Bear Market Rally or Turning Point (Again)?

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Do you remember July?
Here we are again: left to assess whether we are looking at a bear market rally or a sustainable turning point for the stock market.

Last week’s softer than expected inflation print spurred a massive rally across asset classes: the 60-40 portfolio posted one of its strongest 2-day performances ever, precious metals zoomed higher while the US Dollar took a beating.

The magnitude of the market reaction was exacerbated by technical reasons we will discuss, but to assess medium-term implications we need to break down the CPI report and take a broader look at the global macro puzzle.

Hence, in this article we will:

  • Decompose the latest CPI report looking at the drivers behind the surprise, with a particular focus on the inflation features the Fed is the most interested in;
  • Contextualize the markets’ reaction, taking into account cross-asset signals and keeping an eye on lessons from the past;
  • Look at Long-Term ETF portfolio implications and tactical trade ideas that could be considered going forward.

    A Breakdown of The CPI Report

    Core CPI came in at a monthly pace of 0.27% for October 2022, the lowest monthly print since summer 2021.

    When it comes to inflation, growth and other macro drivers here on TMC we prefer looking at momentum rather than one-off prints: this helps smoothen volatility and seasonality, and Powell told us he’s looking at inflation the same way with a particular focus on the 3-month moving average.
    Here is how it looks like now:

    Using this momentum metric, we are still far from levels consistent with 2% YoY core inflation (see 2017-2018) but the pace has undeniably slowed down from its peak.

    As we had two false positives in late 2021 and mid-2022, it’s worth looking into the underlying drivers and the breadth of this inflation surprise – the Fed is also very attentive to how broad inflationary pressures are.

    The biggest negative contributors of the core CPI print were goods (especially transportation, i.e. used cars) and medical care services, while the most positive topline contributor was shelter inflation.

    The positive news is that goods disinflation is finally here – and it was about time.
    The transition from a pandemic, goods-centric world to a post C-19 services driven economy and the decongestion of global supply chains will ensure further weakness in goods prices.

    The NY Fed Global Supply Chain index is now sitting at only 1 standard deviation away from its long-term mean: we are not totally out of the woods yet, but definitely making progress there.

    Source: New York Fed GSCI (Global Supply Chain Index)

    The less positive news is that almost 70% (!) of core CPI components still run at above 4% annualized inflation rates, which makes inflationary pressures still broad.

    And most importantly, as shelter inflation lags house prices and on-the-ground negotiated rents it’s very unlikely its monthly pace will markedly slow down before ~6 months from today.

    Ex-energy core services CPI is running at 6.7% YoY, the fastest pace in over 40 years.

    Going forward, as goods disinflation accelerates and the momentum of core services inflation stabilizes we should expect MoM core CPI prints to range around 0.3-0.4%.

    That implies YoY core CPI will be slowly trending down towards 4% by June 2023: a welcome development, but still way too high for the Fed to feel at ease.

    By the end of 2023 though, my models point towards a rapid drop in inflation at or below 2% coupled with a likely earnings recession.
    The very negative Global Credit Impulse print in July 2022 leads YoY CPI by 5 quarters and it therefore suggests a major downtrend in inflation and nominal growth in Q3-Q4 next year.

    On the inflation front, we can expect only partial good news going forward followed by a rapid disinflationary trend in the second half of 2023.
    But that second leg will be also associated with higher unemployment rate and an negative EPS growth.

    In other words, a recession.

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