CPI shock upsets markets

The consumer price index (CPI) dipped to 8.25% (seasonally adjusted) for the 12 months to August but disappointed stock and bond markets who were anticipating a sharp fall.

CPI

The S&P 500 fell 4.3% to test support at 3900. Follow-through below 3650 would confirm earlier bear market signals.

S&P 500

Services CPI — which has minimal exposure to producer prices and supply chains — climbed to 6.08%. Rising services costs indicate that inflation is growing embedded in the economy.

CPI Services

Fueled by strong growth in average hourly earnings.

CPI & Wage Rates

But it is not only services that present a problem.

Food prices are growing above 10% p.a. — signaling hardship for low income-earners.

CPI Food

The heavily-weighted shelter component — almost one-third of total CPI — climbed to 6.25%. We expect further increases as CPI shelter lags actual home prices — represented by the Case-Shiller 20-City Composite Home Price Index (pink) on the chart below — by 6 to 12 months.

CPI Shelter

CPI energy is still high, at 23.91% for the 12 months to August, but the index has fallen steeply over the past two months (July-August).

CPI Energy

The decline is likely to continue until the mid-term elections in November, as the US government releases crude from its strategic reserves (SPR) in order to suppress fuel prices.

SPR Levels

The reduction in strategic reserves is unsustainable in the longer-term and reversal could deliver a nasty surprise for consumers in the new year.

SPR Lowest since 1984

Conclusion

Strong CPI growth for the 12-months to August warns that inflation will be difficult to contain. Services CPI at 6.08% also confirms that inflation is growing embedded in the economy.

Energy costs are falling but this may be unsustainable. Releases from the strategic petroleum reserve (SPR) are likely to end after the mid-term elections in November.

The Fed is way behind the curve, with the real Fed funds rate (FFR-CPI) at -5.92%, below the previous record low of -4.97% from 1975.

Real Fed Funds Rate (FFR-CPI)

We expect interest rates to rise “higher for longer.” A 75 basis-point hike is almost certain at next weeks’ FOMC meeting (September 20-21).

Long-term Treasury yields are rising, with the 10-year at 3.42%. Breakout above resistance at 3.50% is likely, signaling the end of a four decade-long secular bull trend in bonds.

10-Year Treasury Yields

Stocks and bonds are both falling, with the S&P 500 down 18.0% year-to-date compared to -25.4% for TLT.

S&P 500 and iShares 20+ Year Treasury ETF (TLT)

The best short-term haven is cash.

Base case: global recession

The Treasury yield curve is flattening, with the 10-year/3-month yield differential plunging sharply, to a current 0.24%. Another 75 basis point rate hike at the next FOMC meeting is expected to drive the 3-month T-Bill discount rate above the 10-year yield, the negative spread warning of a deep recession in the next 6 to 18 months (subsequent reversal to a positive spread would signal that recession is imminent).

10-Year & minus 3-Month Treasury Yield

The S&P 500 is retracing to test short-term support at 4200. Breach would warn of another decline, while follow-through below 3650 would signal the second downward leg of a bear market.

S&P 500

 

21-Day Volatility troughs above 1% (red arrows) continue to warn of elevated risk.

S&P 500

Dow Jones Industrial Metals Index is in a primary down-trend, warning of a global recession.

DJ Industrial Metals Index

Supported by a similar primary down-trend on Copper, the most prescient of base metals.

Copper

Brent crude below $100 also warns of an economic contraction. Goldman Sachs project that crude oil will reach $135 per barrel this Winter, while Ed Morse at Citi says that WTI Light Crude will likely remain below $90 per barrel. Obviously, the former foresees an economic recovery, while the latter sees an extended contraction. Of the two, Morse has the best track in the industry.

Brent Crude

Natural gas prices are climbing.

Natural Gas

Especially in Europe, where Russia is attempting to choke the European economy.

Russia: EU Gas

Causing Germany’s producer price index to spike to 37.2% (year-on-year growth).

EU: PPI

Conclusion

Our base case is a global recession. A soft landing is unlikely unless the Fed does a sharp pivot, Russia stops trying to throttle European gas, and China goes all-in on its beleaguered property sector. That won’t address any of the underlying problems but would kick the can down the road for another year or two.

Inflation is coming

Inflation tops investor concerns according to Fed report

Concerns over higher inflation and tighter monetary policy have become the top concern for market participants, pushing aside the COVID-19 pandemic, the Federal Reserve said on Monday in its latest report on financial stability. ….Roughly 70% of market participants surveyed by the Fed flagged inflation and tighter Fed policy as their top concern over the next 12 to 18 months, ahead of vaccine-resistant COVID-19 variants and a potential Chinese regulatory crackdown. (Investing.com)

The market is no longer buying the Fed’s talk of “transitory” inflation.

Fed’s Bullard expects two rate hikes in 2022

St. Louis Federal Reserve Bank President James Bullard on Monday said he expects the Fed to raise interest rates twice in 2022 after it wraps up its bond-buying taper mid-year, though he said if needed the Fed could speed up that timeline to end the taper in the first quarter. “If inflation is more persistent than we are saying right now, then I think we may have to take a little sooner action in order to keep inflation under control,” Bullard said in an interview on Fox Business Network……Bullard has been among the Fed’s biggest advocates for an earlier end to the Fed’s policy easing, given his worries that inflation may not moderate as quickly or as much as many of his colleagues think it will. (Reuters)

The Fed are reluctant to hike interest rates, to rein in inflationary pressures, as it would kill the recovery.

Producer Price Index

Producer prices (PPI) climbed more than 22% in the 12 months to October 2021, close to the high from 1974 (23.4%). Consumer prices have diverged from PPI in recent years but such a sharp rise in PPI still poses a threat to the economy.

Producer Price Index (PPI) & Consumer Price Index (CPI)

Iron and steel prices, up more than 100% year-on-year (YoY), will inevitably lead to price increases for automobiles and consumer durables. Other notable YoY increases in key inputs are construction materials (+30.6%), industrial chemicals (+47.3%), aluminium (+40.7%), and copper (+34.5%).

Producer Price Index: Commodities

Underlying many of the above price rises is a sharp increase in fuel, related products and power: up 55.7% over the past 12 months.

Producer Price Index: Fuel & Energy

Conclusion

Inflation is coming, while the Fed are reluctant to hike interest rates. Buy Gold, precious metals, commodities, real estate, and stocks with pricing power —  a strong competitive position which enables them to pass on price increases to their customers — if you can find them at reasonable prices. Avoid financial assets like bonds and bank term deposits.

Markets that are likely to outperform in 2021

There is no reliable benchmark for assessing performance of different markets (stocks, bonds, precious metals, commodities, etc.) since central banks have flooded financial markets with more than $8 trillion in freshly printed currency since the start of 2020. The chart below from Ed Yardeni shows total assets of the five major central banks (Fed, ECB, BOC, BOE and BOJ) expanded to $27.9T at the end of November 2020, from below $20T at the start of the year.

Central Banks: Total Assets

With no convenient benchmark, the best way to measure performance is using relative strength between two prices/indices.

Measured in Gold (rather than Dollars) the S&P 500 iShares ETF (IVV) has underperformed since mid-2019. Respect of the red descending trendline would confirm further weakness ahead (or outperformance for Gold).

S&P 500 iShares ETF/Gold

But if we take a broad basket of commodities, stocks are still outperforming. Reversal of the current up-trend would signal that he global economy is recovering, with rising demand for commodities as manufacturing output increases. Breach of the latest, sharply rising trendline would warn of a correction to the long-term rising trendline and, most likely, even further.

S&P 500 iShares ETF/DJ-UBS Commodity Index

Commodities

There are pockets of rising prices in commodities but the broader indices remain weak.

Copper shows signs of a recovery. Breakout above -0.5 would signal outperformance relative to Gold.

Copper/Gold

Brent crude shows a similar rally. Breakout above the declining red trendline would suggest outperformance ahead.

Brent Crude/Gold

But the broad basket of commodities measured by the DJ-UBS Commodity Index is still in a down-trend.

DJ-UBS Commodity Index/Gold

Precious Metals

Silver broke out of its downward trend channel relative to Gold. Completion of the recent pullback (at zero) confirms the breakout and signals future outperformance.

Silver/Gold

Stock Markets

Comparing major stock indices, the S&P 500 has outperformed the DJ Stoxx Euro 600 since 2010. Lately the up-trend has accelerated and breach of the latest rising trendline would warn of reversion to at least the long-term trendline. More likely even further.

S&P 500 iShares ETF/Euro Stoxx 600

The S&P 500 shows a similar accelerating up-trend relative to the ASX 200. Breach of the latest trendline would similarly signal reversion to the LT trendline and most likely further.

S&P 500 iShares ETF/ASX 200

Reversion is already under way with India’s Nifty 50 (NSX), now outperforming the S&P 500.

S&P 500 iShares ETF/Nifty 50

S&P 500 performance relative to the Shanghai Composite plateaued at around +0.4. Breakout would signal further gains but respect of resistance is as likely.

S&P 500 iShares ETF/Shanghai Composite

Growth/Value

Looking within the Russell 1000 large caps index, Growth stocks (IWF) have clearly outperformed Value (IWD) since 2006. Breach of the latest, incredibly steep trendline, however, warns of reversion to the mean. We are likely to see Value outperform Growth in 2021.

Russell 1000 Value/Growth

Bonds

The S&P 500 has made strong gains against Treasury bonds since March (iShares 20+ Year Treasury Bond ETF [TLT]) but is expected to run into resistance between 1.3 and 1.4. Rising inflation fears, however, may lower bond prices, spurring further outperformance by stocks.

S&P 500 iShares ETF/Long_term Bond ETF (TLT)

Currencies

The US Dollar is weakening against a basket of major currencies. Euro breakout above resistance at $1.25 would signal a long-term up-trend.

Euro/Dollar

China’s Yuan has already broken resistance at 14.6 US cents, signaling a long-term up-trend.

Yuan/Dollar

India’s Rupee remains sluggish.

Indian Rupee/Dollar

But the Australian Dollar is surging. The recent correction that respected support at 70 US cents suggests an advance to at least 80 cents.

Australian Dollar/Dollar

Gold, surprisingly, retraced over the last few months despite the weakening US Dollar. But respect of support at $1800/ounce would signal another primary advance.

Spot Gold/Dollar

Conclusion

Silver is expected to outperform Gold.
Gold is expected to outperform stocks.
Value stocks are expected to outperform Growth.
India’s Nifty 50 is expected to outperform other major indices. This is likely to be followed by the Stoxx Euro 600 and ASX 200 but only if they break their latest, sharply rising trendlines. That leaves the S&P 500 and Shanghai Composite filling the minor placings.
Copper and Crude show signs of a recovery but the broad basket of currencies is expected to underperform stocks and precious metals.
The Greenback is expected to weaken against most major currencies, while rising inflation is likely to leave bond investors holding the wooden spoon.

Crude oil: Opportunities and value traps

On the weekend we wrote that the bottom had fallen out of the oil market after Nymex crude broke support at $20 per barrel.

Now, the previously unimaginable has occurred, with Nymex Light Crude falling below zero for the first time in history, closing at -$13.10 per barrel with reports of intra-day lows at -$37.63.

WTI Crude

From The Age:

“Traders are still paying $US20.43 for a barrel of US oil to be delivered in June, which analysts consider to be closer to the “true” price of oil. Crude to be delivered next month, meanwhile, is running up against a stark problem: traders are running out of places to keep it, with storage tanks close to full amid a collapse in demand as factories, automobiles and airplanes sit idled around the world.

Tanks at a key energy hub in Oklahoma could hit their limits within three weeks, according to Chris Midgley, head of analytics at S&P Global Platts. Because of that, traders are willing to pay others to take that oil for delivery in May off their hands, so long as they also take the burden of figuring out where to keep it.”

Cushing Storage

Brent Crude is trading at $25.57 per barrel but a Trend Index peak deep below zero warns of similar strong selling pressure.

Brent Crude

Outlook

Crude oil production is still in a long-term up-trend. Low prices may present opportunities to buy cyclical stocks at historically low prices.

IEA Oil Production

The Oil & Gas sector has plunged as expected.

DJ US Oil & Gas

Oil infrastructure is also suffering from low activity levels.

DJ US Pipelines

Energy-consuming industries, however, may benefit from lower oil prices.

EIA: Industrial Sectors

Transport

Transport is the biggest consumer of crude oil products.

IEA Oil Sectors

If we break usage down by fuel types, the largest is diesel/gas, followed closely by motor gasoline, with jet kerosene significantly smaller.

Products from Crude

Airlines which have suffered from a massive drop in air travel.

DJ US Airlines

While delivery services (formerly air freight) are suffering from the collapse of global trade.

DJ US Delivery Services

So is marine transport.

DJ US Marine Transport
But trucking is holding up well.

DJ US Trucking

Construction Materials

Crude oil runs a distant second to coal as the chief energy source for cement production.

IEA Cement - Energy Usage

But the industry is a heavy transport user and should benefit from lower oil prices.

DJ US Construction Materials

Mining

Mining is also likely to benefit from lower extraction and transport costs.

DJ US Basic Materials

Forestry & Paper

Forestry is another heavy fuel user.

DJ US Forestry & Paper

Chemicals & Plastics

Basic chemicals (including fertilizers) are the largest industrial consumer of crude oil.

DJ US Chemicals

Specialty chemicals are also largely oil-based.

DJ US Specialty Chemicals

Aerospace & Automobiles

Aerospace, laid low by problems at Boeing (BA), has been floored by a massive downturn in the airline industry and will take a long time to recover.

DJ US Aerospace

Automobiles have so far stood up well because of stellar performance from the likes of Tesla (TSLA).

DJ US Automobiles

But the sting is in the tail. Light vehicle sales have plummeted.

Light Vehicle Sales

Low vehicle sales and less travel also means lower tire sales.

DJ US Tires

Oil Producers in Affected Regions

The IEA graph below shows producing regions that are uneconomic at varying prices/barrel (x-axis). If we take $25/barrel as the average over the next two years, North American producers would suffer the most, followed by Asia-Pacific and Latin America.

Uneconomic Crude Production by Country

Middle-Eastern producers enjoy the lowest extraction costs and are mostly still profitable at lower prices.

Avoiding Value Traps

Value opportunities abound in industries that are badly affected by the economic contraction and falling crude prices — as well as by those industries that stand to benefit from low oil prices. Some affected industries, however, are going to struggle to survive without state assistance.

The problem with value stocks is that, although they may seem cheap, prices can fall a lot further. That is why we use both technical and fundamental analysis to evaluate opportunities.

There are many stocks that are trading well below our assessment of fair value at present but we will not buy until the technical outlook turns bullish. It takes plenty of patience. But helps to avoid value traps.

The stock market remains an exceptionally efficient mechanism
for the transfer of wealth from the impatient to the patient.

~ Warren Buffett

The S&P 500 and Plan B

The S&P 500 penetrated its rising trendline, warning of a re-test of support at 3000. But selling pressure on the Trend Index appears to be secondary.

S&P 500

Transport bellwether Fedex retreated below long-term support at 150 on the monthly chart — on fears of a slow-down in international trade. Follow-through below 140 would strengthen the bear signal, offering a target of 100. The bear-trend warns that economic activity is contracting.

Fedex

Brent crude dropped below $60/barrel on fears of a global slow-down. Expect a test of primary support at 50.

Brent Crude

Dow Jones – UBS Commodity Index broke primary support at 76 on the monthly chart, also anticipating a global slow-down.

DJ-UBS Commodity Index

South Korea’s KOSPI Index is a good barometer for global trade. Expect a re-test of primary support at 250.

KOSPI

While Dr Copper, another useful barometer, warns that the patient (the global economy) is in need of medical assistance.

Copper (S1)

The Fed can keep pumping Dollars into financial markets but at some point, the patient is going to stop responding. In which case you had better have a Plan B.

Commodities & Global Growth

Commodity prices warn that the global economy is still in a slump.

The Dow Jones – UBS Commodity Index remains at one-third of its 2007 peak, with no sign of recovery.

DJ-UBS Commodity Index

The fall in crude prices hasn’t been as severe, but Brent Crude is again weakening and looks set for another test of $50/barrel.

Brent Crude

Shipping rates for dry bulk goods, such as iron ore and coal, have fallen, with the Baltic Dry Index close to long-term support at 500.

Baltic Dry Index

Supply interruptions to iron ore production in Brazil have cushioned Australian producers from a sharp down-turn in iron ore prices. But coal exporters are feeling the pinch.

RBA Chart Pack: Bulk Commodity Prices

Recovery of Brazilian production over the next two years is expected to add downward pressure to iron ore prices.

The only positive appears to be container shipping rates. The Harpex Index rose steeply in 2019, reflecting increased demand for container shipping of finished goods.

Harpex Index

Somewhat surprising, since this coincided with US-China trade tensions and tariff increases. The answer may lie with importers on both sides of the Pacific attempting to front-run the imposition of tariffs and build inventories in case of supply interruptions and to allow time to adapt their supply chain. Expect the index to retreat in the early part of 2020.

It looks like low global growth will continue.