latter in April’s Retail Sales. On a nominal basis, Retail Sales were flat (0%) in April (and March was revised down from +0.7% to +0.6%). In real (volume) terms, after accounting for inflation, Retail Sales actually fell -0.3%. Sales at pharmacies fell -0.6% (down in five of the last six months) and sales at big box retailers were soft at -0.3% month/month. The most economically sensitive goods are sporting goods. In real (volume) terms, those sales fell -0.9% in April after tumbling -1.3% in March. These data points speak volumes about what the immediate future holds for the consumption portion (70%) of the GDP.

Surveys

The manufacturing economy continues in Recession, at least according to the latest Federal Reserve Bank surveys. The New York Empire State Manufacturing Index (NY Fed) fell further in May, to -15.6, from its -14.3 April reading. The consensus expectation was -10.0, so a big miss. Orders, Shipments, Backlogs, Delivery Times, the Workweek, and Employment were all negative. Inventories did rise, but most likely that was unintended. Prices Paid and Prices Received continued to show disinflationary trends.

The Conference Board’s Employment Trends Index (ETI) is down -4.0% on a year over year basis and has shrunk now for 17 months in a row.

The Philly Fed’s Manufacturing Index also declined to +4.5 in May from April’s +15.5. Orders fell to -7.9 from +12.2 and shipments to -1.2 from +19.1. These are large changes rarely seen on a month/month basis. In addition, employment, the workweek, backlogs, and vendor delivery delays also showed up with negative signs. And price pressures continued to recede.

The National Association of Home Builders (NAHB) Index fell to 45 in May from 51 in April. Traffic of Prospective Buyers fell to 30 from 34, and Future Sales Expectations took it on the chin, falling 15% to 51 from 60 in April. NAHB correctly blames the softness on high mortgage rates.

Housing starts fell again as did applications for new building permits. Multi-family starts were off -33.1% from a year earlier. However, multi-family completions are still +18.1% higher than last year. This will keep rents on a downward path and no doubt raise the apartment vacancy rate (which has been rising for more than a year). Rents will be negatively impacted and that will continue to put downward pressure on the CPI.

When “Bad News” is “Good News”

Despite the weakening economic backdrop (the “bad” news), prices in financial markets have been rising. Seems illogical. But a weakening economy heightens the prospects for rate cuts by the monetary authority, the Fed. And, because of the “good” CPI reading for April, markets are now pricing in two rate cuts (25 bps each), one in September and one in December, that’s up from one or none in April. The continuing hawkish comments from FOMC members (this past week: Mester (Cleveland), Harkin (Richmond) and Williams (NY)) keeps a lid on rate cut views, but markets are reading the incoming data and have begun to ignore the hawkish rhetoric. Our own view is that there will be at least two rate cuts this year.

10-Year Treasuries, which had yields over 4.7% in late April, closed Friday (May 17) at 4.42% and were as low as 4.35% last Tuesday (May 14). In the equities world, prices rose again for the week with Nasdaq up more than +2%, the S&P 500 +1.5%, and the Dow +1.2%. By the way, the Dow hit another milestone in reaching the 40,000 plateau intraday on Thursday (May 16) and closing above it (40,003.59) on Friday. The other indexes (S&P 500 and Nasdaq) are also flirting with all-time highs.

And, while we didn’t comment on Commercial Real Estate in the body of this blog, there were several large foreclosures this week. Our view remains that we will see banking issues before year’s end.

Final Thoughts

We got mixed messages from PPI and CPI, but in the end, markets appear to be convinced that inflation is abating and that, despite their hawkish pronouncements, the Fed will lower rates twice prior to year’s end. Because of the way the CPI is constructed with long lags on the heavily weighted shelter component, we know that shelter will push the CPI’s year/year rate to 2% or below by the end of 2024. Markets know this too. Thus, the upward price bias.

Another key reason for our inflation view is that the consumer appears to be tapped out. We see this in rising delinquencies and flagging retail sales. In addition, the housing data have turned soft both in single family (due to mortgage rates) and in multi-family (rising vacancy rates).

The various economic surveys have all been downbeat. Manufacturing continues to be in Recession with Industrial Production and Manufacturing Indexes showing weakness. Same for the Fed’s Regional Bank Surveys and even those from the Conference Board.

However, for the financial markets, a weakening economy (i.e., “bad news”) is “good news,” as this portends lower interest rates. While FOMC voices continue to preach “higher for longer,” the financial markets have stopped paying attention and now have their sights set on incoming economic data. The weaker they get, the higher the market goes in anticipation of rate cuts.

Robert Barone, Ph.D.

(Joshua Barone and Eugene Hoover contributed to this blog.)

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