Yesterday’s brief bout of indigestion is a distant memory as stocks surge anew. The media story is that investors’ moods have been boosted by ECI and PCE deflator reports that came in below economists’ expectations. As Financology readers know, however, we’re often skeptical of media narratives. This one is no exception. So out with the green eyeshades for a little deeper look.
For starters, we suspect Wall Street “economists” play the same expectations game with ecodata that Wall Street analysts play with corporate earnings estimates. Lower the bar to make for an easy beat. But that’s not our issue of the day.
Rather we find it more interesting that gold prices are up about the same as stocks. We would love to ask the media editors how it is that great economic news would kite gold prices as well as stocks, but would doubt the veracity of any answer anyway. We already know. It’s not stocks that went up, it’s dollars that went down. I know I’ve said it a zillion times, but it’s a zillion times true. When you see across the board moves in disparate assets, look for the common denominator. That common denominator is usually your unit of measure.
What might break up this otherwise inexplicable conspiracy between assets that have nothing in common? At this point we have to “pivot” (just had to toss in that word of the year) from analysis to speculation.
My big picture base case is thus: The “good news” in inflation data is about to run out. Over the second half of the year, year-over-year CPI increases will rise from their June low water mark. As we discussed in detail in CPI Hijinks, for purely technical reasons the path of least resistance is higher, even if each monthly increase is bang in line with the 3% annual rate reported in July. Month-over-month increases would actually have to decline in order for the year-over-year readings to remain level. That seems like a long shot …
Why is elementary. What we concluded above isn’t a one-off. The dollar has entered a bear market, in terms of just about everything that isn’t nailed down. Foreign currencies, stocks, commodities … reversing the trend that dominated 2022. That strong dollar trend preceded the softening in official, lagging, inflation data that the markets now are supposedly celebrating. Now that it has reversed, we expect the official, lagging, inflation data to follow suit.
The relationship is robust, but this is where the storied “long and variable lags” come in too, so we’re loath to try and pinpoint timing. But softening energy prices were a major factor in the softening of said data, and they are no longer softening. Crude is bubbling up again, and gasoline prices are rising as well. Put that together with still burgeoning wage inflation, stock price inflation, fiscal deficit inflation, and an increasingly ambivalent Fed, and all arrows are pointing in the same direction. The renewed depreciation of the dollar in real time markets is about to become evident in a reacceleration of depreciation against consumer goods and services.
Meanwhile the market zeitgeist isn’t prepared for it. Inflation is licked, the Fed is done, is what’s priced in. What happens when, contrary to the market narrative, inflation data start creeping higher again?
The policy response is an unknown variable. Last year the Fed was on the case, citing tighter “financial conditions” (easing asset price inflation) as a necessary intermediate in quelling consumer price inflation. It had that right, but this year has looked the other way as the opposite has happened. Given that it has turned its priorities towards accommodating Wall Street, it’s not difficult to imagine it reverting to its embarrassing “transitory” story or otherwise finding some other excuse to wave the white flag. But it also could be a wake up call. And it very well could be that markets take the problem into their own hands, as they did in 2022, and the problematic asset price inflation itself reverses. Bullish market psychology becomes bearish market psychology and inflation turns to deflation. That’s a weeks and months issue, but considering sentiment and overbought conditions, stocks could start selling off at any time. I’ve been bearish on stocks for most of the past eighteen months; wrongly so for the last nine, but had a lot of company, a headwind for any position. Now with sentiment widely bullish, that headwind is no longer there.
Is this the only plausible scenario? They’re is never just one cockroach. Its possible overheated growth slows, the dollar strengthens, and assets sell off far enough fast enough to mute inflation before lagging indicators catch up. It’s possible the Wall Street narrative proves correct and inflation just gradually dissipates without a trace or ripple as the economy comes in for a soft landing. Just kidding about that last one.
All things considered, the collision of overvaluation and overbullish psychology with a renewed inflation shock is a bearish cocktail for asset prices.