CPI Deflationary; Full-Time Employment Swoons; Housing In The Dumpster – Could The Fed Be Any Further “Behind The Curve”?

There appeared to be some shifting in the equity market rally this past week (ending July 12^th) with small cap stocks (Russell 2000, +6.00%) upstaging tech (Nasdaq: +0.25%), the cap weighted S&P500 (+0.87%) and the DJIA (+1.59%). Note that the tech heavy Nasdaq barely rose during the week. It was a similar story for the cap weighted S&P 500, with the DJIA doing slightly better.

As noted, all the performance for the week was in the small caps (Russell 2000) taking its year-to-date performance from flat the prior week (ending July 5^th) to the 6% level.

Apparently, market players heard street commentary that the rally through July 5^th was all in the Mag 7 + Tesla, as shown on the chart above, and decided it was time for the smaller players to catch-up. The rally in the small cap space may also have been driven by the improvement in the inflation readings on Thursday (as discussed below), moving the probability of a September rate cut by the Fed to more than 90%. The rally in small caps likely occurred because small businesses have much less pricing power than larger ones and benefit from a lower inflation environment.

Jobs

The headline Nonfarm Payrolls (NFP) report for June, as reported in early July, appeared healthy on the surface at +206K. A closer analysis, however, shows that the labor market is weakening. Here’s why:

• There were -111K downward revisions to the April and May NFP payrolls, moving the net gain from +206K to +95K;
• Per Rosenberg Research, over the past 18 months, there have been negative revisions to NFPs 85% of the time. The NFP number has lost much of its credibility;
• The Birth/Death trendline model used by BLS added +90K to the NFP. But data on net new small business formations indicate that small business employment is falling, not rising. Eliminating that 90K from the NFP, which makes the assumption that small business employment was flat, would leave NFP at +5K. If small business employment actually fell, as is likely, the actual net change in NFP employment was more likely negative.

The Household Survey (HS) showed a net gain in jobs of +116K. But that barely put a dent into the -408K fall in May. Of equal or greater importance, full-time employment fell -28K, the sixth decline in the past seven months. As of June, full-time jobs are -1.2% lower than a year earlier (June 2023). The chart shows that, at least since 1990, whenever full-time jobs have fallen, a Recession was brewing.

Fed Chair Powell continues to call the labor market “strong.” But the chart below shows both rapidly rising Initial and Continuing Unemployment Claims.

Then there is the Sahm Rule regarding the U3 Unemployment Rate. It says that a 0.5 percentage point rise in that rate has historically always been associated with a Recession! The U3 low at 3.4% occurred in January ’23 and again in April of that year. The current 4.1% rate is 0.7 percentage points higher….

Inflation

The big story for the week was always going to be the inflation numbers. The headline CPI surprised the markets on Thursday (July 11), actually deflating by -0.1% in June, and likely cementing the Fed’s first rate cut for September (see the appendix for a discussion of the meaning of inflation, disinflation, and deflation). While unlikely, we would be pleasantly surprised if the Fed cut at their upcoming July 30-31 meeting, not because we think they will, but because they are already significantly behind the curve when it comes to fighting the oncoming Recession. There already is ample evidence that inflation is in retreat and the labor market has softened considerably.

Friday’s Producer Price Index (PPI) showed up slightly above expectations at +0.2% for June vs. May. However, looking at certain subsets of the index, like the Core Intermediate State PPI, which tends to be a leading indicator of CPI, gives us more confidence in our view that the inflation genie is back in the bottle. That sub-index fell -0.1% and was flat over the Q2 span. The PPI, like CPI, also showed that the prices of goods fell (-0.5% in June vs. May), and have fallen in three of the past four months. While a little hot on the headline, a deeper dive indicates that our disinflation/deflation thesis remains intact.

In past blogs, we forecast that we would see some deflationary CPI prints in Q4 and on into 2025. The first such print came earlier than we expected, and it came on the back of deflating core goods prices (ex-food and energy), down -1.8% from a year ago, and the lowest print in more than 20 years (since the Great Recession). (We note that Used Car Prices, the poster child for this inflation episode, are now down -10.1% from a year earlier (Manheim Used Car Index).

In past blogs, we have opined that we saw deflation coming because of the long lag in the rent data used by BLS in the CPI calculation. The chart below shows various inflation indexes through May. Note that the Apartment List National Rent Index peaked more than 2.5 years ago and has been negative since Q2/’23, currently standing at -0.7% year/year. Meanwhile, the Rent of Primary Residence used in the CPI was 5.3% in May, way above reality. And so, over the next few quarters, rents, with more than a third of the CPI weight, will continue to push the index lower.

Because we know that goods prices are deflating and that Rents in the CPI calculation will trend lower because of the lags used by BLS, we are confident that the CPI will show deflationary tendencies over the next few quarters. While many will cheer a deflationary spiral (things will cost less), we caution that one should be careful what one wishes for. Deflation, historically, is always associated with rising unemployment and with Recession.

Housing

As we have reported in past blogs, existing home sales have been dragged down by high mortgage rates (7% range), especially since mortgage rates for the 15 years prior to the latest Fed rate raising cycle were in the 3%-4% range.

Construction of homes and apartments has always been a key ingredient in the GDP recipe. The left side of the chart shows the low level of existing home sales (mortgage rates!). This negatively impacts GDP because it is normal for the buyers to do a ton of home improvements. The right side of the chart shows the downtrend in new housing starts, which directly feeds GDP.

SURPRISE!

While not a data point, the Economic Surprise Indexes are useful signals as to upcoming strength or economic weakness. Essentially, such indexes compare the actual data as opposed to expectations (the “consensus” estimates). If the data disappoint, i.e., are weaker than the consensus estimate, that is a sign that the item in question is lower or slower than perceived by the analysts. When the “surprises” become one-sided, it is a sign that the economy is expanding (positive surprises) or slowing (negative surprises) faster than the analysts expected.

The chart below shows that the Citigroup Economic Surprise Index turned negative in April and surprises to the negative side have since dominated. Another sign of a slowing economy.

Commercial Real Estate (CRE)

The picture below is a 41-story office tower in Manhattan (180 Maiden Lane) that sold for $173 million less than its last exchange. In 2015, that office complex sold for $470 million versus $297 million recently.

CRE issues aren’t confined to the coasts. The next picture is a Class A Indianapolis apartment complex of 292 units built in 2018 with a ground floor Whole Foods tenant. This complex now facing a $101 million foreclosure.

As we’ve cataloged over the last few months, the CRE problems continue to mount. Many smaller and mid-sized banks and other financiers have CRE as a staple in their loan portfolios. We suspect that we will soon see issues in the financial system that the Fed and the FDIC will have to deal with. The fallout is likely to have large economic impacts.

The Fed and Interest Rate Cuts

The Fed meets at July’s end and then again in the middle of September. No doubt July’s Fed statement and the press conference with Chair Powell will set the stage for the first rate cut in September, especially since the Fed will see two more CPI prints prior to that September meeting. We think that those prints will show no inflation in July and August at the very least, and possibly some slight deflation. Since the Fed is already “behind the curve,” it is our view that they should lower by 50-basis points in an effort to “catch-up.” They won’t, but that’s our view. Note that even with a 50-basis point reduction (to a 4.75%-5.00% Fed Funds rate), monetary policy will still be very restrictive, as the Fed itself has set “neutral” at 2.60%-2.75%. Because of the long lags from a monetary policy change to economic impact, we see the Fed as way “behind the curve.”

Final Thoughts

Signs of a cooling economy are emerging, from Retail Sales to the Employment data. Despite the NFP headline number, our analysis reveals that employment is weakening as seen in the spikes in Initial and Continuing Employment Claims.

A pleasant surprise occurred on Wednesday (July 10^th) when the CPI showed deflation for the month of June (see appendix below for inflation/disinflation/deflation definitions). In several of our past blogs, we threw down the possibility of deflation in 2025. It now looks to us like deflation is coming sooner. The -0.1% change in the CPI in June could be the first of a string of deflationary numbers.

Housing, a critical factor in the economy’s growth, continues to languish under the Fed’s restrictive interest rate regime. And we believe that Commercial Real Estate issues will soon be front and center in the banking system, especially in the Regional and Community Banking spheres.

Given the long lags from the implementation of monetary policy actions to their visible economic impacts, it appears to us that the Fed is “behind the curve.” Let’s not forget that even a 25 or 50 basis point easing only gets the Fed Funds rate to the 4.75%-5.00% range, still quite restrictive since the Fed has defined “neutral” as somewhere near 2.60%. Hence, even two rate reductions by year’s end still leaves monetary policy in severely restrictive mode. In addition, let’s not forget about the lags, as rate reductions in September and December won’t likely be felt by the economy until sometime later in 2025.

We’ve long forecast two rate cuts this year. Market odds of a September rate cut are now above 90%. The Fed is scheduled to meet at the end of July, then in September (rate cut) and again in December (another rate cut). While we are fairly confident that the Fed will not cut at the July meeting, we would welcome such action. And while we think it will be too little to stave off the oncoming Recession, every little bit helps!!

(Joshua Barone and Eugene Hoover contributed to this blog.)

Appendix: Inflation/Disinflation/Deflation

Everyone knows what the term “inflation” means, i.e., rising prices for goods/services without any quality improvements. Inflation comes in various forms: 1) outright price increases; 2) same price but smaller quantity; 3) same price but lower quality, or some combination of these.

Some people confuse the term “Disinflation” with the term “Deflation.” Disinflation still means prices are rising, but at a slower rate than they were previously. For example, assume the CPI rises 0.5% in July but by 0.3% in August. While we still have “inflation,” the rate of inflation has fallen and this is termed “disinflation.”

“Deflation” actually means falling prices. We saw that in June’s CPI report (overall index -0.1%) and we are seeing it in the falling prices of some goods. While many wish for deflation, we say that this is one of those times to be careful what you wish for. To get to a deflationary spiral, there must be an imbalance between supply and demand, i.e., either oversupply, or, more likely, demand has fallen. When retailers wind up with excess inventories, they put their goods “on sale,” i.e., “lower prices.” If demand has fallen fast, then we also see employee layoffs. A factory, for example, that isn’t getting orders because retailers have too much of what it produces, first reduces workweek hours (hourly employees earn less because they are working fewer hours), and, if such conditions persist, some employees are laid off. This further reduces demand as those laid off cut back on purchases, and a vicious cycle ensues. Recession inevitably accompanies deflation. The classic example of this is the 1930s Great Depression.