October CPI was a “game changer” supporting equity rally into YE. If inflation is vanquished, will stocks see a vertical rally ala 1982?

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Our latest “Inflation Dashboard” has been updated and is attached

October CPI was a “game changer” supporting equity rally into YE.

The October core CPI (released 11/10) came in at a soft +0.27%, below Street consensus of +0.5% and break in trend from the +0.6% seen in August and Sept CPI. As we noted earlier this week, our view is the market would view of soft Oct CPI as a “game changer” and arguably in far greater magnitude than the massive bearish reaction to Aug CPI (stocks down 15%).

• The S&P 500 rose +5.5%, an eye-popping rally, and so the soft CPI had a seismic impact
• Many inflationistas skeptically suggested this soft reading is not repeatable

But 3 drivers were behind this soft CPI, which we view as “repeatable”:

• Shelter finally showed a meaningful slowing in CPI MoM, as OER (owners equivalent rent, >23% of CPI basket) slowed to +0.6% (+0.7%/+0.8% Aug/Sept) and trending towards market reality of deflation in housing
• Durable goods finally showing “bullwhip” payback as durables CPI fell to -0.7% MoM (-8.4% annualized) and even used cars finally showed some weakness down-2.4% for the month (but still 15% further to fall)
• Medical health insurance massively flipped to -4% MoM from 12 consecutive months of +2.4% (since Oct 2021) and given annual adjustment is set to fall 40% over the next 12M
• In other words, there are building drivers to massively slow CPI core inflation over the few months and it is possible we will see 3 to 4 consecutive months of +0.3% Core CPI MoM
• This would pull down core inflation towards 3.5% or so. Far slower than the 6.5% seen in most of 2022

As far as market implications, we think the case for a strong rally into YE has been strengthened:

• Foremost, Fed no longer has its “back to the wall” on inflation as October CPI beat looks repeatable (see above) and therefore the case for a pause after December is stronger. This counters the hawkish rhetoric of Powell post-FOMC but he did not have October CPI in hand.
• For most of 2022, Fed has not been able to point to measurable progress on containing inflation but a significant constellation of leading indicators showed deflation/soft inflation was in the pipeline. October CPI is the first month the “hard” data syncs with the “soft” data.
• Softening inflationary pressures strengthen the case for a “soft landing,” counter to the consensus narrative that Fed is spiraling economy to a hard landing. Core inflation running at 3.5% annualized (above) will not require Fed to bang out +75bp and arguably 4.5% Fed funds would be very tight.
• A Fed shifting from “higher in a hurry” to “predictable but possibly longer” is far better for risk assets. Fed has acknowledged serious and unknown lags in monetary policy and with inflation improving, Fed can gain some measure of patience.
• While some bears say the Fed doesn’t want equities to go up, this is an oversimplification. Fed just was in a hurry to slow things down in 2022. Stocks are far more complex than bonds which are arguably two variable assets (inflation and future Fed funds).
• Stocks are acting like “beach balls under water” because P/E averages 19X when 10Y between 3.5% to 5.5% — true since 1871. Thus, those arguing P/E should be 15X or less are just plain ignoring history.
• The “false dawn June pivot” rally lasted 23 trading days and saw S&P 500 rise +16%
• We believe this “Fed pause” rally should last closer to 50 days and push S&P 500 +25% higher. Thus, we think S&P 500 should surpass the 200D average of 4,100 and given possibility of another weak Dec CPI could see a move well beyond that. Why wouldn’t 4,400-4,500-plus be a possibility?
• Recall, in 1982, following the final low in August 1982, the S&P 500 reached a new all-time high within 4 months, erasing entire 27-month bear market. That was a vertical rally. Vertical.

CPI: Good month even for food…

Our data science team’s, led by tireless Ken, analysis of CPI MoM is shown below. The top 10 drivers remain the same but with diminishing magnitude:

• Shelter largest contributor but the CTG was 20bp down from 25bp
• New Cars is #9 at 1bp but down from 3bp
• 17 items outright DEFLATED MoM and that is accelerating slowing of CPI MoM

SERVICES: Ex-shelter, outright deflation in October

This might surprise many but CPI Services, ex-shelter, actually fell MoM in October as shown below.

• this is a huge break in trend from +0.9% in Sept and +0.6% August
• lower utilities, medical contributed to this, but it is a big break in trend
• durables also saw a steepening “deflation” falling -0.7%, or -8.4% annualized

HOUSING: slowing suggesting “lagging” CPI will start to reflect actual reality of deflating housing

This was a surprise but OER, owner’s equivalent rent, slowed to +0.6% MoM from +0.7%/+0.8% in past two months:

• this was a break in trend
• while eventually expected, this means markets and Fed can now appreciate the “lagging” CPI versus the market reality of deflating housing and rental costs
• hotel costs are still surging as reflect by “lodging away from home” being up +4.9% but we think the Fed doesn’t necessarily target hotel costs in its monetary policy

GOODS: Payback finally apparent as used cars, apparel deflate while food costs slow

With the easing of supply chains, durable goods and commodities have seen growing inventories. Part of this is the “bullwhip” effect of how goods get over-ordered. For most of 2022, this was not captured in CPI “hard” data. But this goods deflation is now seen in October CPI:

• Used cars finally showing the downside break at -2.4%
• Apparel is no longer mysteriously appreciating given all the prevalent discounts

There is still a lot of deflation in CPI Used Cars as the YoY CPI Used Car Index is still up +2.0% YoY

• yet, Manheim is down -10% YoY
• as shown below, since 1995, CPI Used Cars eventually falls to the same level, but with a lag
• this means even more CPI deflation in the pipeline

MEDICAL: 2022 Annual Healthcare Insurance adjustment drives huge deflation swing

Medical Care services went into deflation in October, falling -0.6%

• the swing factor is Health Insurance which fell -4% in the month vs +2.4/2.1% in Aug/Sept
• Insurance is the largest YoY driver of Medical Care services +21%

As shown below, the CPI of Health Insurance adjusts annually. JPMorgan Economists estimate the YoY decline in 2022-2023 will be -40%.

And our dashboard of 35 items show that more than 50% of factors are in outright deflation.

REGIONAL CORE CPI: All 9 regions see slowing Core MoM

The trend of Core CPI MoM for each of the 9 regions is shown below. And we can see the clear deceleration of inflation MoM.

1982: Valuation nor earnings constrain stocks, if inflation has bottomed

We don’t know if the Fed has vanquished inflation. But we have written in the past that Powell doesn’t have to go full “Volck-an” as the cumulative inflationary pressures as far lower in 2022 than 1980s.

As shown below, the cumulative inflation in 2022 is about 7% above trend compared to +72% when Volcker became Fed chair. That is far less inflation that needs to be erased from the mindset of households and businesses.

And the stock market “sniffed” out the end of inflation war 10 weeks before Volcker even posited a change in inflation tactics. His first public musings were not until October 5, 1982.

• by then, equities were furiously rallying as shown below
• and made new all-time highs only 4 months after the bottom
• a vertical rally

37 GRANNY SHOTS: Updated list is below

The revised 37 Granny shots are shown below. The list is sorted by the most attractive (most frequently cited) to least. To be a “Granny shot” the stock needs to appear in at least two portfolios:

• $AAPL in 4 of 6 portfolios
• $GOOGL $MSFT in 3 of 6 portfolios
• $AMZN $META in at least 2
• This reinforces our favorable view of FANG in 2H2022

37 Granny Shot Ideas:

Communication Services: $GOOGL, $META

Consumer Discretionary: $AMZN, $AZO, $GPC, $GRMN, $ORLY, $TSLA

Consumer Staples: $BF/B, $MNST, $PG, $PM

Energy: $CVX, $DVN, $EOG, $PSX, $XOM

Financials: $ALL, $AXP

Health Care: $AMGN, $HUM, $UNH

Information Technology: $AAPL, $AMD, $AVGO, $CSCO, $KLAC, $MSFT, $NVDA, $PYPL, $QCOM

Materials: $CF, $FCX, $LIN

Real Estate: $AMT, $CCI, $EXR