Colas: "We're Not Out Of The Woods Yet"

Authored by Nicholas Colas via,

Not to be a party-pooper, but we wouldn’t take too much comfort in today’s US stock rally. Wednesday was the expiration day for monthly CBOE VIX Index options. Traders in those instruments have been on a wild ride over the last week. Squaring up positions on expiration day tends to create incremental volatility in normal environments. Add the much higher levels of open interest now, and you have the makings of a “Black Cygnet”, if not “Swan”. We linked to a Bloomberg story yesterday that highlighted this, and include it here.

We’ve seen the volatility market “tail” wag the stock market “dog” a lot recently, so we’re going to chalk up today’s move to the downdraft in the VIX related to expiration. One possible compounding effect: short covering as the S&P went unexpectedly positive just after 10am. While explaining daily moves is hard, we like this narrative better than “Stocks have discounted higher rates already”. That feels premature.

The combination of sluggish retail sales and higher CPI inflation, both out this morning, actually had a whiff of “Stagflation” about them – low economic growth and inflation. That term, by the way, was not invented in 1970s America even though it fit the economic mood of the times. Rather, it was the creation of a colorful British politician named Iain Macleod who used it in a magazine article in 1965.

Now, we aren’t especially worried about the retail sales number (0.3% lower than December, seasonally adjusted) for three reasons:

  • We will shortly see the effect of lower tax and withholding payments in worker paychecks from last year’s tax reform. Very little of the reduction in personal tax rates and higher standard deductions appeared in January paychecks. Payroll processors needed more time to adjust withholding tables, but the new rates should be in place by the end of this month. US consumers have a long history of spending “found money” – this time shouldn’t be any different.
  • Negative retail sales prints are hardly uncommon, even in economic expansions. There were 3 last year, for example, and 2 the year before that.
  • Year on year growth is still 3.6% higher. Yes, that is slower than the +5% prints of Q4 2017, but similar to those from June, July and August of last year.

Now, the CPI inflation story is one that equity investors do need to keep top of mind. A few points here:

  • While not part of “Core” inflation, both Food and Energy (21% of the headline CPI number by weighting) are getting more expensive. Food inflation was +1.7% year-on-year in today’s report; it was negative 0.1% a year ago. Gasoline prices (half of the Energy basket) are +8.5% higher than a year ago.
  • Owners Equivalent Rent (how the BLS factors inflation for shelter) is an important category – 32% of headline CPI and 42% of core. Inflation here has ticked down from 3.6% at the end of 2016 to 3.2%. Full employment and the stimulus from tax reform should filter through to the housing market quickly enough to see a difference in 2018. Given its importance to the CPI calculation, this is the number to watch.
  • Telephone services (mostly wireless plans) are no longer a headwind to higher inflation. This is a small part of CPI – just 2.3% of headline – but it was one explanation the Federal Reserve used last year to explain low inflation. That excuse is slowly receding – the CPI reading here was -6.6% year over year, but off the worst comps of -9.0% from last year.

The upshot here is that the US growth story is fine, but inflation is slowly ticking higher. If that were the end of the story, equity investors and markets would be fine. The great unknown: what will larger worker paychecks, a weaker dollar, further Federal stimulus, and tighter central bank policy do to consumption, inflation and interest rates?

One last point to cap the discussion: today, Fed Funds Futures showed a large increase in the odds that the Federal Reserve hikes rates 4 times or more this year rather than the guidance of 3 bumps. The odds of “4-or-more” increases now stands at 26%. The last time they were in the same neighborhood was last week, right at the start of the equity market decline.

Fed Funds Futures Odds: