The recent fall in consumer prices has confounded the Federal Reserve and market experts alike. Luckily, not us. Energy investors have been shellacked by falling prices. The sector is the worst performing in the S&P 500 by a long shot, down -14% in 2017 versus the broader index's gain of 8%.
If you missed it, falling prices have been a painful reality to swallow. The Consumer Price Index, along with other market based measures of inflation, slipped for the third straight month in June to 1.87%. That drop is from a high of 2.74% hit in March. Still, the Fed has called this slide in consumer prices "transitory." We remain unconvinced. Inflation is falling, and will continue falling.
Nevertheless, on Wednesday, Fed Chair Janet Yellen reiterated the party line in her prepared testimony blaming weak inflation readings on "a few unusual reductions in certain categories of prices."
Huh?
The Drivers: What's Behind Falling Consumer Prices
To show the absurdity of Yellen's statement, we've created what we’re calling a “Key Cost Center Basket,” that measures the change in essential consumption categories within the Consumer Price Index. (To get a bit more technical, it is a PCE-weighted basket (Personal Consumption Expenditure) of the 5 consumption categories included in the CPI reading).
Here are the weightings:
- Shelter: 33.6%
- Food At Home: 7.6%
- Medical: 6.7%
- Energy: 3.7%
- Wireless Services: 1.6%
- Total CPI Weighting of Key Cost Center Basket: 53%
This should give you a pretty good picture on what's happening, in the real world, to actual consumers.
CHAIR YELLEN, MEET REALITY...
The picture painted by our consumer price basket could not be clearer. As shown in the chart below, "the year-over-year percent change in our "Key Cost Center Basket" peaked in February at +4.3% and marched down the ladder to +2.4% in May," writes Hedgeye Macro analyst Ben Ryan in today's Early Look. "Our work suggests this trend will continue with Friday’s June CPI report."
In other words, it's odd that Yellen would say "a few unusual reductions" had caused falling prices. No, the most heavily weighted components of consumer price inflation (accounting for 53% of the inflation reading) are falling!
This is Just Strange
Furthermore, the Fed's obsession with stoking inflation is strange. Falling prices are, in fact, net positive for U.S. economic growth. Think about it, if consumer are paying less for goods and services, they have more money to actually spend. That's why inflation subtracts from U.S. GDP readings.
But who cares about the Fed anyway. Our prior analysis of the Fed's forecasting track record showed that our illustrious central bankers are wrong about 70% of the time. So comments like this from Yellen's testimony yesterday are totally not helpful:
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"At present, I see roughly equal odds that the U.S. economy's performance will be somewhat stronger or somewhat less strong than we currently project." |
Not really going out on a limb there...
Bottom Line
Inflation is slowing. And despite the Fed's hand-wringing that it's transitory, we think falling prices will continue to hit Energy shares.
