The June CPI report was lighter than expected and showed broad-based relief, making the Fed more likely to engage in a rate cut in the upcoming September meeting. Inflation came in at the lowest level in the last three years. The persistently sticky Shelter component finally budged down and suggested that the relief in inflation can remain consistent. Other evidence of housing market softness supports this notion as well.
This report finally affirms the "soft landing" once and for all, as inflation dropped to levels not seen in three years.
A slowdown in housing costs finally materialized, helping drive the downside beat.
Core inflation fell by 0.1%, driven by lower gas prices. That is the first decline since the pandemic started and rounds out a hump in inflation.
Airfares, hotels, hospital stays, and new and used vehicles all declined. These areas had been driving higher-than-expected inflation over the first months of 2024.
This inflation report dramatically increases the odds of a Federal Reserve cut in September. The Jackson Hole meeting in August will provide more direct evidence as to their intent, but lately, Jay Powell has been stressing the dovish side of the argument and suggesting that he has cuts on the mind. This is decidedly positive for markets, and this report suggests that you can stick a fork in inflation.
The Shelter component was the stickiest item plaguing the reports earlier in 2024 when many analysts suggested a rebound in inflation was occurring. The persistence of shelter can be explained partially by lags, and concurrent and leading data has suggested it would come down for a long time.
For example, the leading data from sources like Red Fin that showed progress months ago now appear to be showing up in the OER Shelter calculation. This is significant because Shelter is the largest CPI component that kept the number elevated and sticky earlier in 2024. It had been stuck at 0.4 for four consecutive months; this month, it came in at 0.2%.
Now that it is coming down, and given its prominence in the average American's wallet, the odds of a behavioral inflationary spiral like that seen in the 1980s have diminished from already minuscule levels. This fact should give the Fed the confidence to cut in September and boost the multiple Big-Tech market leaders this year. After the surprisingly dovish CPI report, the odds for a September rate cut increased to about 86%.
One of the reservations many Americans have about the current market is the levels of concentration that exist. However, while these levels are elevated and reaching historical highs, I would say that the artificial intelligence revolution will benefit incumbents more so than the internet revolution did.
For example, the gains for Nvidia ($NVDA) seem quite extraordinary. But when you consider the spike in revenue growth and in the ROIC-WACC, a key indicator that shows how much value managers are delivering to shareholders, the gains seem primarily in-line with the extraordinary numbers the company has put up. Their commercial advantage is so considerable and essential that from a qualitative perspective, it is understandable why they have reached their current heights. Understandable if you understand parallel computing.
This creates a fundamentally different commercial character from the artificial intelligence revolution, which seems to bolster Big Tech's ability to hold the heights of the economy that they now so comfortably occupy. Because of this, I think a lot of the seasonal trends can be bucked in the remainder of 2024. Concentration may actually work in the market's favor despite its many detractors. This is because of the unprecedented financial strength of the stocks in which the market is concentrated.
Remember that when you analyze public companies since the 1920s, you can identify a recurring pattern: certain dominant companies are responsible for the lion's share of economic earnings. When you consider that about 2% of companies have created about 90% of the wealth in the public space, the rise of dominant giants like Nvidia, which provides extraordinary products and services, is more in line with history than a lot of pessimistic analysts would care to admit.
Risks and Where I Could Be Wrong
Overall, I see a high likelihood that the July and August reports can confirm the downside surprises we just experienced. Given the size of the Shelter in the CPI calculation, if it continues to decline as the long-term trend suggests, you can stick a fork in inflation.
The other meaningful categories that led to elevated readings showed meaningful progress in this report, and there is little reason to think things will change unless an unanticipated catalyst enters the screen.
However, some low-rumbling catalysts could also re-emerge in a negative way that shocks markets. It is important to remember that we are not only in a period of war, which tends to be inflationary, but that one of the things that drove the downside to miss this time was the unseasonable weakness in gasoline.
If this item reverses, it could dampen enthusiasm about the decline in inflation, given its prominence in both consumer wallets and psychology. Overall, the main risks to my thesis are:
Unanticipated re-emergence of inflationary pressure that makes cuts less likely or postponed.
Re-emergence of inflationary pressure or economic impact from geopolitical risks.
Commercial Real Estate, Banking, or Credit Event that leads to recession
Fed policy error or domestic political risk in the United States leading to recession or risk-off environment.
Overall, the likelihood of all of these risks is diminished at this time. That is to say, I find them all unlikely, and the positive market momentum will continue in my forecast. One thing people don't realize is that an assumption in most volatility models is that volatility stays the same today and tomorrow. Of course, this is not true during turning points and rapid re-adjustments, which often lead to so much carnage in markets.
Volatility has been near all-time lows, and this is reflecting the positive fundamentals of a strong market at all-time highs. Overall, strong markets stay strong, and I think there are many reasons, like an unprecedented commercial revolution revolving around artificial intelligence, why we could buck the seasonal trend and volatility could remain subdued through the summer.
Conclusion: Ding Dong, The Witch is Dead
"There are two main drivers of asset class returns - inflation and growth." -Ray Dalio
Now that one of the main risks for the equity asset class has been vanquished and the Fed will have conducted an entire rate cycle without a recession, it doesn't seem a good time to sell equities. While many may feel like all-time highs might be a good time to sell equities, the historical data actually suggests the contrary.
Inflation is the bane of asset management and can render even the most successful strategies into failures. Removing this catalyst as a significant market risk driver should not be underestimated, mainly since it simultaneously means the Federal Reserve will be cutting. This means that pressure on stocks facing valuation risk will be somewhat relieved. Another important consideration is that we are entering earnings season soon, which tends to suppress market-wide volatility. It is good to buy the current market and let your winners ride now that one of the most significant risks for markets has been effectively removed.
