The Week Behind

Market action picked up midway through the week reacting to Wednesday’s hot CPI report. Headline made a new peak at 9.1%, compared to 8.6%. Core continued to cool at 5.9%, compared to 6.0%. Despite the red hot number, major indices tallied only relatively minor losses while exhibiting resilient intraday activity. For the week, the DOW ended about even; the S&P lost ~1%; and the NASDAQ fell ~1.5%.

Highlights

• U.S. Dollar and Euro reached parity for the 1st time in 20-years, reflecting the historic degree of FED Tightening and European Recession Fear. 
• Multiple yield curves closed the week inverted. The greater duration and depth of the inversions add to the recession signal’s predictive value.
• Technicals appear ripe for continued, short-term upside in the NASDAQ. While the NASDAQ remains in a downtrend, since June’s low, the index has formed higher-highs and higher-lows. Buyers are entering at relatively higher prices, taking more risk, and sellers are waiting for relatively higher prices, waiting for more upside, to exit. Underlying momentum indicators, such as OBV, justify these moves. 
• Despite optimistic commentary on the current state of consumers and businesses, JPM increased cash on their balance sheet: a material step in preparing for credit losses synonymous with economic downturns. 

June CPI: So Bad It’s Good

Following Wednesday’s 9.1% CPI, major indices started each day with a gap down. Each time, the gap was met by a wave of buying that completely evaporated the gap by midday. Had I known the CPI would feature a 9-handle, I would have guessed an immediate retest of the lows. So, why the resilience? This number was so bad, it was good. 

Every single CPI component – apparel, food, energy, used and new cars, etc… – was higher MoM. Airline fares may have been slightly lower but still significantly elevated. However, food and energy commodities are now clearly in a downtrend. Furthermore, PPI, an economic indicator that leads (predicts) CPI, appears to have peaked. If this were a stock, wouldn’t you want to short it? With all this in mind, how could Headline CPI have made a new peak? Well, CPI is a lagging indicator: it tells us what’s already happened, not what is to come. 

Here is the new argument for peak inflation: CPI could only be so hot because it was taken at the absolute worst time, when prices were at their highs. There is no way this CPI captures the collapse in oil, copper, lumber, wheat, soy, or corn. Subsequent reports will reflect this collapse. Consequently, inflation, through the lens of CPI, which the FED uses to help shape monetary policy, has peaked. By the time the FED meets in September, the next two CPI reports will likely be below the highwater mark of 9.1%, which could provide the FED an opportunity to be less hawkish in the form of a sub-75bps rate hike. 

In my view, the argument for peak inflation, while still requiring some proving out, is, perhaps, at its strongest. However, we need more data before anyone that matters – anyone at the FED – would be convinced. Currently, the argument is standing on the notion of “it was so bad that it cannot possibly get worse, and that’s good”. We still lack follow through.

Personally, I think Headline CPI has peaked. Despite that personal belief, I do not think that means we are all clear from here. There are still known-unknowns, factors we know exist but are unable to accurately measure the impact of, for the market to digest and contend with. 

• Earnings Revisions 
• Rate of Balance Sheet Reduction substantially increasing at the end of September

The Week Ahead

We have a heavy week of earnings that includes a healthy mix of banks, technology, and healthcare. Noteworthy are Bank of America, Goldman Sachs, Tesla, JNJ, and Netflix. Given the definitive nature of CPI and its implication to the macro, I think the market will be more focused on earnings. Since Microsoft (MSFT), which does not report this week, mentioned foreign exchange (FX) headwinds for the coming quarter, I think the market has priced-in the impact of a strong dollar. Specifically, I think the market will fixate on forward guidance. 

With the macro debate temporarily paused and FX accounted for, I hypothesize the driving force behind price action this earning season will be forward guidance. Right now, the market is clearly concerned with the severity of recession. Recession represents a material decrease in future demand across all sectors. Forward guidance is essentially a company’s forecast of future demand. Consequently, I think investors and analysts are looking to forward guidance for signs of recession-driven demand destruction. Furthermore, analysts, which are ultimately responsible for revising earnings, place a lot of weight on the guidance and management’s commentary. To summarize, of all the information distributed on an earnings call, the stakes for forward guidance have seemingly never been higher, which is why I predict it will be the driving force of price action this earning season.