Wentz Weekly Insights
Inflation Is Everywhere
Last week was a fairly uneventful and quiet week until Friday’s inflation report before the market opened. The consumer price index (CPI) showed consumer prices increased 1.0% in May and are now 8.6% higher from a year ago, the highest in over 40 years. The problem is inflation is not just confined to temporary factors like supply chain issues or higher energy prices, it is broad-based. In May, every major category in the CPI saw an increase.
May’s increase was again driven by a 3.9% increase in gasoline but is now starting to see food prices accelerate. Food rose 1.2% in the month, most of the increase came from dairy products which rose at the highest monthly rate in over 15 years. Going forward food prices remain an upside risk for inflation as the crop season is still threatened by the war in Ukraine. And without energy reform, it is becoming more apparent inflation cannot be substantially reduced.
Core prices, which exclude those categories that sometimes rise due to temporary factors and that are more volatile like food and energy, rose a more than expected 0.6% in May and are up 6.0% from a year ago. Prices on categories that tend to be “sticky” or that experience more persistent price increases have accelerated in recent months and, along with energy prices, pose one of the biggest concerns. Shelter, which makes up over 30% of the index and includes housing rents and rental value of owner-occupied homes, rose 0.6% in May for a 7.2% annualized pace. Home prices are still up over 20%, so this category has some room to make up and could be a driver of inflation even if energy and food prices slow. Prices for vehicles have reaccelerated, with new cars 12.6% and used cars 16.1% more expensive than a year ago.
Yes, goods prices could probably be peaking, and we are seeing signs such as Target lowering prices to remove excess inventories, but stickier prices are starting to pick up pace as we just mentioned and goods prices make up a small portion of overall inflation with services now making up more. Prices for services have begun accelerating as the economy continues its shift to service-based spending, and away from the stimulus-driven goods spending. Airline fares continue to tick higher, now up 38% from last year, while transportation services like car rentals are up 12% and hotels up 22.2% from a year ago. You pick the area, inflation is higher.
After the data release, stocks immediately moved lower while bond yields moved higher after throwing out the “peak inflation” narrative and pricing in a better chance of higher rates. Markets interpreted the report as the Fed needing to be more aggressive to attack higher inflation. Investors are still expecting a 50 basis point increase in the Fed Funds rate at this week’s FOMC meeting which concludes Wednesday with a policy announcement at 2:00 pm, followed by Chairman Powell’s press conference. But after the inflation report, the expectation for a 75 basis point hike has increased, which now stands at about a 25% chance. However, this will likely not happen as Powell dismissed this when asked at the previous meeting and Powell prefers to be transparent and signal what the Fed will do well before it does it. Either way, our focus will be on what Fed officials’ new projections look like along with what Powell will say about future moves and its willingness for larger moves.
As of now, the economy still appears to be on solid footing, driven by the continued strong labor market. That is showing very early signs of cracks though – a number of companies announced hiring freezes and layoffs, and unemployment claims ticked higher in the latest week. Given the current environment and uncertainties, our base case is we will experience a technical recession in 2023, but one that will not be deep or long-lasting. As such, and with the number of uncertainties investors face today, we still favor defensive investments. Dividend reinvestments and dollar cost average also work well in this environment as each purchase is made while the markets are 20-25% off recent highs.
Week in Review:
Positive news out of China on the Covid front as Beijing made moves to ease restrictions, in addition to reports its government ended the probe into Didi, helped global markets move higher to open the week. Outside of those headlines it was an uneventful day with US markets little changed, but bond yields moved higher with the 10-year Treasury yield back over 3% for the first time in several weeks. The S&P 500 finished positive by 0.31%.
Markets got off to a lower start on Tuesday after Target warned it will see a lower margin this quarter as it is forced to mark down items in effort to reduce its excess inventory. But stocks reversed losses and ended up moving higher on another low volume day (about 25% below the recent average) in another uneventful session. The S&P 500 closed higher by 0.95% while small caps outperformed with the Russell 2000 gaining 1.47%. Later in the day the World Bank updated its global growth forecast, now expecting growth of 2.9%, down from 4.1% in its January estimate while warning the risk of stagflation is rising. In addition, the Atlanta Fed GDPNow is modeling Q2 U.S. growth of 0.9%, down from its last estimate of 1.3%.
The lack of conviction in stocks continued Wednesday with stocks opening lower but moving into the green shortly after the open. It was a quieter day, with several company specific headlines but no market moving headlines. Despite stocks moving higher after the open, it was short lived as markets reversed and moved lower, finishing the day down 1.08%.
A wave of headlines out of China resulted in back and forth trading before markets opened Thursday. A Bloomberg and Retuers report indicated China’s regulators were considering letting Ant Group’s IPO move forward (expected to be one of the largest in the world), signaling its willingness to ease the crackdown on internet companies, but later China denied such report. Premier Li reiterated support for the economy, while exports and imports rose much more than expected. However, its zero Covid policy sent Shanghai residents back into a lockdown for mass testing, while Beijing closed entertainment venues in one of its districts after a new cluster was found. In the US, jobless claims rose to the highest level since January, sparking concerns after recent company announcements of hiring freezes. Stocks opened slightly lower and traded at that level most of the day. It was not until the last two hours of trading that stock fell sharply and ended down 2.38%.
The whole week was about Friday morning’s inflation report, and it was worse than feared, causing a broad market selloff. The consumer price index showed consumer prices rose 1.0% in May while 8.6% higher than the same period a year prior, the highest since 1981. There was a bit of company news overnight as well including several larger firms announcing a pause to hiring and several high profile analyst downgrades. To make matters worse, the mid-month read on consumer sentiment fell to the lowest reading on record, with data going back to 1978, and inflation expectations increasing. The inflation report also caused bond yields to rise, resulting in another down week for bonds. The S&P 500 fell 2.91% while the NASDAQ fell the most, down 3.52% as the 10-year yield rose to 3.16%.
For the week oil traded in a tighter range, only rising 1.5% for the week. Bonds sold off as yields rose and the curve inverted again, with the 10-year Treasury yield rising from 2.96% to 3.16%. The major US indices finished as follows (including the 11th weekly decline out of the last 12 for the Dow, the first time since the Great Depression): Russell 2000 -4.40%, Dow -4.58%, S&P 500 -5.05%, NASDAQ -5.60%.
Recent Economic Data
- The trade deficit narrowed a little more than expected but still remains much wider than pre-pandemic levels as the U.S. imported $87.1 billion more than it exported in April, down from a deficit of $107.7 billion in March (a record high). Imports saw a large decline, down 3.4% to $339.7 billion while exports rose 3.5% to $252.6 billion. Year-to-date exports are 18.8% higher and imports are 24.3% higher than a year ago.
- Consumer credit grew by $38.1 billion in April, or about 0.8% and again above expectations (of $35 billion) to $4.567 trillion, but below March’s massive increase of $52.3 billion. Revolving credit (credit cards) grew $17.8 billion, or 1.6%, while non-revolving grew $20.3 billion, or 0.6%. Revolving credit is now 13.7% higher than the pandemic low set in January 2021.
- Jobless claims rose 27k to 229,000 for the week ended June 4, for the highest levels since January. The four-week average moved 8k higher to 215,000. Continuing claims were 1.306 million, unchanged from the prior week, with the four-week average at 1.317 million, for another new 52-year low. While this is the highest level since January, initial claims are still historically low.
- The mid-month read on consumer sentiment was much weaker than expected with the index level at 50.2 versus expectations of 58.5 and down from 58.4 in May, for the lowest sentiment reading on record going back to 1978 (also coincides with the last period inflation was as high as it is now). The current situations index fell to 55.4 from 63.3 while the index on expectations fell to 46.8 from 55.2. Inflation expectations rose to 5.4% from 5.3% in May.
- Consumer prices rose a more than expected 1.0% in May, according to the Consumer Price Index. Expectations were for a 0.7% increase. Core prices, which exclude the food and energy categories, rose 0.6%, also above expectations. Compared to a year ago prices are up 8.6%, accelerating from April’s y/y rate of 8.2%, for a new four-decade high, while core prices were up 6.0%. The increase was broad-based with no major categories seeing a decline – food rose 1.2%, gas rose 4.1%, used vehicles up 1.8%, apparel up 0.7%, transportation services up 1.3%, airline fares up 12.6% (after a 19% increase in April, now 38% higher from a year ago), and shelter was up 0.6%. Food is 10.1% higher than a year ago, the first reading above 10% since 1981, while energy is up 35%, including a 49% increase in gas. This report suggests there are zero signs inflation is easing – many categories are accelerating, including food and more sticky categories like shelter, which is up 5.5% from a year ago.
- Target warned it will see operating margins fall in the current quarter to 2%, versus the consensus of 6.5%, before moving back toward 6% in the second half of the year. The main reason is discounts it needs to apply to excess inventory as it said will take a series of actions to reduce its excess inventory including additional markdowns along with investing in its supply chain to address high transportation and fuel costs.
- Elon Musk accused Twitter of withholding data on fake accounts and said it materially breached its obligations under the merger agreement over Musk’s request for more information about spam and fake accounts. Twitter said it plans to enforce the merger agreement upon its terms but also agreed to share its data on spam and fake accounts.
- Apple hosted its Worldwide Developers Conference where it revealed new models of its MacBook that will use its new M2 processor, updates to its iOS operating system, and new payment features through the Apple Wallet including a buy now pay later option.
- After potential buyers submitted final proposals, Kohl’s entered exclusive talks with Franchise Group for a potential sale, one that is reported to be $60/share.
- Roku made a move higher last week after the Business Insider posted an article saying that employees are talking internally about a potential acquisition by Netflix.
- Scotts Miracle-Gro updated its guidance by cutting its earnings forecast by over 30%. It also said it expects slower sales, mainly from its Hawthorne division, and as retailers’ replenishment orders in May were more than $300 million below expectations in the U.S. consumer segment.
- The supply-demand imbalance in the oil market shows no end in sight. Despite OPEC+ increasing production targets, UAE’s energy minister said OPEC’s efforts to increase output are not encouraging as the group is 2.6 million barrels per day (bbl/day) short of its target. For reference, global demand is around 100 million bbl/day. U.S. producers remain reluctant on pumping more due to difficulties around getting permits, supply constraints, the high costs and time it takes to ramp up production, and because of their focus on capital return to shareholders rather than pumping due to fears of huge losses during the next downturn, like what was seen in the previous downturn several years ago. U.S. production of approximately 11.6 million bbl/day remains well below the previous peak of about 13 million bbl/day.
- In global central bank news, the Reserve Bank of Australia last week raised its policy rate by 50 basis points, a bigger increase than what was expected, and gave a more hawkish tone in its policy statement. The European Central Bank announced an end to its quantitative easing program on July 1 and said it intends to raise its policy rate at its next meeting (July 21) for the first time in over a decade. It will continue to reinvest maturing securities to maintain ample liquidity conditions. The policy statement indicated a larger increase (50 basis point increase) in the September meeting could be appropriate. There was speculation of a new policy tool as well, but the statement mentioned nothing about it. The central bank increased its inflation forecast as well.
- China has shown no intent to ending its zero Covid policy, announcing more lockdowns in Shanghai after a cluster was found, and additional restrictions in Beijing, days after relaxing restrictions. Separately, investors were encouraged after several reports the government is considering relaxing its crackdown on the tech sector and finding more ways to support its economy. The government and regulators last week indicated it will be ending its probe into ride-sharing firm Didi, considering letting Ant Group IPO, approving a second group of licenses for video games (after halting new licenses), and Premier Li’s comments on providing maximum policy support.
- The Atlanta Fed GDPNow is modeling Q2 U.S. growth of 0.9%, down from its last estimate of 1.3%. The model uses recent economic data and updates as new data is released. The estimate is creeping closer to negative territory, and if so would make it two consecutive quarters of declining growth. Although this is from temporary factors like high imports and a slowdown in inventory growth.
- After the trading frenzy in popular “meme stocks” a little over a year ago, the Securities and Exchange Commission said it is preparing for a change in stock market rules around best execution requirements that would make trading firms directly compete to execute trades from retail investors. Speculation is the SEC is considering an auction system to improve execution transparency and lower fees. Currently, brokers earn money by sending retail orders to wholesalers, also known as payment for order flow (PFOF). Also under consideration is allowing exchanges to quote shares in increments under one cent, which would be another hit to wholesalers and create increased competition for trades. The change in PFOF would be a hit to no-fee brokerage firms like Charles Schwab and Fidelity, who charge no commission on certain trades.
Did You Know…?
Many companies have made comments on the strength of the dollar and how it is impacting their financials in recent earnings reports and company updates. For global businesses, when the dollar rises in value those goods exported become more expensive to foreign buyers. The dollar index opened June at 101.96, well above its 30-year average of 91.43, and compares to pre-pandemic levels of around 98. Many different factors influence the value of the dollar including trade and geopolitics, but the main culprit for the strength this year has been the Federal Reserve tightening policy.
The Week Ahead
The earnings calendar will be quiet again this week, the economic calendar has several notable reports, while all eyes will be on the Federal Open Market Committee’s policy meeting. Notable earnings released this week will include Oracle on Monday, and Kroger and Adobe on Thursday. It will be another busy week of corporate events with many investor conferences and analyst/shareholder meetings. The economic calendar begins with the producer price index on Tuesday where, after seeing the CPI report last Friday, estimates moved up to a 0.8% monthly and 11.0% year-over-year increase. Then Wednesday will see retail sales where sales are expected to have slowed in May, followed by the Empire State Manufacturing survey results, import and export prices, business inventories, and the housing market index. Thursday’s reports include jobless claims, housing starts and permits, and the Philly Fed manufacturing survey. Then, on Friday industrial production for May is released. The Fed’s policy meeting wraps up on Wednesday with an announcement at 2:00 pm where a 50 basis point increase in rates is expected, along with an update on its economic projections and its “dot plot” (where Fed members expect rates in the short- and medium-term future), and Chairman Powell’s press conference shortly after. We will be looking for cues on future rate moves, where the market has gradually priced in more increases.