The dominant market related story at the beginning of 2023 was inflation, how bad it was, and how high it was going. While things haven’t done a complete 180, the narrative is now focusing on disinflation – how much will the rate of change in inflation slow in the months to come. There was even mention of deflation this week (more below).
This change of heart was reinforced by this week’s release of both the consumer (CPI) and producer (PPI) price reports. Consumer prices overall were unchanged in October and the year-over-year rate of slowed to +3.2%. So-called core prices, which exclude food and energy, rose a modest +0.2% in October from the prior month and increased +4% from a year earlier, the smallest annual change since September 2021.
It's evident from the chart above that the rate of change is slowing (disinflation), but housing costs are still boosting the inflation numbers. If you exclude the so-called shelter component in the inflation calculation, overall and core inflation are up just +1.5% and +2.0% respectively year-over-year, as you can see below.
On this measure inflation is back to where it was before the pandemic, but of course this number seems like only looking at inflation excluding the bad stuff.
But it’s a good bet that shelter inflation is headed lower in the months to come. As you can see below, actual rental prices are down year-over-year while the shelter calculation hasn’t caught up with reality yet.
There are also hints of disinflation in the latest corporate earnings announcements. For example, take Walmart:
Deflation? That’s very 2011!!!
The market’s certainly responded well to the disinflation theme. Stocks have rallied, bond yields declined, and investors are placing bets that the Fed will be cutting rates next year. Yes, these are the same investors that were betting on a rate hike only a few short weeks ago, but such is the way of the markets.
And yes, it is a bit crazy how quickly expectations can swing around. But the bet on rate cuts isn’t totally irrational if you think disinflation persists. The chart below shows the fed funds rate minus inflation. Specifically:
Latest Fed Funds rate = 5.25%
Headline inflation (October) = 3.2%
Different = +2.05%
The higher the number the more restrictive policy is viewed to be. On this measure you’d say things are moderately restrictive, but not unusually so. However, if inflation falls to 2% next year, the real fed funds rate will then stand at 3.25% - now this is getting to the high range of normal (whatever normal is over such a long period!!). Now say this happens at the same time that weekly jobless claims are increasing and we have a couple negative payrolls numbers.
A fed cut under this scenario wouldn’t be out of the question at all. Time will tell.
(Other) Charts We Found Interesting
- The Biden-Xi meeting wasn't the big China news this week. Taiwan's two main opposition parties, the pro-China Kuomintang (China Nationalist Party) and the upstart Taiwan People’s Party, agreed to run on a combined ticket. Together the KMT+TPP would likely defeat the ruling pro-independence Democratic People’s Party in the Presidential election on January 13. Such a result would please Beijing and possibly defuse China-Taiwan tensions.
- This chart shows direct investment into China from outside the country. An amazing turnaround in a short period of time.
- European GDP per person relative to the U.S. Heading in the wrong direction for Europe.
- An estimate of political advertising spending in key swing states next year. That’s a depressing chart regardless of your affiliation.
- There’s always a bull market someone – beef edition.
- The United States is on the threshold of not growing.
- I had to do the math on this because my initial reaction was ‘there’s no way!!!’ I can neither confirm nor deny that swear words might have followed the calculations.
Have a good weekend
Chief Investment Officer
Gemmer Asset Management LLC
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