What Central Bankers Hate More Than Inflation
The latest inflation data… Status quo for the markets… Considering the three 'flations'… What central bankers really hate… The surprising winners from deflationary periods…
It wasn't bad news...
This morning, the U.S. government published one of its final major inflation readings of the year, and the November consumer price index ("CPI") showed price growth of 0.1% from October and 3.1% versus a year ago.
These numbers were mostly in line with Wall Street expectations. The market shrugged. Three of the four major U.S. stock indexes were higher by mid-morning, and the market's "fear gauge" – the CBOE Volatility Index, or VIX – remained at peaceful levels.
While the month-over-month CPI reading from Uncle Sam was up slightly from flat headline price growth in October, November's year-over-year number was down from October's 3.2%, continuing a downward trend of the pace of inflation since a peak of 9.1% in June 2022.
Beneath the headline numbers, here are a few details worth noting...
Falling energy prices, including a notable 6% decline in gasoline from a month ago, balanced out still-rising rent costs and slight gains in food prices. This CPI report also showed higher prices in most other major categories (like medical care, used vehicles, and car insurance), though apparel saw deflation of more than 1% from October.
Status quo for stocks, bonds, and the Fed...
All in all, it doesn't matter what I (Corey McLaughlin), you, or anyone else think about inflation in our community or line of work. This data probably won't have much influence over the Federal Reserve's decision on monetary policy tomorrow, and thus the direction of the broader stock market in the short term.
As Ten Stock Trader editor Greg Diamond wrote to his subscribers today...
There were no big surprises with the Consumer Price Index ("CPI") number this morning. We saw an initial drop in stocks, but the bulls charged right back.
As I mentioned yesterday, we could just see a grind higher.
The leading odds are on the central bank to keep its benchmark lending rate in a range of 5.25% to 5.5%. And this report didn't show anything significant enough for the Fed to break its interest-rate "pause" streak that began in June, which is bullish for stock prices on balance.
To some investors, the inflation fight is over... The Fed has already defeated it. However, the headline inflation numbers aren't what Fed Chair Jerome Powell has targeted. These investors won't like it if Powell uses his post-meeting press conference to remind them things like, "The data shows that inflation isn't dead yet" and, "We're committed to our 2% target."
Keep in mind, though, as we've said recently, the Fed's preferred inflation gauge – the "core" personal consumption expenditures ("PCE") index, which strips out "volatile" food and energy prices – has averaged 0.2% monthly growth for the past five months.
That's already in the ballpark for the central bank to meet its 2% annualized inflation goal. So, investors have been betting over the past few months that the next most likely move for the Fed is to cut rates rather than raise them or hold them steady, given simultaneous expectations for the economy and jobs market to deteriorate.
While we're on the subject of the three 'flations'...
I don't want to get too far ahead, but as we talk about continued "disinflation" – prices rising, but by less than before – it's wise to also consider the next possible major stop in this discussion...
A few weeks ago, we noted we heard the "d-word," or deflation, coming from the voice of Walmart CEO Doug McMillon. The head of America's largest retailer (and grocery chain) raised this possibility on the company's most recent quarterly earnings call.
And afterward, we received a few notes about the subject, so we want to follow up on it.
As we wrote in the November 21 edition, McMillon said price growth in general had been slowing and suggested consumers could even see growth reverse for items such as canned goods and consumables soon. He said on the call...
In the U.S., we may be managing through a period of deflation in the months to come. And while that would put more unit pressure on us, we welcome it, because it's better for our customers.
He followed up on these comments in a television interview last week. McMillon said record-high credit-card balances and dwindling household savings raise questions to him about how much consumers will spend in the year ahead.
Combined with deflation he's already seeing – for example, general merchandise items at Walmart have dropped by 5% from a year ago – that could hurt a company's profits. Walmart's full-year earnings forecast last month was lower than Wall Street expected.
This deflation talk is notable to me for a few reasons...
We're bringing up Walmart because it's America's largest retailer. Buying trends in its stores happen all around the country to varying degrees.
As we wrote in the November 21 edition, if the big trend in prices in America turns from disinflation to deflation – outright decreases in prices – that will mark a sea change for the markets...
We could be approaching the next part of the post-pandemic U.S. economic story... That is, when the dominant market narrative of cheering disinflation turns to one of fearing and dealing with deflation.
Deflation is when nominal prices go down. That would be great for real people on a budget who need to buy things, but not so great for businesses interested in growing profits in an environment where everything got way more expensive the past few years, labor included.
Deflation happens when tires or balloons pop. The same could be said for the economic bubble we saw begin in early 2020. Trillions of dollars in stimulus were injected into an economy that had already enjoyed a decade of abnormally low interest rates that juiced the market.
You could argue the economy needs a period of deflation to get back to "normal," whatever that is these days. But even if that is true, it won't happen without painful consequences. You could also argue that the pace of inflation will keep on gliding down ever so neatly forever – or other outcomes.
Some of those consequences to consider are a more difficult road for businesses to turn profits, as McMillon suggested. This discussion also serves as a reminder that the next stop from disinflation is deflation, absent a catalyst otherwise.
Today's CPI report showed slight deflation in apparel versus last month, as I mentioned. More specifically, prices fell in categories like toys (2.8% lower than a year ago), furniture (down 3.1%), appliances (down 3.5%), school supplies (down 4.8%), and airline tickets (down 12.1%).
Let me be clear: We are not seeing deflation all across the entire economy. But it is out there already in pockets, especially interest-rate-sensitive areas. Whether we see widespread deflation ahead, I can't tell you.
But it's a worthy subject to discuss.
Again, deflation might be good for consumers like you and me, but it makes life more difficult for businesses. And the last time we wrote about deflation, a few of you wrote in wondering about what assets, stocks or otherwise, might hold up the best in deflationary periods.
To this point, deflation is not great news for markets – at first...
The effect of deflation on stocks runs parallel with that of interest-rate cuts (like we discussed last week). Deflation is painful for markets when it begins – it signals economic downturn. But if history is a guide, there's better news in the long run.
We did some digging into the subject recently, and what we found might surprise you.
First off, deflationary periods are historically rare: Since the start of the Great Depression, only nine calendar years have registered a negative CPI reading, or outright deflation. The most recent was in 2009 when the CPI was negative 0.4%.
Second, as they are arriving, these periods have been mostly painful. The Depression was not surprisingly the worst, when prices fell each year by 3%, 9%, 10%, and 5% from 1930 to 1933, respectively, according to the CPI.
In 1937, as the Fed tightened policy near the end of the Depression, interest rates rose and the benchmark stock index dropped 35%. Deflation set in in 1938 (with prices dropping 2%) and 1939 (falling 1.3%) before the Fed relented and lowered rates to rock-bottom levels for another few years. That helped juice the markets higher...
The story has been similar in the last few, rare periods of deflation in the U.S.
But what stands out is just how much stocks returned amid these periods of deflation.
The chart below shows the last three years when CPI was negative (1949, 1955, and 2009). Perhaps counterintuitively, deflation is correlated with double-digit positive returns for stocks. (Since it went by different names over the years, consider the label "S&P 500" to mean the leading index of the day)...
Corporate bonds have also done well, with Treasurys and real estate lagging the performance of major asset classes generally. By definition, the relative value of cash should also rise.
The reason? If you think central bankers dislike inflation today, they have tended to really hate deflation, and they don't hesitate to step in and "rescue" the markets.
In 1949, after a period of rising interest rates led to deflation (a negative 1% CPI for the year), according to a history by the St. Louis Fed...
Short-term rates declined abruptly around the middle of the year, following reduction of member bank reserve requirements and discontinuance of net sales of securities by the Federal Reserve System to meet market demand (which began early in the year).
The deflation in 1955 was mild (negative 0.3%) and the outlier of this group. Yet it has some similarities to today.
It happened as interest rates rose after the post-Korean War inflationary period and in between the recessions of 1953 to 1954 and 1958, or the "Eisenhower Recession." The between period went fine for stocks. In 1954, the year before the deflation, stocks were up 53%.
But the Great Recession reminds us of the dangers of deflation fears and reality again.
The S&P 500 was down 37% in 2008 before the Fed stepped in with its newfangled rescue measures and ultra-low interest rates. The deflation wasn't as bad as some feared (negative 0.4% in 2009), and the events kicked off a record-long bull market and other consequences.
Will the Fed "let" deflation happen for very long if deflation strikes before the central bank would prefer to cut rates? I doubt it – the bank is in tune with trying to fix any crises that may arise. But if deflation does happen, it could be a bumpy ride until we see a "fix."
Said another way, the worse the deflation, the worse for stocks and the economy as it's happening... but then you may want to expect a bigger response and return for stocks on the other side.
New 52-week highs (as of 12/11/23): ABB (ABBNY), Adobe (ADBE), Advanced Micro Devices (AMD), A.O. Smith (AOS), Brown & Brown (BRO), Costco Wholesale (COST), Cintas (CTAS), D.R. Horton (DHI), Enstar (ESGR), Expedia (EXPE), Fidelity National Financial (FNF), W.W. Grainger (GWW), Huntington Ingalls Industries (HII), ICON (ICLR), Ingersoll Rand (IR), iShares U.S. Aerospace & Defense Fund (ITA), JPMorgan Chase (JPM), Lennar (LEN), London Stock Exchange Group (LNSTY), Motorola Solutions (MSI), Palo Alto Networks (PANW), ProShares Ultra QQQ (QLD), Qualys (QLYS), Invesco S&P 500 Equal Weight Technology Fund (RSPT), SentinelOne (S), Sprouts Farmers Market (SFM), Sherwin-Williams (SHW), VanEck Semiconductor Fund (SMH), SPDR Portfolio S&P 500 Value Fund (SPYV), Trane Technologies (TT), and Vanguard S&P 500 Fund (VOO).
In today's mailbag, a comment on yesterday's Digest about reality versus fantasy... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.
"Hi, I wouldn't trust YouGov [polls], they have a political agenda. They'll ask lots and lots of questions, and then carefully select out the one question where they got the answer they wanted. [It's] selective quotation. What is the full list of questions they asked the people?..." – Subscriber Richard M.
Corey McLaughlin comment: Richard, I'm with you on being skeptical about polls and how data can be skewed based on how questions are presented. I read through the details of this one and found the common answer about inflation – from various demographics and political preferences – to be significant. You can find the whole thing here.
All the best,
Corey McLaughlin with Tyler Jarman
Baltimore, Maryland
December 12, 2023