This week, the Consumer Price Index (CPI) inflation number came in lower for July (8.5% YoY) versus June (9.1% YoY). Seeing this number begin to decline has certainly been welcome news for markets. However, the headline rate (8.5%) may not be telling the whole story on this battle to stymie inflation.
Hear Chris and Jesse talk through the various components of the CPI "basket", reveal how some internal numbers are still growing, and share some strong comments from a normally more dovish Fed Governor that suggest the fight to beat inflation isn't over!
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Charts & Transcript below...
Jesse: Hello again. I'm Jesse. He's Chris. We're back at Random Gleanings. Thanks for watching. Chris, inflation is down. Victory won?
Chris: I mean, let's party, right? So, first chart, Cleveland Fed comes out and says, hey, inflation, it's gone from 9.1 to 8.5. And I mean, yeah, that's a step in the right direction. Less bad equals good is what I was often taught in the equity markets with respect to earnings, etc.. But for inflation, I don't know.
Jesse: Yeah, I mean, right there in the tweet, they suggest inflationary pressures remain broad based because of the median CPI.
Chris: Yeah. So let's let's look at what median CPI is. So the definition of median CPI is to calculate the median CPI. The Cleveland Fed analyzes the median price of change of goods and services. The median price change is the price change. It's right in the middle of the long list of all the price changes like energy, etc.. So next chart, let's look at our friend Willi CPI.
Chris: Indeed. Better than expected.
Jesse: Yeah, but he points out that again, very much like what the Cleveland Fed said. The median CPI has been increasing for the for the last 12 months in a row, and it's at its highest level ever.
Chris: So and and so he goes on to say, I don't see how the inflation backdrop has meaningfully improved. So let's look at what CPI's made of.
Jesse: Yeah, I think it's it's at least healthy to kind of take a look behind the curtain because we hear a lot about it. And they're not equal. They're just not equal. That's just it. And so housing is the biggest component. And that's not just the cost of rent or mortgage or whatever, but, you know, fuel and insurance and all the all the components of housing.
Jesse: But it is an unequal, unequal weighting. And and then you see that the remaining list there.
Chris: You know, the thing to me, though, housing I mean, Zillow shows rents year over year, up 14 and a half percent still right today. Right. Okay. Up 14 and a half percent. So if 40% of that's made up of up 14 and a half percent, some other things would have to shrink pretty hard to get those numbers to eight and a half, right?
Jesse: And I think we've covered this before, but housing in particular or shelter in this next chart is is understood, I think, by all economists to be a slow moving drift up just based on how they track that number. And when you think about rents, you know, maybe 1/12 of people who are renting are changing over every every month.
Jesse: And and so you're not seeing those price increases happen all at once, but over time.
Chris: Yeah, and that's a fair point.
Jesse: And so, you know, that's just part of it that one would you would expect to continue to climb for a period to catch up to what you're seeing the evidence of on Zillow.
Chris: So this is why this notion of of the median is so interesting to me, highlighted in green and red are the increases in gas in in red in March and June like major increases. And then in April and July, you see them fallen off a fair amount. Right. And and yet you look at the number at the end of the day, on the right hand side, in yellow. I mean, the numbers are big.
Jesse: They are big.
Chris: They're super big. So just to say, hey, this is all over with, is is kind of hard to me. All right. So next chart. So I put a chart up here. DVC is the INVESCO Deutsche Bank Commodities Index right in. And the first yellow line that you see on the left is an uptrend. And you see on the right hand side that yellow line is going down, right? I mean, commodity prices have fallen in the last three months, which is not inflationary.
Jesse: That's correct.
Chris: They're going the correct direction. They're down about 8% somewhere in that neck of the woods. But the thing is, this is a one year chart. So commodity prices are up 35% year over year, according to the index.
Jesse: And I think, you know, he shared this next this next graphic with me and I love it, is that, yeah, we're at eight and a half percent off of 9.1. We were at eight and a half percent back in March and people were apoplectic. Right. So what does that mean?
Chris: So, okay, so what's the Fed after? I mean, we've talked about this. You know, the Fed wants to see inflation drop all inflation. All right. Here's the problem. You got commodity inflation. You got wage inflation, right? Commodity inflation is dropping, right. Wage inflation is not. You've seen wage growth of plus 5% for the last seven months in a row.
Chris: I mean, that that is inflationary. That's right. There's no way it's not inflationary. So next chart, I thought it's pretty good hat tip to me, Julie. Imagine. Just imagine that you were 200 lbs a year ago and now you're 217 lbs, right? That's an eight and a half percent increase year over year. So what mean if you I mean, I guess that means last month you were 220 lbs and now you're 217.
Chris: Right. So what would the doc say? Well, I.
Jesse: Mean, I'd say good, good start. Right on. Getting back to your target weight. But we're not there yet. Right. And I think that's that's the that's the useful analogy here, is that. Yeah, you know, maybe if we were to 17 in March, we got up to 20, we kind of let ourselves go a little bit and we've gotten ourselves back down.
Jesse: We've, we've we're heading in the right direction, which is, I think, where you started this conversation. But in order to get back to a healthy weight, we've we've got some more room to go.
Chris: That's right. So let's look at Fed Governor Neel Kashkari and his comments just the other day.
Jesse: So he's the doc getting us back to 200 lbs.
Chris: He said doggedness back 200 lbs. That's right. Or he's the Fed governor getting us back to 2% interest rate, which is where he is. Which is where the target is. Right. Okay. So look at what he says. By the way, the Fed funds target rate now is two and a quarter, two and a half. So just call it, you know, two and 3/8.
Chris: Right. I mean, that that's where we are from a from a Fed funds rate. And their goal is to get inflation back to 2%. So how are they going to do it? Well, they're going to do it by raising interest rates. Right. And so you look at the bottom of this graphic, Kashkari says he wants the Fed funds rate at 3.9% by year end.
Chris: And here's what blows my mind. It's like the market is not nobody's taking it seriously. It's like they don't believe him. And so the adage, you know, when the Fed is is, you know, giving stimulus and and don't fight the Fed, right? Don't fight the Fed buy stocks. Don't fight the Fed because the Fed is you know, don't fight the Fed because they're the end all, be all.
Chris: Here is a Fed governor telling you that he believes the Fed funds rate needs to be 70% higher by the end of 2022.
Jesse: Four and a half months with three hikes.
Chris: Three hikes, right?
Jesse: Yeah. I mean, that's that's guns blazing in the analogy of don't fight the Fed.
Chris: That is straight out guns blazing. That's a percent and a half a percent in three quarters. So 50, 25 and 25, which seems to be the narrative of the three, you know, interest rate increase hikes for the rest of the year that get you nowhere near 3.9. Yeah it gets you may be halfway there so and then 4.4 by the end of 2023.
Chris: He's saying in here it's a much more likely scenario. We will raise rates and then we'll sit there until we're absolutely convinced that inflation's 2%. Because if you go back and study the seventies, that's the big piece, right? Like they let off. They kept they kept letting off and it kept coming back and it kept persisting.
Jesse: This is where I think looking forward is challenging right now because they've got a blunt instrument in which they can have historically tamed inflation. Right. I think I've heard it stated that raising the the Fed funds rate does not cool down employment. It is a recession, right?
Chris: That's right. That's exactly right. And in recessions, companies tend to earn less money, which affects...
Jesse: … their multiple.
Chris: Right, but let's talk about earnings themselves. Okay. So so looking through the end of the second quarter, if we look back four quarters, we're looking at call it a, so earnings for the last four quarters, including Q2, which in June 30th about just call it 220. Right. Okay. Basically, and today, the market's trading right at dead on 4230 as of this taping.
Chris: That's a little north of 19 times earnings. Right. Right. So what was what was the rule of 20?
Jesse: It is the expected inflation rate plus the market multiple.
Chris: Right. So 20 minus the ten year inflation rate. Well, the ten year inflation rate, you know, according to tips, is like 3% rate. So that would imply that a 17 multiple is where we need to be. So if you look forward in terms of this quarter plus the next three quarters, basically expectations are around 245, $245 on the S&P.
Chris: So if you add up all the S&P 500 companies and you take their earnings for the entire year in terms of what's estimated, it's $245 combined. Okay. So 42, 30 divided by $245 is 17 and a quarter times earnings that we're trading at right now. Here's the thing. I can't shake said, okay, if you go from 1900 to 2021 and we shared this chart three or four months ago, I mean, you look at a CPI north of six and markets traded at 13 times earnings. Okay. And that's the average across all periods from 1900 to 2021. Do you get if you get 5 to 6%, which we make it to, okay. Like by the end of the year, is it possible?
Chris: Okay. But but you're still nowhere near, you know, five or 6% you see on screen, you know, 15 times earnings. Right. Okay. Well, 15 times earnings is is still like 300 on the S&P. I mean, it's a lower number from here. Now, if you look forward, it may be a slightly higher number, but at the end of the day, it's it's lower than here.
Jesse: That's the difficulty. That's the difficulty. We've seen a bit of a breakout off the June lows and the the lowered CPI number that just came in this week had a bit of a rally behind it. But you you you brought a technical chart that has us kind of hovering around an important level.
Chris: Yeah. So on a one year chart, if you look at what really doesn't matter if it's one year or otherwise from the top at the very beginning of January to the bottom in mid-June until now, I mean, we are setting technically smack dab right in the middle of the chart, meaning we've we've recovered half.
Chris: Half. So that leads me to the question, Jesse, are you half empty or you half full?
Jesse: I tend to be an optimist, but in the short term, I just say I'm a half glass of water.
Chris: Yeah. I mean, I'm I'm open to the glass being fuller. I'm open to the glass going the other direction.
Jesse: I just need some more evidence. You know, I think we find ourselves in a bit of no man's land because that 50% level has historically been a pretty good gauge of a bull or a, you know, a bear market rally. If if it if it gets there and kind of hovers or, you know, if it breaks through there, there is another piece of evidence.
Jesse: But again, you've drawn a yellow trend line. We're not there.
Chris: Yet. No, we're not. And by the way, we have gotten there on the Nasdaq and on it on the Russell 2000 SMALLCAPS. But the question is, will that hold in the long run? And, you know, the Fed's telling you they want evidence. Hmm. I think we'd kind of like to have some evidence, right, too.
Jesse: That's right.
Chris: Because I mean, everything you see with respect to inflation implies this is going to take a little while. Yeah. And it's it's not a quick fix. And I'd love to say I'd love to just reach the the moment of less bad equals good and that's all there is to it. But the challenge is, you know, when you've had wage growth up plus 5% for seven months in a row, adding jobs and adding jobs.
Chris: At the same time, the unemployment rate went down. Right.
Jesse: That it doesn't solve the problem that the Fed I think, is ultimately trying to solve at least the conditions don't solve it. So the probability of their their soft landing is very complicated right now.
Chris: It is indeed. It is indeed. And that's all I got.
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