A Whiff of Deflation

What the newest CPI report showed... A mixed market reaction... Small caps surge... Big Tech tumbles... Bad news is good news – to a point... Watch the jobs market...

Hello, deflation...

This morning, traders in front of their computers were in for a surprise...

Uncle Sam's latest inflation report showed that prices went down. Yes, you saw that correctly – according to one headline number, at least.

The consumer price index ("CPI"), which measures a basket of goods and services, fell by 0.1% in June. That might not sound like much... but it's notable because it's the index's first "official" deflationary monthly reading since May 2020 during the pandemic lockdowns.

Lower gas prices – down almost 4% last month – played a big part in the headline data, like last month.

In short, over the past two months, the CPI has shown flat headline growth and slight deflation.

That said, year-over-year prices were still up 3%. So the folks on Main Street likely won't appreciate the decline in the same way investors will. Prices for stuff you buy at the store are still higher, as are payments to lenders.

"Core" CPI, which excludes food and energy essentials, also remains 3.3% higher than a year ago. But core CPI only rose by 0.1% last month, the lowest monthly reading since April 2021.

So we're once again seeing disinflation – prices rising at a slower pace. We haven't seen this since the rate plateaued in the first quarter at around 0.4% per month.

Add it all up, and the June CPI report is positive for the "Federal Reserve is going to cut rates relatively soon" camp. But, it's also a reminder about potential trouble for the economy ahead...

Today's 'mixed' market reaction...

When the markets opened in the U.S., the indexes initially moved higher – led by small-caps, which have been lagging the S&P 500 Index and Nasdaq Composite Index for what feels like forever. Gold and bitcoin also jumped. Bond yields dove.

But the Nasdaq closed substantially lower, down roughly 2%. The benchmark S&P 500 was lower too. Both of their seven-day win streaks snapped. "Short Big Tech, go long small caps" was the winning trade today.

This "divergence" between small caps and large caps is something I (Corey McLaughlin) haven't seen much during the current bull run...

Holy small caps!...

Forty-five minutes into trading today, the Russell 2000 Index was more than 3% higher and just a few points from setting a new high for the year. That's equal to a level it last traded at in the downtrend of early 2022.

Except now the story is different...

Small-cap stocks – while more volatile than their larger counterparts – have quietly been in an uptrend since the fourth quarter of 2023, despite lagging large-cap stocks. A lower cost of money for capital-intensive, more speculative businesses is a bullish prospect.

It's a similar but different story for the real estate market, with the prospect of lower interest rates likely to support activity. The biggest winner of the S&P 500's major sectors today was real estate, up more than 2%.

But there has been some uncertainty about the timing of an easier money environment. Recently, Fed officials have clearly stated they want to see "several months" of "good" inflation data before they pull the trigger on cutting rates.

Today's whiff of deflation counts.

It has intensified bets that the Fed will cut rates by 25 basis points at its September policy meeting. Fed-funds futures traders increased their bets on that idea today, with odds jumping to around 85% from below 70% just yesterday, according to the CME Group's FedWatch Tool.

But the market's prevailing expectation is for the central bank to hold rates at its next policy meeting next week.

Bad news is good news – to a point...

For more than a year, investors have taken bad news for the economy as "good news" because it meant that a relatively easier monetary policy environment was closer to becoming a reality.

So every time a piece of data showed disinflation, investors cheered. It meant the Federal Reserve was closer to cutting rates. This has been the story since the market bottomed in October 2022 when investors determined inflation had "peaked."

But now, Fed Chair Jerome Powell has been talking about the "two-sided risks" for central bank policy. Bankers are concerned about a weakening economy (like the growing unemployment rate over the past few months) as much, if not more than, inflation.

And as we wrote earlier this week, the only thing central bankers fear more than inflation is deflation.

Just the sniff of deflation could give the Fed the willies... and be enough of a catalyst (barring another inflation spike) to support at least one rate cut by the end of the year.

But a deflation report is also a potential warning sign for the economy ahead and poses a risk for more cyclical industries like semiconductors and consumer discretionary stocks. Semiconductors and airline stocks were among today's biggest losers.

Cyclical troubles...

Today, for example, Delta Air Lines (DAL) shares dropped by 5% (to just around its long-term 200-day moving average) after the company reported lower-than-expected second-quarter profit (down 29% from the prior year) and cut its outlook for the third quarter.

The airline said it's now adjusting its business strategy because of lower demand compared with the past few years and higher operating costs. As the Wall Street Journal reported today...

As the Covid-19 pandemic receded, airlines worked to catch up with travel demand that seemed insatiable by buying planes, hiring staff and increasing flight plans... Now, there is a glut of airline seats, especially at the lower end of the market, and carriers are discounting domestic fares to fill them, said Delta CEO Ed Bastian in an interview.

Bastian said travel demand remains healthy, and he expects the domestic market to improve in the coming months as airlines dial back supply...

"We see the industry already taking pretty significant corrective action by pulling capacity down," Bastian said. "And we expect by the end of August, we'll have that back in balance."

That's not the sourest of outlooks, but it's also corporate-speak... and it signals a business that's slowing. Delta and other airlines have been lowering fares lately (deflation) to generate income. Today's CPI report showed airline fares falling for the fourth straight month, and 5.1% in June.

As the Journal also reported...

Delta wasn't immune to the airline industry's race to the bottom on domestic ticket prices, as competitors have had to match falling fares to lure passengers. While total domestic revenue is up, Delta is earning less money per seat flown a mile, reflecting diminished pricing power. Its planes were slightly less full than they were a year earlier, too.

In short, bad news for the economy is becoming "bad news" for stocks. Slowing airline fares is something the prospect of a few tiny rate cuts can't soothe. But quality companies can deal with these challenges better.

Don't forget about the 'why'...

Central banks loosen policy when the economy is weakening.

We've been noting the weakening labor market here lately. The unemployment rate for June rose to 4.1%. That's up from 3.5% just a year ago.

Some analysts have been seeing recent government jobs reports as "strong" because they show job additions. But they've been overlooking the fact that most of these are part-time jobs, and full-time job losses are on the rise as the toll of a higher-interest-rate environment and still high prices has been weighing on businesses.

As our founder Porter Stansberry recently pointed out on social media platform X, "It isn't different this time." He wrote...

The number of full-time jobs peaked in the U.S. at 134.8 million in June 2023, and is now down to 133.2 million – a loss of 1.6 million full-time jobs over the last year.

If the pace of these job losses picks up, it'll be a shock to the system. And it's possible. Remember, the "Sahm rule" – associated with the onset of recessions – isn't far from triggering. As we wrote last week...

This indicator is named for Claudia Sahm, an economist and onetime employee at the Fed. Basically, it's a measure of the change in the unemployment rate, and it has a perfect record of signaling recessions over the past 50 years.

The rule says that whenever the government's unemployment rate rises 0.5 percentage points off a cycle low – the difference between the current three-month average and the past year's three-month-average low – we're in a recession.

The 3.63% three-month average in the unemployment rate from June 2023 to August 2023 is the present trailing-12-month cycle low. So an unemployment rate of 4.5% next month would be good enough to trigger this recession indicator.

That's unlikely to happen given the current reads of the labor market so far this month. But if the nation's unemployment rate continues to rise in the months ahead, this recession signal could flash.

There is a history to consider...

I'm reminded today of the history of central bank leaders grossly underestimating how much unemployment can rise during a recession (which the Fed was expecting not all that long ago).

For example, in 2007, the Fed forecast less than half a percentage point of a rise in unemployment... and the rate ended up growing by more than 10 times that amount. The bank significantly miscalculated the rise in unemployment in 1973, 1981, and 1990, too.

According to ClearBridge Investments, since 1969...

Specifically, Fed forecasts have underestimated the rise in unemployment by 2.5% on average. If this holds, unemployment could rise above 7% in the coming potential downturn, which is hardly consistent with a shallow recession.

That's our quote of the week.

Don't get me wrong...

I'm not predicting a terrible recession right here, right now. And no matter what I think, the markets aren't acting like it's going to happen yet.

As I've pointed out this week, the major U.S. indexes are in a strong bull market and the S&P 500 and Nasdaq have been trading at new all-time highs lately.

One day of trading doesn't change the bullish momentum or our thoughts about the value of owning shares of high-quality businesses and inflation hedges like gold, which traded near a new all-time high today.

At the same time, we did just make the case yesterday that a pullback in stocks could be ahead because of weakening "breadth."

As we mentioned, the Stansberry's Investment Advisory team's Complacency Indicator, which has an excellent track record of predicting 10% drawdowns in the S&P 500 within the following 12 months, triggered earlier this year.

So there are risks ahead. Two to consider are a deflationary trend and/or a spike in the unemployment rate. Either of these would likely not result in a "mixed" market reaction... but instead a bearish response.

It's one thing to wake up and see one deflationary reading while the Fed is itching to cut rates. It's quite another to see sustained deflation and job losses when our financial system is hooked on debt, fiat currency, and consumer spending, which drives roughly 70% of U.S. economic activity.

So don't forget about the prospect of bad news for the economy potentially becoming "bad news" for stocks. And in the shorter term, keep an eye on if the "divergence" we saw between small caps and large caps today continues.

New 52-week highs (as of 7/10/24): Apple (AAPL), Agnico Eagle Mines (AEM), Applied Materials (AMAT), Amedisys (AMED), ASML (ASML), Cintas (CTAS), iMGP DBi Managed Futures Strategy Fund (DBMF), Electronic Arts (EA), iShares MSCI Emerging Markets ex China Fund (EMXC), Alphabet (GOOGL), Intercontinental Exchange (ICE), Nuveen Preferred & Income Opportunities Fund (JPC), KraneShares MSCI Emerging Markets ex China Index Fund (KEMX), Kinross Gold (KGC), Eli Lilly (LLY), Altria (MO), Motorola Solutions (MSI), Nuveen California Quality Municipal Income Fund (NAC), Neuberger Berman Next Generation Connectivity Fund (NBXG), Newmont (NEM), Novartis (NVS), ProShares Ultra QQQ (QLD), Invesco S&P 500 Equal Weight Technology Fund (RSPT), Skeena Resources (SKE), VanEck Semiconductor Fund (SMH), S&P Global (SPGI), ProShares Ultra S&P 500 (SSO), Teradyne (TER), Torex Gold Resources (TORXF), Texas Instruments (TXN), Vanguard S&P 500 Fund (VOO), Verisk Analytics (VRSK), Wheaton Precious Metals (WPM), and the short position in Teladoc Health (TDOC).

A quiet mailbag today. What's on your mind? As always, e-mail us at feedback@stansberryresearch.com.

All the best,

Corey McLaughlin
Baltimore, Maryland
July 11, 2024