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Despite Fed Hawkishness  Recent Inflation Data Give Markets Hope

The financial markets were “mixed” this week (ended June 14) with the tech sectors moving smartly ahead while the more traditional sectors lagged. The S&P 500 (+1.6%) and the Nasdaq (+3.0%) both closed higher. But the industrial stocks were flat to down as represented by the Dow Jones Industrials which were off -0.8% for the week. Year to date, both the S&P 500 (+13.9%) and the tech heavy Nasdaq (+17.8%) are up double digits while the industrial based Dow Jones is only up +2.4% for the year and is down -3.1% so far this quarter.

The tech heavy Nasdaq is hot because of the Artificial Intelligence craze, and that shows up in the S&P 500 in the Magnificent 7. As noted by Rosenberg Research, on a quarter-to-date basis, Nvidia is up +46%, the Magnificent 7 are up +15%, but the S&P 500 in total has grown just over +3%, and if we look at the “other 493,” i.e., S&P 500 ex-Mag 7, we see a negative sign (-2%)! That comes through in the Dow Jones Industrial Average which are off more than -3% year-to-date, indicating issues in the manufacturing/industrial space, and likely presages Recession.

Today’s equity market reminds us of the dot.com market at the end of the 1990s at which time Cisco Systems (CSCO), the Nvidia of the era, sold at a high price of $77.31 (December 1999).  Nearly twenty-five years later, it hasn’t been anywhere near that price, closing at $45.68 on Friday (June 14). In today’s equity market, if it doesn’t have an AI story (or a weight loss pill), it likely hasn’t participated much in the upside.

In addition, the markets don’t appear to be “buying” the Fed’s hawkish tone or its “dot-plot” result (one rate cut in 2024 – more on this below). The recent lower than expected readings in Consumer and Producer Prices (CPI and PPI), which are now expected to continue, moved rate cut expectations for 2024 to two, likely at the November and December Fed meetings with a slight possibility of the first move being as early as September. Markets also expect rate cuts to continue into 2025, pricing in a 25 basis point (0.25 percentage points) cut at the January meeting. As a result, interest rates, which were marching higher from Fed hawkishness, declined in the later part of the week (ended June 14) as is notable on the right-hand side of the 10-Yr. Treasury chart (see above).

Inflation News

Finally, there was good news on the inflation front. And the events this past week that moved markets were all inflation related: the CPI (inflation) report, the Fed meeting, and the PPI (inflation) report. The CPI release and the Fed meeting both occurred on Wednesday. The PPI inflation report came Thursday.

The inflation news was a positive for the financial markets, especially the fixed-income market. The headline CPI number was essentially flat (i.e., 0.0%; actually +0.006% to the third decimal) against expectations of a +0.1% print. And the “Core” inflation rate (i.e., the headline number less food and energy) was +0.16% (expectations were +0.3%). On a year over year basis, the headline CPI fell to +3.3% for May from April’s +3.4%. The consensus was for the year-over-year number to remain at the +3.4% level. In addition, the “Core” annual reading fell to +3.4% in May from April’s +3.6%.

Rents rose +0.4% in the CPI. As discussed in previous blogs, the shelter data in the CPI are lagged about a year, and while +0.4% is lower than the numbers aired in the recent past, the fall in rents in the second half of 2024 has yet to be included. They soon will be, and that will continue to drive inflation lower. To show where it will go, if rents are excluded, the “Core” inflation rate would read +1.9% year over year, below the Fed’s target. So, when the lagged rent data turn negative in the next few months, the Fed will be scrambling to ease, and bond prices, especially those of long duration, will rise.

Then, on Thursday, the Producer Price Index (PPI) surprisingly showed up in negative territory at -0.2% for May. Expectations were positioned for a positive print (+0.1%), so yet another downside inflation surprise. Since PPI occurs at the business level, it is a strong precursor to what will occur at the consumer level (CPI) in the coming months.

The Fed

The Fed meetings began on Tuesday and ended at 2 pm (EDT) on Wednesday with Chairman Powell giving his Press Conference at 2:30 p.m. The official Fed Statement indicated that the FOMC had held the Fed Funds Rate steady at the 5.25%-5.50% level. The much-anticipated dot-plot (see chart above), the rate forecasts by the 19 individual members of the FOMC, showed a median forecast of one rate cut of 25 basis points (0.25 percentage points) for 2024. Since there are 19 dots, the 10th dot is the median, and that falls in “one” rate cut territory, but not by much (see the left side of the dot-plot chart above). Given the weakening economic outlook, it won’t take much for some of the eight dots in the one rate cut row to move to two cuts. And that is our forecast.

When asked by the press if the morning’s CPI release had any impact on the dot-plot, Powell said that participants were given an opportunity to alter their forecasts (dots). In our view, without ample time to consult with their staff economists, most of which are located in the 12 Regional Federal Reserve Banks, it is unlikely that the low CPI number had much impact on the dots. It is our view that, if the CPI release had been a day earlier, the dots would be showing two rate cuts for 2024 rather than one. And especially if the FOMC members also had the PPI results in hand. Two rate cuts for 2024 has been our base case for several months, and that appears to now be the view of the financial markets.

The FOMC continues to be fixated on inflation, and not on the economy’s overall health. In addition, that fixation appears to be on the lagging or coincident indicators, such as the year over year reading on the inflation data instead of the trend in the last few months. If they were forward looking, they would be concerned with the emerging signs of deflation. Note the downtrend in consumer prices shown in the CPI charts above. In addition, given the heavy weight (35%) of shelter in the CPI, and given its nearly 12-month lag, inflation is destined to fall to the Fed’s 2% target by year’s end.

Because monetary policy acts with long and variable lags, and because this Fed has remained “higher for longer,” monetary policy will continue to act as a depressant on economic activity long past year’s end. As a result, we think inflation will dip well below the Fed’s 2% goal in 2025 and possibly into deflation if the Fed waits too long to pivot to at least neutral (2.75% in its view).

The Labor Market

While not currently in the media’s focus, the labor market is still an important indicator of economic health. Despite Chairman Powell’s characterization of it as “strong,” it clearly isn’t. In our last blog, we outlined weakness emerging in JOLTS (Job Openings and Labor Turnover Survey), the loss of full-time jobs over the past year, and the negative trends in full-time jobs in the Household Survey. This week, we saw a spike in Initial Unemployment Claims to 242K, up +13K for the week, and the highest level since last August. And Continuing Unemployment Claims (those collecting unemployment for more than one week) spiked +30K to 1.82 million.

More on CRE

As we have outlined in past blogs, we have growing concerns around Commercial Real Estate (CRE), especially commercial office buildings. The pandemic emphasized sheltering, and the improvement in communications (ZOOM, Teams, etc.) made it possible for many employees to work from home. Since the pandemic, this has become a trend, and vacancy rates in office buildings in major metropolitan areas have skyrocketed. Last Tuesday (June 11), as reported by Bloomberg, PIMCO, the large financial advisor made famous by Bill Gross (the first “Bond King”), warned that they see “More U.S. Regional Bank Failures” due to a “very high concentration of troubled real estate loans on their books.”  As leases expire, the vacancies are destined to increase and CRE issues are going to plague the Regional and Community Banking systems for the next few years.

Final Thoughts

Equity market behavior has become concerning. The popular indexes have been powered by the AI craze, and a closer look reveals that stocks in the industrial and manufacturing space are being left behind. (That’s because the U.S. manufacturing sector is already in Recession!) Such behavior reminds us of the dot.com market at the turn of the century.

There finally was good news on the inflation front from both the CPI and PPI. Because of the timing of those releases, it doesn’t look like the Fed’s FOMC had the full benefit of the results. Either that, or they don’t want the fixed-income markets to get too enthused and get ahead of where the Fed wants them to be. The median June Fed “dot-plot” indicated only one rate cut in 2024 (the mode, however, showed two), a somewhat “hawkish” result. Despite the dot-plot, and we suspect because of the good inflation news, markets are now pricing in two 25 basis point cuts in 2024, and a third cut next January.

The Fed’s concept of a neutral rate (one that is neither expansionary nor contractionary) is 2.75% (recently raised from 2.50%). We expect them to get to that level or below over the next 18 months as this business cycle plays out (i.e., Recession). That’s 250 to 275 basis points (2.50 to 2.75 percentage points) lower than today’s rate. Longer duration bond prices will benefit from such a move.

While the May U3 unemployment rate is 4.0% (which is the Fed’s end-of-year number), it has risen six-tenths of a percentage point since April ’23. (This Fed appears so consumed with lagging and past data that it apparently thinks that the economy will stop slowing and the U3 rate will remain at 4.0% till year’s end!) The labor market has clearly weakened from what it was in 2022 and 2023. Because layoffs are up, initial unemployment claims have risen. And because finding a new job once laid off is now more difficult than it was, the number of Continuing Unemployment claims is on the rise. The more inclusive U6 Unemployment Rate now sits at 7.4%, up +0.7 percentage points from 6.7% last July. According to Economist David Rosenberg, in post-WWII history, the U.S. economy has never avoided a Recession when the U3 Unemployment Rate has risen +0.5 percentage points or more. It is currently up +0.6 percentage points. The question is: “Is this time going to be different?” (We think not!)

Robert Barone, Ph.D.

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


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