Inflation is obviously running high, but benchmarks like the Consumer Price Index don’t fully explain it. This piece uses home prices to show how measuring inflation is fiendishly complicated. Trying to fix one problem can introduce others.

Key Points:

  • In 1983 the CPI switched from using actual home prices to a new method called “Owner’s Equivalent Rent.”
  • The cost of owning a home depends heavily on interest rates at the time of purchase, which creates a statistical challenge.
  • A home’s resale price can rise while the new buyer’s monthly payment is actually less than the seller’s, or vice versa.
  • Including mortgage payments in CPI would create confusing signals as changing interest rates mechanically raise and lower inflation.
  • Homes are better thought of as capital goods that produce housing services, which are what actually get consumed. OER tries to reflect this.
  • BLS doesn’t use homeowner estimates to compute CPI. It looks at market data for rents on similar nearby properties.
  • Absent the 1983 change to OER, the authors estimate average annual inflation since then would have been about 2.2%, vs. 2.7% under official CPI.

A broad summary of inherently individual living costs is never going to be precise. Everyone has their own experience. The Federal Reserve and other policymakers need some kind of yardstick, though. What’s important is that is be consistent over time so they can see changes that may need a response.

 

Cathie Wood of ARKK

 

There was a lot covered and with all the performance pressure Cathie is under, she has not wavered in her conviction for her process. We run a portfolio of her highest conviction ideas on our platform and given my overbought, overvalued, overleveraged views on the market in general, I’ve been waiting for a better entry. Seems it is nearer. Following are a few select highlights.

  • Innovation solves problems. Today, inflation, energy, and supply chains are problems that technology is ready to solve. The costs are low enough that they can be scaled to reach a solution.
  • Technology will enable deglobalization, self-sufficiency, and resilience. Innovation is deflationary.
  • She continues to like Tesla and she believes 3D printing, or additive manufacturing, is ready for primetime and will help solve our supply chain issues.
  • She sees manufacturing returning to the US.
  • Rare-earth minerals are crucial for technology, so how do we get more resilience in that area. Finding substitutes is one way. Technological ingenuity will pull us away from dependence on these minerals.
  • Regarding food security, look at precision agriculture—Deere is at the forefront of this. It will improve yields, conserve fuel, and reduce herbicide use.
  • Agriculture solutions will accelerate over the next few years.
  • Gene editing will enable crops to use less water.
  • Liquidity is drying up for technology. Yet, the need for technology has never been greater. Companies with real growth will continue to do well.
  • Would not be surprised if we are in a recession now, with forces to the downside that will lower inflation.
  • She remains steadfast in her 5-year outlook on companies. If she is right on the fundamentals, she believes her portfolio will show spectacular returns.
  • Expecting the growth of the companies, even during a recession to be far greater than the economy. Adding that truly disruptive innovation companies will make up nearly 50% of the benchmarks cap weighting by 2030.
  • She is not worried about battery issues and the EV sector.

 

The Fed

 

Last week the Fed announced the initial asset sheet rundown plan. This is the longawaited swing from “quantitative easing (QE)” to “quantitative tightening,” or “QT.” The chart shows the plan—if the Fed follows through, which is not guaranteed—won’t actually tighten much.

 

 

The black line shows the Fed’s balance sheet assets, which rose steadily in the years following the Great Recession. It then took off like a rocket in the COVID era. The right end is a projection through the end of 2023, based on the Fed’s announced plan. You can see the Fed will still be holding over $7 trillion after almost two years of reductions. Also interesting is the blue line showing the S&P 500 index. Stocks rose nicely as QE unfolded. That wasn’t the only factor, of course, but they’re certainly connected. With that influence diminishing at such a slow pace, will the S&P 500 have a similarly gentle decline? We’ll probably know soon.

Here are Powell’s comments from last Thursday:

“If things come in better than we expect, then we’re prepared to do less. If they come in worse than we expect, then we’re prepared to do more,” Powell continued. “I will also say that the process of getting inflation down to 2% will also include some pain, but ultimately the most painful thing would be if we were to fail to deal with it and inflation were to get entrenched in the economy at high levels, and we know what that’s like.”

 

Albert Edwards, Global Strategist for Société Générale

 

  • Edwards blamed central bankers for inflating an asset bubble. The Fed insisted that inflation was transitory, and got called out on it (they were wrong). A bit of a wage-price spiral is unfolding in the U.S., and central bankers are now “beating their chests” about how far they will go in raising rates.
  • The Fed will be aggressive in its rate hikes to curb demand and reduce inflation.
  • When the S&P is down 30–35%, the Fed will capitulate. That translates to a level of 3,000, which Edwards said will happen. The “Fed put”is lower because of inflation.
  • But, he said, within two to four months of reaching that level, the Fed will reverse course and we will see a big rally.
  • The last 19 bear markets have had an average decline of 39%. But we could go “way below that,” he said. Technology will lead the way down.
  • Bond yields will go to “higher lows and higher highs…when the recession unfolds, the 10-year yield could go back to 50 basis points.”
  • “We are approaching a secular bear market for bonds. But the cyclical recession will temporarily derail that.”

 

Felix Zulauf, Zulauf Consulting

 

  • Nothing is linear. Things progress cyclically, as determined by greed and fear.
  • There is a business cycle up-wave, then a bear market down-cycle.
  • Government fiscal stimulus has caused supply-side distortions. Because of the inability to meet the quick increase in demand, we got inflation.
  • Money printing by the Fed only postpones our problems.
  • The Fed is attempting to regain its credibility. There is a big risk that inflationary psychology becomes embedded.
  • The Fed must bring down demand, yet that will damage the economy. Jay Powell is not Paul Volcker.
  • QT is the reduction of liquidity and we will get a liquidity crisis at some point. Will the blow-up this time be in Turkey or Hong Kong? We don’t know.
  • He believes there is more room on the downside.
  • We will see a big bull run in equities if the Fed U-turns.
  • He sees a peak for now in commodities, and he’s bullish on commodities and agriculture commodities longer-term.
  • On gold: He’s bullish long-term, while he believes the short-term trend is lower. He thinks gold will rise when faith is lost in authorities and the system itself, which will start in 2024.
  • He sees more upside in yields and the dollar, and expects inflation to continue into the mid-2020s.
  • He expects a rollercoaster ride in the markets over the next 10 years.
  • In reference to bonds and equities, he said you must be aligned with the main trend and the trend is bearish.

 

Mark Yusko’s 10 Potential Surprises for 2022

 

In Mark’s early years, he was CIO of the University of North Carolina’s endowment. Today he runs his own firm, Morgan Creek. He believes each has a 50/50 chance of happening.

 

  1. The CPI spike is merely base effects resulting from the lockdowns and re-openings, and the inflation trend reverts back toward deflation due to big demographic headwinds.
  2. The market panics that occur even from the threat of rising rates cause the party train to stall and QE forever will return.
  3. The music finally stops and there clearly aren’t enough deck chairs to go around. Serious hangovers ensue.
  4. Equity market turmoil will shoo away the hawk. When the dove returns, the U.S. dollar falls.
  5. Powell slips and falls, bumps his head, forgets about tapering and raising rates, and the bubbles get even bigger.
  6. Politics magically result in OPEC pumping, or the SPR gets tapped and oil prices head back to $60.
  7. Global investors see the strong growth and cheap prices of Japanese stocks and the Nikkei surges to 33,000.
  8. The three dead dogs of higher rates, lower growth, and high valuations sink European equities and Mario’s campaign.
  9. The PBOC stimulates again, stocks surge and China is the best-performing global equity market.
  10. Crypto winter is back. Bitcoin prices struggle, but there are myriad opportunities to profit in emerging areas like P2E, social tokens, NFTs, and the metaverse.

 

US Economy

 

  • The NFIB small business sentiment index held steady last month (at the lowest level since early 2020).

 

 

  • Outlook is at record lows due to inflation concerns

 

 

 

  • Near-record percentage of firms have been raising prices

 

 

  • Where are we in the business cycle?

 

 

  • The Citi Economic Surprise Index broke below its 50-day moving average, signaling slower growth.

 

 

  • High inflation and rising mortgage rates are pressuring discretionary spending.
  • Retail gasoline prices hit a record high, which will be a drag on consumer sentiment this month.
  • The CPI report surprised to the upside. Inflation continues to run hot.
  • The core services CPI (ex. energy services) saw the biggest monthly gain in decades, boosted by rent, airfares, new and used vehicle prices and energy.
  • Economists expect inflation to moderate in the months ahead.
  • Treasury yields jumped initially in response to the CPI report but retreated shortly after. The yield curve flattened.

 

 

  • The Bond market is pricing in a deterioration in economic activity. The stock market is now signaling a manufacturing recession in the US.

 

 

  • Many economic indicators are pointing to lower bond yields.

 

 

  • Mortgage applications have been remarkably strong, given the spike in loan rates.
  • But bankers now see slower demand for mortgages.
  • Refi activity is collapsing.
  • ARM financing is picking up.
  • Home price appreciation is holding up well, even as affordability deteriorates.
  • Consumer sentiment continues to weaken.

 

 

  • The April PPI print was roughly in line with expectations, showing that wholesale inflation remains elevated. However, there were signs in the PPI report pointing to some moderation in the PCE inflation index (which will be reported later this month).
  • Jobless claims remain very low.
  • With the Fed, is a soft landing possible? Yes, it is. But soft landings are relatively rare. For example, each past hiking cycle ended up in a manufacturing contraction.
  • The sharp deterioration in financial conditions indicates that markets expect a recession

 

 

  • Spikes in energy prices tend to signal economic shocks.
  • How does the Fed reduce labor demand without causing a recession?
  • Upper-income households’ wealth has taken a hit from the stock market rout. A significant spending pullback could follow.
  • By the way, here is the search activity for “inflation” and “stagflation.”

 

 

Market Data

 

  • The current drawdown in the Nasdaq Composite and Nasdaq 100 indices is approaching the COVID shock.

 

 

  • The S&P 500 forward P/E ratio went through the 17x support level. Market participants are increasingly skeptical about consensus earnings estimates.
  • The balance of earnings revisions has been flat lately. Will we see it turn lower?
  • There are a lot of new lows.

 

 

  • Panic is setting in as bitcoin dips well below 30k.

 

 

  • Isn’t Bitcoin supposed to protect you against inflation?
  • Bitcoin now basically trades like a high-beta stock.
  • Other cryptos have been crashing. Here is Coinbase

 

 

  • Consumer discretionary stocks have been getting crushed as the market increasingly expects a pullback in spending.
  • Precious metals have been selling off as the dollar surges.

 

 

  • This week, we saw more weakness across most markets. There was a large spike in issues falling to 52-week lows on both the NYSE and Nasdaq exchanges, as more than half of S&P 500 stocks fell into a bear market. The price/earnings ratio of the index has already dropped more than 35%. Declining markets are causing financial conditions to tighten and sentiment to become despondent.

 

Quote of the Week

 

When you forgive, you heal.  When you let go, you grow.

 

Picture of the Week

 

 

 

 

All content is the opinion of Brian J. Decker