Andrew Pyle
November 11, 2022
Expect the worst, but don't get carried away with the surprise
We knew this week was going to be interesting. The US mid-term elections and that country’s October consumer price report each offered different things for financial markets; but they shared one thing in common and that was the concentration of expectations towards a certain outcome. In the case of the elections, this was supposed to be a thrashing of the Democrats by Republicans, resulting in a massive swing in control of the House of Representatives and potentially the return to a Republican Senate. The CPI report was seen as providing further supporting evidence that inflation was intractable, requiring a continued heavy hand by the Federal Reserve.
Well well. Joe Biden, despite having a miserable popularity rating across many regions of the country, had the pleasure of watching results that went beyond what most pundits had predicted. Instead of a “red wave”, the Republican victories in the House were more like a dribble. At the time of writing, several House districts were still undeclared and the Republicans had not yet reached the 218 seats needed for a majority. The Senate outcome was also unclear, though indications were that the Democrats would likely maintain a wafer-thin majority.
Yet, the story here isn’t that Democrats did better than what many had projected. It is how these elections appear to have unveiled a more normal political landscape than has existed over the past six years. Not only did extreme factions not do well, but the umbilical cord between many Republican members and former President Trump looked to unravel a bit at the margin. Suddenly, the 2024 election looks like it will have an alternative slate of candidates to the election denialism of recent years. This isn’t a political reflection, but a suggestion that policy debate and formation might enter a more constructive environment.
That doesn’t mean that the policies that come out of Washington will be better or worse for the economy or markets. There is also the other elephant in the room and that is whether Biden runs in the 2024 election and, if he doesn’t, what candidate does? In other words, there is still enough uncertainty out there to rock the boat, even if we feel that political tensions may be about to subside a bit. This would certainly be an example of fearing the worst, but hoping for the best – only that we should probably count on something in the middle.
The inflation story this week was not in the same camp as the mid-terms. I wouldn’t say that traders were expecting the worst, nor that what they got was really the “best” outcome. For October, economists predicted that US consumer prices would rise 0.6% after the 0.4% increase in September and that core CPI (excluding food and energy) would see a lift of 0.5%. Instead, the headline CPI increase simply matched the previous month’s gain of 0.4% and core prices rose by 0.3%. Were these better than what the street feared? Of course, but where the variances from expectations significant? I would have to say to no.
In terms of headline CPI inflation, the rate fell from 8.2% in September to 7.7%. Back in June, the inflation rate was 9.1% and October’s rate essentially takes us back to where things were at the start of the year. Core inflation, however, fell by only 3-tenths to 6.3%. That is still above the rate seen at the start of the year and is also above the recent low of 5.9% back in the summer. Drivers behind the moderation were clothing (prices have fallen for two straight months), used vehicles (wonder why Carvana’s share price is down more than 80% from the August peak?). Medical care costs also fell in October, though this looks like an outlier given the strong advances in the previous two months, while air fares fell 1.1%. On the latter, I have heard so much anecdotal evidence of travel demand booming that I would take this with a pinch of salts. Air fares, even with the October decline, are still up more than 40% from the same month a year
ago.
Meanwhile, food prices rose 0.6% in October (keeping year-over-year inflation at over 10%), and energy prices increased by 1.8% after months of decline. Remember, it was the correction in oil and gasoline prices over the summer that fueled optimism that inflation could be broken on its own, without central banks necessarily having to break the economy. Since the end of September, crude oil futures have staged a recovery and analysts are talking about $100 a barrel again. Most of this coming from anticipation of a China re-opening, with some OPEC production cuts thrown in for good measure. Are we going back to the highs the second quarter? I sincerely doubt it, but any revival in energy costs will exacerbate the thing that the Federal Reserve fears the most – embedded inflation expectations.
Before I continue with the examination of the inflation story, let’s first step back and remark at how market participants reacted to a report that was better by a couple of tenths of a percent. Ok, maybe I won’t mince words. The reaction was completely irrational. For example, the Dow Jones advanced by 1200 points on Thursday, or 3.7%, which is the best gain we have seen since May 2020. The bounce in the S&P500 was even more impressive, at 5.5%. If you exclude the extreme volatility events of the pandemic and financial crisis, this is the best day we have seen in over 20 years.
The only problem is that we haven’t had a crash or crisis. All that we have been dealing with is the reality of higher inflation, a central bank response that was a tad late, but now very aggressive and the growing sense that North America’s economy is about to enter a recessionary phase. The need for further rate hikes has been well communicated and the Fed’s recent decision to raise rates another 0.75% (and Powell’s press conference) seemed to close the door on the debate on whether he was prepared to move aggressively in December.
After more than three decades in the market, from providing strategy recommendations on the trading desk to advising individuals like yourselves, you learn a few things. First, you don’t change course on a single data point. Guess what – neither does the Fed. Second, you are always alert to head fakes. It is clear that the street inferred from the CPI report that the Fed won’t have to raise rates substantially at its December meeting and/or that the peak in rates was now going to be lower than what people thought last weekend. Let’s remind ourselves that there is another jobs report and CPI release before the December Fed meeting.
On the same morning that the CPI report came out, we also got the latest batch of weekly US jobless claims figures. Again, to say that the latter was overshadowed by the inflation data would be an understatement. Initial claims edged up to 225,000 in the first week of November and total claims rose less than 10,000 to 1.493 million at the end of October. Some highlighted these increases as further reason to believe the Fed would cool its jets on rate hikes. If you ignore the early pandemic spike in the above chart, you will notice that total claims are still below where they were before COVID-19 was a household word. In other words, the labour market remains tight – indeed, tight enough to allow wage pressures to continue.
So, we came into this week with some fear perhaps about how events might unfold. It is safe to say that the outcomes were completely outside expectations and that they were much better than feared. Just as it might be tempting to think that the Democrats will enter the 2024 election with increased odds of success, some may be thinking that we have seen the bottom of the equity market. Both views, however, require some careful consideration. If we have seen the worst of the equity correction, then that would mean that financial conditions get easier and if the Fed actually pauses on rate hikes earlier than anticipated, then those conditions will improve even more.
That also means that any inflation expectations that are becoming entrenched in the collective behaviours of businesses and consumers will get even harder to extract. In that event, the Fed (and likely the Bank of Canada) will have to resume tightening. Unless we get evidence in the coming weeks showing severe cross the board cracks in the economy, I believe the Fed maintains its battle against inflation in December. Suffice to say, Chair Powell and FOMC members were probably not too happy seeing the market response after the CPI report (note, bond yields also dropped sharply).
I know that many of you were extremely happy with the bounce in markets Thursday, however, I don’t believe it is a green flag to jump back into full equity positions without fear. For now, Ally and I maintain that this environment calls for more defense than offense. We don’t necessarily expect the worst from either the economy or the equity market next year, but it’s hard from today’s vantage point to see a best outcome either.
On behalf of the Pyle Group, we remember all those who have made the supreme sacrifice over the past decades to ensure that we can enjoy the things we love today. Lest we forget.
Have a wonderful weekend.
Andrew Pyle
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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.