On the heels of a huge month for stocks in October, the bull continued to soar in November, as the S&P 500 had its best week since June and the NASDAQ had its best week since March. Sparking much of the rally was news that inflation has likely peaked and is finally slowing. We’ll discuss that more below, but the bottom line is this could be a major catalyst for a continuation of the rally. We noted recently that many bear markets have ended in October, and we continue to think the odds are above average that it happened once again.
- Better-than-expected inflation data opened the door to more dovish monetary policy from the Federal Reserve.
- Goods deflation buys time for services to ease, especially rents.
- Stocks had a huge week on the back of softer inflation, even as crypto currencies imploded.
- Midterm election results surprised, and the results are still uncertain.
- Monetary policy remains the overarching concern.
Stocks have risen consistently during the six-month period from November through April of a midterm year, going back to World War II. One year after the midterm election, the market has also been higher every time. Conditions aren’t perfect, and we are aware of the many worries, including the fact that we don’t know who will control the House of Representatives yet.
But the stock market is a discounting machine, and it has priced in a lot of bad news. Should we get any more good news on inflation, the war in Ukraine, or the economy, the rally could have plenty of legs left.
A Very Encouraging Inflation Report, Including Goods Deflation (Finally)
The October inflation report was probably the best one we’ve seen in about 15 months, especially because it contained so many encouraging signs. Let’s walk through it.
Headline inflation rose 0.4% in October, as expected. Core inflation, which strips out volatile food/energy prices, and is arguably more important for the Fed, surprised. It rose 0.3% in October, below expectations for a 0.5% jump. This was the lowest monthly increase since September 2021.
Headline inflation is up 7.8% over the past year. That’s high, but it has come down from 9.1% in June. The deceleration stems largely from falling energy prices. As the chart below shows, the lighter red bars have accounted for a smaller portion of inflation over the past few months.
The chart also shows that food prices (dark red bars) continue to account for a large chunk of inflation. But we got a break here as well. “Food at home,” i.e., groceries, which make up close to 9% of the inflation basket, rose just 0.4% in October. That’s the lowest in more than a year and well below the average 0.7% monthly increase that occurred over the first nine months of 2022.
The Goods Deflation We’ve Been Waiting For
Private inflation data has shown decelerating prices for goods outside of energy and food. At Carson, our chief market strategist, Ryan Detrick, wrote recently about collapsing used car prices. Retailers have been telling us for a while that they’re discounting items as well. We’ve just been waiting for the official inflation data to catch up, and it looks like that’s finally happening.
A broad list of goods, including used cars, saw prices fall in October, which is what makes it even more encouraging. The items below make up about 11% of the inflation basket (and 14% of the core basket). Falling household goods prices probably reflect the slowdown in residential activity, as home sales collapse amid higher mortgage rates.
Are Rents Breaking?
The best part about goods deflation is it offsets high services inflation. As the chart below shows, vehicles (blue bars) are now below the zero line for the second month in a row. We also got good news in the form of medical care services, which was a function of falling health insurance premiums.
The largest sector of the inflation basket is shelter, including rents on primary residences and “Owners’ Equivalent Rent” (OER), which is the “implied rent” that owner-occupants would have to pay if they were renting their homes. The latter is also determined using rents of equivalent homes. In other words, OER is effectively a measure of rents, and altogether rents make up a whopping 40% of the core inflation basket.
Rents have been rising, putting a lot of upward pressure on core inflation. As shown in the previous chart, housing (gray bars) grew larger and larger over the past year.
However, market rents have decelerated quite rapidly over the last few months. The problem is this movement hasn’t shown up in the official inflation data because of methodological reasons (we wrote about this quite extensively).
But the official rental data may be beginning to turn. Rent of primary residences rose 0.7%, and OER rose 0.6% in October. These are smaller increases than what we’ve seen over the previous couple of months. Make no mistake, a 0.7% rise is still a lot — it translates to an annualized pace of 9%, which is why the Fed is really worried about it. But hopefully the October report is a sign that the official data is beginning to turn lower.
A Soft Inflation Print Acts as a Pressure Release Valve
The softer-than-expected core inflation print was the catalyst for the S&P 500 Index gaining 5.5% on the day the inflation report was released, marking its best day since April 2020. The chart below shows some historical perspective for days that saw more than 5% gains. One year later, markets were up 91% of the time, with an average return of almost 28%.
The market’s response shows how much negativity and expected hawkishness from the Fed has been priced in. A soft report was like a pressure release valve.
We Need Time, and the Inflation Data Bought Us Time
One month does not make a trend, but the October inflation report was still very positive. Several leading indicators have shown decelerating prices. (We’ve written about this here and here.) The official data is clearly lagging, but the timing of the inflection point was uncertain. And it looks like we may have just gotten it.
This report is important for two main reasons:
Firstly, the goods deflation in October offset the upward pressure from strong price increases in services, which is primarily rents. It effectively buys time for official rental data to catch up to the private data, which are showing a rapid decline in rents.
Two, it buys time for the Fed. If this was yet another hot inflation print, that would have put enormous pressure on the Fed to go for a 75 bps (0.75%) increase in December. But now it looks like a 50 bps increase is the most likely scenario, assuming the November CPI report doesn’t surprise us by coming in hot. Investor expectations have shifted significantly. The probability of a 50 bps hike has gone from a near coin flip (57%) to 85%.
An interesting point Fed Chair Jerome Powell made a couple of weeks ago was that improved inflation data is not a precondition for slowing the pace of rate hikes. Instead, it’s the terminal rate that matters. The terminal rate is the highest rate the Fed will hike up to this cycle, and at the September meeting, Fed members released projections estimating it to be around 4.6%. Markets have expected this number to move close to 5% when the Fed releases new projections at its December meeting. If the October inflation numbers had come in hot, there would have been a lot of pressure on Fed officials to take the terminal rate projection well above 5%. But this report eases that pressure, and investors are currently looking at a terminal rate just shy of 5%.
We also saw a marked downshift in policy rate expectations one to three years from now. That makes sense. If inflation decelerates quickly, then rates don’t have to be as high as previously expected. Of course, a lot will happen between now and then. This is why we focus on the near term as far as investor expectations and Fed projections go. They can change significantly.
Last week was a big one with some major events, including the midterm elections and the crypto mess. But we were once again reminded that the overarching concerns right now are the Fed’s next steps, and for that, look to inflation.
This newsletter was written and produced by CWM, LLC. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The views stated in this letter are not necessarily the opinion of any other named entity and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
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Market Commentary: A Big Bounce