Steno's Signals: The Recession That Never Was

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1:41the signals are telling me that inflation will soon be gone welcome to this live edition of steno signals it's always a pleasure to send it to you each and every week with the latest updates on the global macro landscape and this week we're going to touch upon the inflation report released yesterday and whether we can extrapolate that into the future as a good sign of inflation disappearing slowly but surely. And we're also going to touch upon the recession that kind of stayed away. Is the recession risk still real and is it linked to the lack of inflation now? Let's have a look at the details and we'll start with the details from the inflation report released in the U.S.

2:25yesterday. It was an interesting report, and I actually think it's the first report that actually showcased a true disinflation environment, so slowing inflation in all major categories. The table here shows all of the major categories, and as you can see from the month-over-month table, we're now at levels close to target if such month-over-month levels are those to be expected over the coming months and quarters as well. We're running below 0.2 % both in headline and core inflation terms and core inflation momentum is actually even lower than headline inflation now that we see a small pickup in oil and energy prices overall.

3:11The interesting thing here is that some of the major categories that pushed up core inflation have now started to decelerate quite clearly. Here I think about, first of all, transportation services, as you can see at the bottom of the table, now only rising 0.13 % on the month, which is much less than what we've grown accustomed to over the past quarters. We also see medical service costs turning lower. We see shelter costs below 0.4 % on the month. So rents are now also declining in the CPI. We've noticed how they've declined earlier in real time, but the CPI lags due to its survey-based nature on rents.

3:52So right about every cost category actually accelerated in a very compelling way. And I think this is the first really, truly solid report when it comes to the hopes for less inflation in the U.S. And just before we went on air here just an hour ago, the producer price index was released in the US, so the PPI index. And the PPI index typically leads to consumer price index since the producers feel the heat first. And then based on whether margins increase or decrease, the price pressures will be forwarded to consumers. And as you can see from the chart here, the PPI continues to decline. And if we update it with the number just released an hour ago, we're actually closer to the zero mark now in the producer price index, meaning that there is no inflation at the producer level anymore.

4:53That's a trend we see across the globe, but also now clearly in the US. And on typical correlations, that would actually mean that the consumer price index, so the headline inflation number, will drop below 2 % in just, say, two or three months from now. So it's a feasible scenario to discuss inflation below target now, which is the first time in more than one and a half years that we can actually say so with a bit of credibility. And if we look at the momentum in the core inflation measure, I think this was the most interesting part of the inflation release on Wednesday. And the momentum on a monthly basis in the core inflation measure is actually below target now.

5:38That is obviously not enough to declare a victory in terms of getting inflation back to target. but should inflation just repeat itself from the trends that we saw in June, we will actually get below 2%. That is what we have on the chart here. So if you annualize the trend from June, we'll get below 2%. And for the first time, I actually feel convinced saying so that it is a decently reasonable scenario to forecast that inflation will get below target into the early innings of 2024. One of the reasons why I'm more upbeat on the prospects of a decline in the inflation momentum is that we have signs from some of the early indicators of coal inflation telling me to expect inflation to disappear over the coming quarters.

6:27One of the key early indicators for core inflation is the Mannheim auction data on used cars. And the price of used cars declined slightly in June in the consumer price index, but we should expect it to decline by, say, 3%, 4%, 5 % over the coming months, according to the Mannheim auction data, which is much more live updated than the consumer price index. And if the price of used cars drops by say 3 or 4 % on the month, then core inflation will struggle to reach more than say 0.1 on the month, given all of these trends that we see in the rest of the consumer basket. So it is really important news that the price of cars is now dropping.

7:14Both used and new cars actually dropped in price through the month of June, and we see the trend continuing. So let's assume that monthly core inflation will print around, say, 0.1%, 0.2%. Is that enough to truly convince the market and the reserve that enough is enough when it comes to interest rate hikes and market pricing of interest rate hikes and forward curves? If we look at the scenarios ahead of us, I've made a very simple scenario analysis on the yearly level of core inflation, given the monthly level of inflation. And when we look at it in core inflation terms, it is quite clear that we need, say, in between 0.5 % and 0.6 % inflation every month to get an acceleration again in inflation.

8:09If we get 0.4 % inflation on the month, we get somewhat of a sideways scenario. But everything below 0.4 % now leads to a clear decline in core inflation. And my best assessment right now is that we will range between 0.1 % and 0.2 % in the months ahead, given what we know on use and new cars, given what we know on shelter trends and the trend in the rent of shelter. and therefore the trend or the trajectory rather will be rather steep towards the 2 % target and it is feasible to discuss a core inflation around 2%, maybe around year turn or early 2024. But the interesting thing is that headline inflation, the inflation number where we include energy costs and food costs, et cetera, will likely increase a bit over the next couple of months, which will send sort of a contradictory signal to markets and the Federal Reserve.

9:10Core inflation down, but headline inflation a bit up. The same simple scenario analysis takes headline inflation a bit higher, even with levels such as 0.2 % headline inflation every month. That is what you have in yellow scenario in the chart. And the reason is that headline inflation was roughly unchanged in July last year. It was almost roughly unchanged in August last year as well. So if we just get a small increase in the monthly inflation number because of rising gasoline prices, for example, we see a rising oil price more or less as we speak here, that would lead to a headline inflation number increasing again from the levels just below 3 % that we saw on Wednesday.

9:55So a bit of a mixed bag of goodies when it comes to inflation in the two, three months ahead. But I think the core inflation is what matters the most. And when it comes to the repercussions for bond markets, equity markets, and the likes, we need to watch the sort of underlying trend. Is inflation slowing or is it increasing? That is everything that matters from an equity and a bond market perspective. And if we look at which sectors that typically perform in an environment of falling inflation, I've made a study over the past 10 years of inflation data relative to the performance of various equity classes.

10:39And one thing that is rather interesting here is that energy tends to be the weakest performer if inflation drops. I don't think that's rocket science because energy is obviously related to inflation very clearly through the price of gasoline and diesel, etc. But it is a very strong pattern that every time we see inflation slowing down, energy is not a strong performer in equity space. We do see some signs right now of the oil price picking up. I'm not overly convinced that it will continue. but I would rather continue to look at the bottom of this leaderboard because when there's a negative beta value in this study, it means that this equity sector performs well when inflation drops.

11:25And we have consumer discretionary stocks like Tesla and information technology, obviously stocks like Meta, Amazon, etc., performing in an environment of falling inflation. And that is still the overwhelming theme out there. We also see the very strong performance in consumer discretionary and tech stocks, AI-related stocks, post the CPI release Wednesday and also after the release of the very soft numbers from the producer price index today. So I still think this is the theme from an equity perspective to stay invested in equity sectors that can cope with folding inflation because of high margins and software AI and super discretionary stocks fit the bill.

12:14We're going to take a quick break and be right back with more of today's top analysis on the Real Vision daily briefing.

12:24if we look at the same uh pattern in uh in europe um it seems uh relatively alike um so if you look at european equity sectors relative to declining inflation and um i can just say that on on top of my head here that european inflation is going to decline faster than than u.s inflation in in my view and on my models, that we have the same picture energy will perform less good, while sectors such as consumer discretionary information technology, but also real estate will likely start rebounding. And I think that's a really interesting juncture to get involved in real estate in Europe due to the beating that it has taken over the past, say, six to nine months.

13:10Those were the takeaways from the inflation report. I think it is very noteworthy that inflation keeps declining towards target. And I think it is the major asset allocation variable right now, given that liquidity is not in the limelight and given that growth is not really in the limelight for asset allocators. I said, I think two or three months ago, that liquidity would dry up materially over software. That is the case in Europe. We also see it partially in the US. So that prediction was actually 100 % correct. But in our asset allocation framework, we both look at liquidity, inflation and growth.

13:50And then we allow the empirical studies of how equity sectors, bonds, etc. perform given various targets for inflation, liquidity and growth. And right now, when we input our forward-looking indicators on inflation and our forward-looking indicators on liquidity, the inflation impulse simply beats the impulse from a declining liquidity. So liquidity is not everything. Inflation can outpace liquidity as the most important asset allocation variable especially in times of big volatility and inflation where we get from high levels to lower levels. It means a lot to asset allocation trends and that is why markets can accelerate with declining liquidity.

14:35So those telling you that liquidity is the only thing that you need to be guided by I think they're wrong, and I think you need to look at it in a broader perspective. Liquidity is probably only one third of the equation, and that is why we try to be very structured around this process with both an inflation forecast, a liquidity forecast, and a growth forecast. And when we look at the growth component, it's probably something that we haven't talked a lot about in StenoSignals over the past months here. The reason being that it seems like this recession keeps getting postponed. And I think when we entered the year, most macro pundits expected the recession to arrive at some point during the first quarter, maybe early springtime thereabout.

15:22And it proved to be a wrong take. Thankfully, I've stayed invested in some of these high beta themes in equity markets throughout since I found the risk of the recession overpriced by markets. and I still think it remains the case that recession risks are overpriced by markets. Let's have a look at four reasons why the recession risks proved to be overpriced and why the recession can ultimately still arrive, but ultimately you also need to look for clues on the actual recession to actually take notice of it or to care about it from an asset allocation perspective. And the first reason I'd like to highlight is the relationship that we see between real wage growth and labor demand.

16:13So wage growth adjusted for inflation. What we saw through 21 and 22 was an outright nosedive in the wage growth adjusted for inflation. And what that means is that companies set higher selling prices relative to the wage component of their cost base. So in my humble opinion, this is positive for most companies because they pay less for their workers relative to their selling prices. And interestingly, you also get that exact pattern when you study it empirically. When there's a slide in the inflation-adjusted wage growth, companies tend to hire more people, which makes sense given that the price of labor has cheapened relative to their selling prices.

17:02and currently we're seeing sort of the opposite scenario slowly but surely unfolding, wages growing faster than selling prices. And that could turn into an issue for the labor market, say three, four, five months down the road, as the price of labor gets more expensive relative to selling prices. And I actually think that is the way that you should look at real wage growth relative to labor markets. And it's completely upside down relative to what most economists will tell you. The second reason why this recession risk kept being postponed through the first half of the year is related to the excess savings built up through the pandemic.

17:48And we've made a very extensive study on the excess savings in the U.S. economy. And we get to the conclusion that the excess savings will be gone by October, November, roughly. So the wealth buildup through the pandemic has slowly but surely veined through the past quarters here. And we will get to a scenario where excess savings will be gone towards the end of the year, maybe a tad earlier. And that is probably the ultimate tipping point for the consumer battling with high prices and the weak trend in real wage growth. So this is one to watch. If excess savings are gone, then the consumer will likely face an uphill battle buying the same volumes as earlier.

18:39The third reason, and this was a reason that we touched upon last week in StenoSignals as well, is the fact that surveys struggle to get things right in a high inflation environment. When surveys are extremely pessimistic in a high inflation environment, it can't be seen as a signal that both consumers but also corporates decide to invest today rather than tomorrow because they know that the price will be higher tomorrow. This holds true in a high inflation environment simply due to the fact that prices do increase at a rapid pace on a monthly basis. So you can't be pessimistic, but still consume a lot on a life basis.

19:23As you know, it will get even more expensive if you wait. And I think that is why we see this major gap in the chart between the consumer sentiment and the actual consumption in light blue. And it would be interesting if consumer sentiment actually picks up due to falling inflation, but consumption drops as a consequence of it. It will wrongfoot a lot of people again if we get to that exact juncture, but we're not there yet. And I will, of course, keep you updated in this weekly show on an ongoing basis. The final reason I wanted to highlight before we move to the Q &A session is that the price of necessities is typically the guiding star for me when I try to pinpoint future trends in inflation.

20:08But it's not the guiding star for most economists and the central banks. They typically look at more structural trends in inflation, core inflation, core services. Jay Powell's favorite inflation measure is core services X, the rent of shelter costs. And that component of the consumer basket truly lacks what happens in the price of necessities. So the price of necessities is the best forward-looking indicator for inflation. And we actually see quite a sharp decline in the price of necessities, at least from a momentum perspective, of that being food, energy, and medical services. That's how I define it here.

20:53And I think those three now point to a clear deceleration of inflation trends, broadly speaking, into 2024. So I'm not yet too scared of what we see in energy space with the rising oil price. If that trend is continued, that is something that we will sure discuss here on Stead of Signals over the coming weeks. We're going to take another quick break and be right back with more of today's top analysis on the Real Vision Daily Briefing.

21:25So finally, let me just in full transparency reveal some of the positions that we have on in our portfolio book right now. We're long consumer discretionary in the US so far with good returns. We're long the AI theme still with a return of 16 % just over the past 60 trading days or so. And we're still long the overall equity market. And we're also long the TLT so far with roughly unchanged returns, as you can see from the table here. Let's have a look at the questions here. Sunil asks me, what impact will the condition of Europe and China have on the US economy? And it's a great question, also timing-wise, given that we received the latest import and export numbers from China earlier this morning, European time, and the exports fell 14.2 % on the year.

22:19I think it's quite telling both for the state of the Chinese economy, not least, but also to a certain extent, the sort of the health of the end consumer in the West. The manufacturing and goods industry is not doing well in the West as a consequence of the reopening and all that. Remember how we all bought stuff on the Internet through the pandemic and now we're spending things in the live economy instead. And I think this is exactly what we see in China right now. The European economy is a bit more of a mixed bag of goodies. Countries with strong pharmaceutical and technological advances in their corporate sector have performed well.

23:00And countries with a strong tourism sector have also performed well. But you see pockets of extreme weakness, for example, in Germany and now also in France. So I don't think the weakness is strong enough to really spill over to the U.S. yet, but there are for sure certain pockets of extreme weakness in Europe. Also a question from Ditesh. Do you think there is a strong case for the Federal Reserve to reduce rates if your forecast turns out to be accurate given a weak or no recession scenario? And I actually think the Fed can cut interest rates without a recession. The recession is likely still.

23:38It just keeps getting postponed, and it's not something for the very near term, in my humble opinion. But if inflation gets back to target, why would central banks remain in what they consider to be restrictive territory on interest rates? It's, of course, not a panic cutting cycle that will commence in such a scenario, but a slow decline in interest rates seems feasible even in the scenario with a soft landing, in my opinion. So yes, I think the July hike from the Federal Reserve will be the last rate hike. And yes, I think that you have compelling evidence now that price pressures are veining to an extent that will allow central banks to stop hiking.

24:21And we've also seen from both the central bank of New Zealand this week, the central bank of South Korea and other big central banks that they are now communicating. we are at the level that we want to be at for interest rates. And now we expect to be there for a while to ensure that inflation gets back to target. But we expect not to hike interest rates any further from here. And that is a message that will grow increasingly likely across most major central banks within one or two months from here, in my opinion, given what we see in the underlying inflation pressures now. I think that was all for this week's edition of Steno Signals.

25:03Remember that we have an exclusive offer for the Real Vision community if you want to follow my live portfolio and if you want access to our data hub and all of our quantitative tools, you can access them via the link shown on the page now, realvision.com. And you can use the coupon code RB40 to get 40 % off your purchase. You're more than welcome to join us. instead of research. Thank you very much for watching this week. Remember that this is just a window into my thinking. Therefore, I can't guarantee you have the same risk appetite or the same risk horizon as I have. But what I can guarantee is that I'll be back each and every week here at Real Vision with more updates on the global macro environment and how I trade them personally.

25:50Thank you very much for watching and see you again next week.

26:01What's up, revolutionaries? Thanks for tuning in to the Real Vision Daily Briefing. For more content like this, head over to realvision.com and get unfiltered access to the very best, brightest, and biggest names in finance.

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