Headline CPI drops but “core” inflation rises … what history tells us about rate pauses versus rate cuts … the bet that investors are making by buying today … the case for “this time is different”
This morning’s inflation data brought good and less-good news.
On the “good,” side, the headline Consumer Price Index (CPI) number came in at an increase of only 0.1% month-to-month, and 5% year-over-year. This was below Dow Jones estimates of 0.2% and 5.1%, respectively.
Here’s legendary investor Louis Navellier from this morning’s Special Market Update Podcast from Platinum Growth Club:
…When we look at the CPI, the headline is great. We went from a 6% annual pace to a 5% annual pace… So, the overall headline number was great.
But as we alluded to a moment ago, there was also “less-good” news.
“Core” inflation, which the Fed prefers as it strips out volatile food and energy prices, actually reversed its downward trend and climbed.
It matched expectations, coming in at gains of 0.4% month-over-month and 5.6% on the year. Louis called this a “stubbornly high” number, going on to say “I don’t like these details.”
Housing costs, which make up the largest component of the CPI, finally began to crack. The month-over-month increase came in at 0.6%, which was the lowest reading since November. However, on a 12-month-basis, prices still rose 8.2%.
Putting it all together, while broadly encouraging, this isn’t a slam-dunk “inflation is done” report that gives the Fed loads of breathing room to stop hiking rates. While CPI continues to cool, this 5% reading remains 2.5X the Fed’s goal of 2% inflation. Meanwhile, with core CPI now rising and shelter costs still north of 8%, the Fed’s oft-repeated mantra of “more work to do” sounds accurate.
The market seems to agree. The CME Group’s FedWatch Tool shows traders are putting 71.5% odds on another quarter-point rate-hike in May. And as to stocks, as I write mid-afternoon, the major indexes have been alternating between gains and losses as they digest the news.
How will today’s news impact the timing of a Fed pause, Fed cuts, and a stock market explosion?
Let’s begin by reminding ourselves of the following reality…
While Wall Street and the economy are interrelated, they operate on different timetables.
For example, in the long-run, Wall Street’s performance is based on earnings, which reflect the condition of the broader economy. So, Wall Street and the economy sync up.
However, in the shorter-term, Wall Street always looks ahead and tries to position itself for what’s six-to-12 months down the road. As a result, it’s not at all uncommon to see a divergence between Wall Street performance and broader economic conditions.
With this divergence in mind, let’s consider the impact of a Fed pause on Wall Street and the economy.
For the economy, a pause is of limited value. It doesn’t necessarily help conditions; it mostly stops them from growing worse. For example, high interest rates continue to choke out business growth, even if those interest rates are no longer climbing.
But for Wall Street, which always looks ahead at what’s coming, a pause is like a starting gun indicating that a market regime change is coming – even though economic conditions aren’t likely to get better anytime soon.
Here’s Bloomberg with the bullish statistics surrounding a Fed pause:
In post-pause data going back to the early 1980s, the S&P 500 Index has posted an average return of 6.9% after three months; 18.9% after a year; and 34.7% after two years.
That’s much better than the index’s 11.1% compound annual return over the past four decades and indicates why investors may be inclined to maintain equity exposure despite recent banking sector jitters.
Today, according to the CME Group, traders put 67% odds on the Fed pausing rates in June.
So, even though the economy might be getting worse, Wall Street appears poised to climb based on how close the Fed is to a pause.
We have to address the unspoken assumption that comes with a rate pause
For the stock market, a Fed pause isn’t the big win. It’s what the pause represents – rate-cuts that will be coming soon.
Bulls have good reason to believe this.
Since 1957, the length of time between the Fed ending rate hikes and then cutting rates measures an average of just 3.4 months.
So, if we go by averages, yes, buying at a Fed “pause” makes sense because you’d be front-running actual rate cuts.
And just to cover all our bases, here’s why rate-cuts help stocks:
One, lower rates goose price-to-earnings multiples. That’s because analysts will use a lower risk-free rate in their valuation models that (glossing over the math to make it simple) increases stock valuations.
Two, lower rates will increase the attractiveness of stocks by decreasing the attractiveness of fixed-income securities and high-yield savings accounts that look mighty good right now. Today, these attractive alternatives are siphoning money out of the stock market.
So, lower rates are a win/win for stock investors.
But let’s call out the obvious…
A rate pause must turn into a rate cut, or else front-running investors will find themselves running off a cliff.
What happens if the Fed cut doesn’t materialize?
Here’s the hypothetical…
The Fed pauses. You assume the Fed will follow the historical average and cut rates in a few months, so you cannonball back into the market.
But then the unthinkable happens…
The Fed does not cut rates. It simply holds them at elevated levels. This continues to choke out the economy.
All of a sudden, it’s Q4 2023 or Q1 2024 and the earnings performance of your stocks is terrible because it reflects a kneecapped economy crippled by rates that never dropped.
Your stocks nosedive as Wall Street is forced to come to terms with the longer-term impact of high rates.
Why might this happen?
Well, for one, Federal Reserve Chairman Jerome Powell and every other Fed president has said there won’t be any cuts this year.
Now, we can brush this off as simply a poker face. But if we do that, let’s do so with a full awareness of “what’s different” about today.
Here’s Bloomberg spelling it out:
Unlike most other recent hiking cycles, this would-be pause comes against a backdrop of rare high inflation.
The last time the Fed paused amid such concerning core PCE numbers was 1989 — then as now, the index was up 4.7% year-over-year — and there’s only one other example of a pause with the policy rate being so low on a real basis (2018).
So even if the pause has arrived, policymakers might have to stay at this level for the foreseeable future to ensure that they don’t drop the ball on their inflation mandate.
It’s hard to get excited about the end of the hiking cycle if cuts don’t follow soon afterward.
That final sentence is what we’ve been saying here in the Digest for months. A rate pause itself does nothing unless there’s follow-through from the Fed with cuts.
We’ve been skeptical that “this time” conditions support a fast transition to rate cuts…which means leaping back into the market could be premature.
As to what else is different about this time, there’s earnings
As we noted in yesterday’s Digest, we’re heading into an earnings season in which analysts have been slashing their estimates.
If estimates play out as expected, we’ll see the largest earnings decline since the pandemic, coming in at -6.8%.
With this context, let’s go back to Bloomberg:
…The S&P 500 is already in an earnings recession that some strategists expect to deepen further.
With the flood of government stimulus and unusual shift in consumption habits during the Covid-19 pandemic, many companies posted unsustainably strong earnings, and recent quarters were always going to appear weak by comparison.
Add to that the blow of the Fed’s unprecedentedly fast policy tightening, and it’s easy to see why the earnings picture could deteriorate more quickly than normal.
Bottom-up Wall Street estimates still suggest that earnings could bounce back in the second half of the year, but the optimism has been waning quickly, and the pace of revisions is often more telling than the forecasts themselves.
Front-running the stock market today as earnings crumble could be quite painful later in the year if there’s a reckoning between bid-up stock prices and lower earnings.
Of course, if earnings can eke out a win regardless and stay healthy enough until the Fed does cut rates (the “soft landing” hypothetical), then buying at the pause could turn out to be a moneymaking move.
Any way you look at it, the key variable here is the Fed and the domino effect of its interest rate policy
We could write an entire Digest on whether it should be this way. It can be frustrating that a handful of bankers and academics wield so much power over your portfolio. But for now, it is what it is.
At least we know the bet we’re making today…
Do you buy at the pause in expectation of the Fed cutting rates a few months from now as has been the historical average?
Or do you wait, because today’s economic/inflation backdrop and Fed-tone are different, and “higher for longer” will win the day?
While this is a binary question, perhaps you’ll be best served by refusing a binary answer.
Remember, you don’t have to be “all in” or “all out” of the market. Dialing up or down your exposure is a reasonable, wise way to remain in the market if the Fed turns dovish, yet being able to sleep well at night if the Fed remains hawkish.
We’ll end with Bloomberg, which wraps up this discussion rather nicely:
…As the Fed finally winds down its rate-increase campaign, one thing is clear:
This is anything but a typical market, and investors would be reckless to bet on an average outcome.
