Three straight days of better-than-expected inflation data fueled a strong rally in stocks and bonds last week. The party got started on Tuesday, when CPI for October showed sequential deceleration and came in lower than consensus across the board:
* Headline CPI was flat m/m and +3.2% y/y (prior = +0.4% m/m and +3.7% y/y )
* Core CPI was +0.2% m/m and +4.0% y/y (prior = +0.3% m/m and +4.1% y/y)
Then on Wednesday, the Producer Price Index (PPI) also cooled by more than expected in October, with Headline PPI seeing outright sequential deflation at -0.5% m/m while the y/y figure fell to just +1.3%. Excluding food & energy, Core PPI was flat sequentially and fell to +2.4% y/y.
And finally on Thursday, trade prices remained firmly in deflation territory, adding some downward pressure on goods prices for the US consumer. Import prices printed at -0.8% m/m in October and dropped to -2.0% y/y, while export prices were -1.1% m/m and fell to -4.9% y/y. Outright deflation in trade prices is not entirely uncommon and does not indicate an overall deflationary environment, but is nevertheless a helpful contributor to the general disinflationary trend.
The response from investors was enthusiastic. Yields moved lower by 15-20 basis points across the Treasury curve, and all probability of another 25bp rate hike this year or next year was removed from futures markets. Meanwhile, the rally in stocks was strongest in parts of the market that have been unloved this year, including so-called “bond substitutes” like real estate and utilities on a yield-driven relative value trade, as well as US small caps which were up 5+% on Tuesday alone.
Albion’s “Four Pillars”:
Economy & Earnings
The US economy has shown resilience so far in 2023, and Wall Street analysts expect full-year corporate earnings to be roughly flat y/y. Albion’s base case expectation is that the US economy will enter recession in late 2023 / early 2024, putting downside pressure on earnings.
The S&P 500’s forward P/E of 18.6x is above the long run average, so valuation could be a headwind to future returns. More predictive metrics like CAPE, Tobin’s Q, and the Buffett Indicator (Eq Mkt Cap / GDP) suggest that compound annual returns over the next decade are likely to be in the mid single digits.
Rates rose dramatically in 2022 due to a sharp pivot in monetary policy, and have remained elevated in 2023 as the Fed remains committed to fighting inflation. Futures markets imply zero odds of another 25bp rate hike, and that the Fed will begin cutting rates in mid-2024.
After reaching 40yr highs in spring of 2022, inflation has moderated somewhat over the past 18 months. Goods inflation has fallen due to softening demand and excess inventory, while services inflation remains elevated, in part due to shelter costs which are somewhat lagged.