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Quantifying Why the Fed Is Wrong On Its Outlook For Inflation

Takeaway: The Fed is conflating what we view as a short-lived trough in reported inflation with a sustainable bottom in structural inflation trends.

This morning we received the NOV CPI report from the BLS; the big-picture takeaways are as follows:

 

  • Headline CPI came in at +0.5% YoY and is now accelerating on a sequential, trending and quarterly average basis; +0.5% represents the fastest YoY rate of change since DEC ’14.
  • Core CPI (i.e. excluding food and energy) came in at +2.0% YoY and is now accelerating on a sequential, trending and quarterly average basis; +2.0% represents the fastest YoY rate of change since FEB ’13.
  • Within Core CPI, the divergence between Goods and Services Inflation remains ongoing:
    • Core Goods Inflation accelerated +10bps to -0.6% YoY in NOV, but is still decelerating on a trending and quarterly average basis.
    • Core Services Inflation also accelerated +10bps in NOV and is accelerating on a sequential, trending and quarterly average basis. The current +2.9% YoY rate of change represents the fastest rate of Core Services Inflation since NOV ’08.
  • The strength in the U.S. dollar (up +10.9% YoY on a trade-weighted basis) continues to perpetuate the considerable divergence between Goods and Services Inflation, with Import Prices contracting -9.4% YoY in NOV.
    • Absent a material rip higher in the USD over the next few months, Import Price trends should continue their trending acceleration back towards 0% over the next couple of quarters in light of the dollar’s steep base effects.

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CORE CPI

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CORE GOODS CPI

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CORE SERVICES CPI

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - Trade Weighted U.S. Dollar Index YoY   Change

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - IMPORT PRICES

What does this all mean for the U.S. consumer? For one, the pickup in Headline CPI in conjunction with the deceleration in Average Hourly Earnings means Real Wage Growth slowed to +1.6% YoY in NOV, which represents the slowest rate of change since NOV ’14. Moreover, Real Wage growth is now decelerating on a sequential, trending and quarterly average basis.

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - REAL WAGES

 

Thinking about CPI trends in the context of what the U.S. consumer is forced to spend money on just to survive, the Inflation Rate of “Everyday Essentials” remains rather muted at +0.2% YoY, but is now decidedly accelerating on a sequential basis and back above its TTM average for the first time since OCT ’14. As we’ve often said, everything that matters in Macro occurs on the margin.

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI ESSENTIALS

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI ESSENTIALS PLOT

 

It’s worth noting that the aforementioned +0.2% YoY figure is simply the weighted average inflation rate of the following CPI indices, scaled according to their respective shares of Aggregate PCE per the 2014 BLS Consumer Expenditure Survey (weights in brackets):

 

  • Rent (19.6% of Aggregate PCE; 37.6% of our proprietary “Essentials” Basket) Inflation decelerated sequentially to +3.19% YoY in NOV;
  • Food (12.6% of Aggregate PCE; 24.2% of our proprietary “Essentials” Basket) Inflation decelerated sequentially to +1.27% YoY;
  • Healthcare (8% of Aggregate PCE; 15.4% of our proprietary “Essentials” Basket) Inflation accelerated sequentially to +3.08% YoY;
  • Utilities (7.3% of Aggregate PCE; 14.0% of our proprietary “Essentials” Basket) Inflation accelerated sequentially to +2.64%; and
  • Gasoline (4.6% of Aggregate PCE; 8.8% of our proprietary “Essentials” Baskets) Inflation accelerated sequentially to -24.08% YoY.

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI RENT

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI FOOD

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI MEDICAL SERVICES

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI UTILITIES

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI GASOLINE

 

Looking ahead, it’s worth stressing that the next four quarters of base effects for Real PCE growth are the toughest since the four-quarters ending in 3Q08 and the next four quarters of base effects for Headline CPI are the weakest since the four quarters ended in 4Q11. Recall that Real PCE growth decelerated sharply from +2.7% YoY in AUG ’07 to -1.2% in SEP ’08 and Headline CPI recorded a massive acceleration from +1.1% YoY in NOV ’10 to +3.9% in SEP ’11.

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - Real PCE Comps Chart

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CPI COMPS

 

While base effects for Real GDP recede ever-so-slightly in 1Q16 – effectively implying the domestic industrial recession may bottom here in 4Q16 absent incremental #StrongDollar #Deflation – a continuation of the trending deceleration in Real PCE growth makes its appropriate to forecast a continuation of the marginal stagflation that is #Quad3 through 1Q16 – especially in the context of our #SecularStagnation and #LateCycle themes. Moreover, a return to #Quad4 by 2Q16 is equally as likely per our model.

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - UNITED STATES

 

Even still, it would behoove us to point out that the lack of sequential momentum in the series implies a rather muted acceleration in Headline CPI over the intermediate term. Moreover, the tight relationship between Headline CPI and the YoY rate of change in the CRB Index (r = +0.82 since JAN ’08 and +0.93 on a trailing 3Y basis) would seem to imply the former index is unlikely to sustainably breach +1.5% before returning to persistent disinflation in 1H16.

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - CRB YoY vs. CPI YoY

 

Viewing domestic inflation dynamics through a wider lens, we see that 5Y 5Y-Forward Breakeven Rates have fallen -38bps over the past 6M to 1.7% (-30bps shy of the Fed’s +2% target for Core PCE) despite every benchmark category of high-frequency growth and inflation indicators confirming the aforementioned #Quad3 setup. As such, we continue to signal risk of the Fed tightening monetary policy into an obvious #LateCycle Slowdown. Any investor who does not consider that scenario to be both highly and increasingly probable at this point is being willfully blind to recent developments in the high-yield credit market.

 

Quantifying Why the Fed Is Wrong On Its Outlook For Inflation - U.S. Economic Summary

 

Is the Fed conflating what we view as a short-lived trough in reported inflation with a sustainable bottom in structural inflation trends? We think so.

 

As such, we reiterate the factor exposure recommendations we outlined at the conclusion of our 12/9 Early Look titled, “Conviction Sells” (CLICK HERE to review). The biggest risk to our thesis isn’t whether or not we are “too bearish”, but rather if we are Bearish Enough to the extent a continuation of our G3 policy divergence theme is responsible for perpetuating incremental #Quad4 #Deflation in market price and global growth terms.

 

Please feel free to email us with questions, comments or concerns. Best of luck out there,

 

DD

 

Darius Dale

Director


Cartoon of the Day: Great Expectations?

Cartoon of the Day: Great Expectations? - FED cartoon 12.15.15

 

"... If the Federal Reserve was running a hedge fund, and they’re so convicted in the idea that #Deflation is “transitory” and the US economy isn’t slowing, why not go for the jugular tomorrow and raise rates by 50 basis points," Hedgeye CEO Keith McCullough wrote in today's Early Look.


Whoops! A Look Back At Some of Wall Street’s Worst Predictions This Year

 

On The Macro Show this morning, Hedgeye CEO Keith McCullough and Senior Macro analyst Darius Dale dissect the predictions of Wall Street’s “top investment strategists,” looking at their 2015 year-end S&P 500 and GDP targets. Verdict? Not good. 


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Fed Day Live with Hedgeye CEO Keith McCullough Wednesday at 2:10PM ET

Live & Interactive

CLICK HERE TO WACTH TOMORROW AT 2:10PM ET

 

Fed Day Live with Hedgeye CEO Keith McCullough Wednesday at 2:10PM ET - FedDay

 

Join Hedgeye CEO Keith McCullough and Senior Analyst Darius Dale for in-depth insight Wednesday at 2:10PM ET on Fed Day Live. Keith will deliver real-time analysis following the FOMC decision and take viewer questions during a live Q&A.

 

KEY TOPICS WILL INCLUDE

  • Is the FOMC's announcement the start of a regular tightening cycle or would a Fed hike be 'one-and-done' with future increases dependent on future economic data?
  • Is #Deflation risk truly 'transitory,' as Fed head Janet Yellen recently claimed?
  • What does the Fed's decision mean for the U.S. dollar?

Builder Confidence | Lots, Labor & Yellow Lights

Takeaway: Lots, Labor and Rates drag on Builder Sentiment for a 2nd month. We profile the HMI-Rates connection across prior cycles below.

Our Hedgeye Housing Compendium table (below) aspires to present the state of the housing market in a visually-friendly format that takes about 30 seconds to consume.

 

Builder Confidence | Lots, Labor & Yellow Lights  - Compendium 121515

 

Today's Focus: December NAHB HMI (Builder Confidence Survey)

 

THE DATA: Builder Confidence dropped -1pt in December to an index level of 61 as all regions and all survey indicators declined modestly and labor and lot costs again headlined builder concerns.   The decline in December marks a 2nd month of retreat off the cycle high reading of 65 recorded in October. 

 

Across the sub-indices, Current Sales fell -1pt to 66 while Current Traffic and 6M Expectations declined -2pts to index readings of 46 and 67, respectively. 

 

Geographically, the South was flat sequentially while the West (76) and Northeast (49) declined –1pt and the Midwest lost -5pts.   

 

HMI & RATES | CYCLE CONTEXT:  Yield Spread compression (10Y-2Y) has characterized every post-war tightening cycle with curve flattening discounting lower future growth/inflation.  Mortgage Yield spread compression has displayed a similar pattern although curve flattening has stemmed largely from the rise in the short end outpacing the concomitant shift higher in 30Y mortgage rates.

 

All else equal, higher rates = ↓ affordability = ↓ pricing power for builders.  Empirically, across cycles, builder confidence is negatively correlated with rates with inflections in builder confidence and housing/builder performance occurring alongside changes in the policy rate and flow through shifts in mortgage financing costs.

 

We profiled HMI and builder equity performance across the prior two cycles last month (See: Builder Confidence: Headfake or Harbinger?). 

 

Broadly, the trend in HMI has served as a good lead indicator for housing fundamentals and the broader economy and a decent coincident indicator for housing related equities.  Historically, there have been multiple instances in which HMI weakened for 1 or 2 months only to bounce back.  However, successive months of weakness have generally signaled further, ongoing softening.    

 

YELLOW LIGHTS & DURATION SENSITIVITY:  Given the historical precedent around multi-month softening in sentiment and the apparent certainty of Janet & Co. pursing policy normalization into decelerating growth, we’d take the 2nd month of decline in the HMI as a cautionary signal. 

 

In the nearer-term, both interest rate and market volatility should continue feed investor angst arund interest rate sensitive exposures and higher beta/higher leverage style factors.  Beyond the knee-jerk and shorter-term reactions, we expect a shallow hiking cycle (if any at all) with curve flattening and a modest drift in mortgage rates – similar to the 1988 and 2004 tightening cycles  where rates on 30Y FRM contract largely traded sideways.

 

We show the trend in HMI alongside inflections in policy and 30Y FRM rates across prior cycles in the series of charts below.  

 

Builder Confidence | Lots, Labor & Yellow Lights  - HMI Tech Buble Cycle

 

Builder Confidence | Lots, Labor & Yellow Lights  - HMI Housing Bubble Cycle

 

Builder Confidence | Lots, Labor & Yellow Lights  - 30Y FRM vs Fed Funds

 

Builder Confidence | Lots, Labor & Yellow Lights  - 2004 Cycle

 

Builder Confidence | Lots, Labor & Yellow Lights  - BUilder vs Cons Conf

 

Builder Confidence | Lots, Labor & Yellow Lights  - Yield Spread vs Fed Funds

 

Builder Confidence | Lots, Labor & Yellow Lights  - NAHB LT

 

Builder Confidence | Lots, Labor & Yellow Lights  - NAHB Survey Indicators

 

Builder Confidence | Lots, Labor & Yellow Lights  - NAHB Regional

 

 

 

About the NAHB HMI:

The Housing Market Index (HMI) is based on a monthly survey of NAHB members designed to take the pulse of the single-family housing market. The monthly survey has been conducted for 30 years. The survey asks respondents to rate market conditions for the sale of new homes at the present time and in the next 6 months as well as the traffic of prospective buyers of new homes. The HMI is a weighted average of separate diffusion indices for these three key single-family series. The HMI can range from 0 to 100, where a value over 50 implies conditions are, on average, improving, a value below 50 implies conditions are worsening, and an index value of 50 indicates that the housing market is neither improving nor worsening.

 

 

 

Joshua Steiner, CFA

 

Christian B. Drake

 


DM Asia/Emerging Markets Investment Strategy Update

***The roundup below is an example of our data-driven internal research process. Specifically, it helps our team contextualize the key economic releases and policy developments occurring across Developed Asia and Emerging Market economies on a daily basis. To the extent you'd like to be BCC'ed on such emails please shoot us a quick note and we'll add you to the list. Also, the summaries below are designed to be just that, so to the extent you'd like additional color on a given economy(ies), please reach out with any requests.***

 

___

 

In China, economic growth decidedly stabilized in NOV per the preponderance of high-frequency data. Obviously there are holdouts (e.g. manufacturing PMI, FX Reserves), but it’s important to call a spade a spade here: Chinese economic growth is clearly no longer “rolling down the cliff”, but rather “descending down the stairs” in an orderly fashion – for now at least. The big risk in China remains the CNY and it continues to be revalued lower on a daily basis by the PBoC, as it seeks to transition its reference rate to a “basket of currencies” from just the USD. PBoC officials are guiding towards exchange rate stability, but we can’t help but think the stealth devaluation we are seeing on our screens now is likely to remain ongoing for years to come; the CNY likely needs to decline by 10-20% vs. the USD to fully quell capital outflow pressure. As such, we reiterate our underweight bias on China in the context of previously identified structural headwinds to growth and inflation – i.e. perpetual #Quad4.

 

DM Asia/Emerging Markets Investment Strategy Update - China Economic Summary

 

In Japan, the 4Q Tankan Survey results came in light – particularly on the growth and inflation outlook components, which, on the margin should perpetuate a pull-forward in QQE expansion expectations. Curtailing this is data that shows the BoJ is projected to hold over 30% of JGB s by year-end, higher than the almost 20% of Treasuries held by the Fed, as well as news of BoJ officials gaining increased confidence in the economy. All told, we reiterate our overweight bias on Japan amid a lack of viable alternatives and an expectation that our #Quad3 outlook perpetuates expectations of increased policy support, at the margins.

 

DM Asia/Emerging Markets Investment Strategy Update - Japan Economic Summary Table

 

In India, NOV trade and export data are confirmatory of our stagflationary #Quad3 outlook, on the margin. As such, we reiterate our underweight bias on India.

 

DM Asia/Emerging Markets Investment Strategy Update - India Economic Summary

 

In Australia, 3Q house price data and NOV auto sales data are incrementally confirmatory of the remarkable resilience of the Australian economy. The latest policy developments are supportive as well: the minutes of the RBA’s DEC meeting reiterated scope to ease further – an outcome that is not being priced into various AUD rates markets – while the government’s mid-year fiscal and economic outlook saw a substantial revision higher in projected budget deficits in conjunction with negative revisions to GDP growth forecasts. All told, we reiterate our neutral bias on Australia amid opposing domestic trends (i.e. #Quad2) and international forces (i.e. Global #Deflation).

 

DM Asia/Emerging Markets Investment Strategy Update - Australia Economic Summary

 

In Brazil, the country’s stagflationary recession and political crisis continues deepened, on the margin, with the advent of the NOV consumer confidence data, as well as news of nationwide protests against the government of Dilma Rousseff. While the latest protests were not as well attended as the August and March versions, they do speak volumes to the level of popular discontent with the current administration – something that could make the ongoing impeachment proceedings worse off for the national’s capital and currency markets. Recall that Rousseff has had a change of heart regarding fiscal and monetary policy; opting to preserve the country’s credit ratings over incremental stimulus. A Rousseff impeachment could be a credit negative event if 2014 runner-up Aecio Neves doesn’t immediately become the front-runner. Regarding the outlook for Brazilian fiscal policy, it’s still too early to tell whether or not things will get worse before they get better – insomuch as it’s still too early to allocate capital to the country. As such, we reiterate our underweight bias on Brazil.

 

DM Asia/Emerging Markets Investment Strategy Update - Brazil Economic Summary

 

In Russia, the NOV industrial production data is confirmatory of our #Quad4 outlook, on the margin. As such, we reiterate our underweight bias on Russia.

 

DM Asia/Emerging Markets Investment Strategy Update - Russia Economic Summary

 

In South Africa, the ZAR overtaken the BRL as the major currency that options traders are most bearish about, with 3M 25-delta risk reversals up +1.26ppts. WoW to 3.76. This comes as investors are now repricing the outlook for South African fiscal policy in conjunction with Zuma firing two finance ministers in five days. South African capital and currency markets are celebrating the restatement of former finance minter Pravin Gordhan (2009-14), but we expect that enthusiasm to be short-lived amid the country’s stagflationary #Quad3 setup. As such, we reiterate our underweight bias on South Africa.

 

 

DM Asia/Emerging Markets Investment Strategy Update - South Africa Economic Summary

 

Recent publications: 

 

 

Best of luck out there,

 

Darius Dale

Director


Early Look

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