AFMC - Inflation And Interest Rates: It All Comes Down To Real Estate

2023-07-13 08:00:00 ET

Summary

• The latest CPI report had some very positive news for investors and the economy at large.
• However, the best news in the report was actually found in the worst part of the report.
• We share our outlook for inflation moving forward, as well as where we think the best places to invest are right now.

The latest consumer price index data just came out and - ironically - the worst part of the report was actually the best news for investors. In this article, we will review the latest CPI numbers and discuss the best part of the report and how it impacts the outlook for the stock market.

Reviewing The June CPI Numbers

Almost exactly one year ago, I stated that I...

...think inflation may have peaked.

It turns out that that projection was correct as the U.S. CPI has plummeted dramatically since then, plunging from a four-decade high 9.1% in June of 2022 to 2.97% in June of 2023:

On a sequential basis, CPI has also fallen considerably from where it was last summer and has sustained a fairly low level in recent months in particular:

Core CPI (CPI without its more volatile food and energy components) meanwhile has been less volatile and remains rather elevated, though it has come down significantly from last summer as well:

On a sequential basis, Core CPI increased at a mere 0.2%, which is also quite tame and the lowest sequential rate of increase for Core CPI since August 2021. Shelter, motor vehicle insurance, apparel, recreation, and personal care all experienced inflation during June while airline fares, communication, used cars and trucks, and household furnishings and operations experienced deflation during the month.

The Best Part Of The June CPI Report

The biggest driver of inflation in the June CPI report was shelter, as it accounted for over 70 percent of the increase. In other words, without it, CPI would have been less than 1% year over year and Core CPI would have been similarly impressive. This is because shelter accounts for 33% of overall CPI and is more than 40% of core CPI.

While shelter's sustained high inflation in the June CPI report is obviously not a positive - especially given that housing affordability is already at or near record lows in most markets across the United States - it actually bodes extremely well for the headline and core CPI readings in the second half of 2023.

This is because the housing data has quite a lag (roughly 6-12 months long) in how it shows up in the CPI index and every indication is that housing inflation has dramatically slowed and possibly even entered deflation in many markets across the United States this year. Rent data is collected semiannually by the U.S. Bureau of Labor Statistics from a specific set of households. These households are divided into six panels, and data collection for each panel is staggered throughout the year. Rent information for each panel is collected in different months, such as January and July for Panel 1, February and August for Panel 2, etc. As a result, it usually takes around a year to complete data collection from all the subgroups.

This means that the deflationary changes in the housing market that have taken hold earlier this year should begin to show up in CPI readings at some point in the second half of this year and carry over into early 2024. As a result, prominent economists like Harvard's Jason Furman, Moody's Mark Zandi, and Capital Economics' Andrew Hunter are all predicting a headwind to inflation coming from the housing sector in the very near future. Furman tweeted :

Shelter is still playing a big role in inflation but that should be slowing in the second half of the year

Moreover, Zandi stated :

I know [falling housing inflation is coming soon] with about as high a degree of confidence as one could have.

Finally, Hunter stated that declining CPI related housing inflation is:

almost as much of a certainty as you can get, really.

Given that shelter is such a huge part of CPI and an even larger part of Core CPI (which carries more weight with the Federal Reserve than the headline CPI number), if these predictions bare out - which it appears a near certainty that they will do so given the lag factor at play here - the odds look very high that CPI numbers will continue to fall moving forward. The only potential headwind is that CPI inflation did peak last June, so the comps may not be quite as challenging moving forward. However, they still were quite strong for the remainder of 2022 and the effect from plunging housing inflation will likely be quite strong on the headline and core figures.

Stock Market Implications

What does this mean for major indexes like the S&P 500 ( SPY ), Nasdaq ( QQQ ), and Dow Jones Industrial Average ( DIA )?

Markets are still reportedly pricing in a more than 90% chance of a 25 basis point hike at the Fed's monetary policy committee meeting later this month. However, the view that the Fed will continue hiking beyond next meeting is now becoming less likely. As a result, stocks and commodities flew higher across the board, with gold ( GLD ) and silver ( SLV ) reaching one-month highs on the more dovish outlook for interest rates, while higher growth tech stocks in QQQ and SPY flew higher as well.

Meanwhile, the high yield side of the market also received a boost, with utilities ( XLU ) advancing nicely and REITs ( VNQ ) and midstream ( AMLP ) also advanced, though more moderately than the news would have seemed to indicate.

Overall, this report is undoubtedly very positive news for the stock market as it provides additional hope that the Federal Reserve can truly score a soft landing by taming inflation to a satisfactory level without having to crash the economy in the process. Moreover, lower inflation means that corporate profits will be under less pressure and real returns on stocks themselves are also better.

Investor Takeaway

While the inflation report was good news in and of itself, the best news was that shelter inflation remains the main driver of inflation and we have good reason to believe that it will subside meaningfully in the coming months. Once this happens, the Federal Reserve should be able to pause its rate hike program. Given that this is happening alongside a persistently strong labor market and an impressively resilient economy means that the Federal Reserve has at a minimum managed to successfully re-arm itself with its primary tool of fighting recessions through rate cuts by getting the Federal Funds Rate up to levels not seen since before the Great Financial Crisis:

While the Federal Reserve deserves to lose a lot of credibility for getting us into this mess in the first place (as it has with virtually all of our boom and bust cycles since its creation over a century ago), investors should take comfort in the fact that interest rates are as high as they are today without the economy collapsing yet.

In our view, while all stocks will likely get a short-term boost from falling inflation and less upward pressure on interest rates, the best place to be right now is in defensive high yield stocks that were beaten down the most in the wake of the Fed's rate-hiking program. Tech stocks and the SPY and QQQ indexes as a whole are far too frothy at the moment. However, there are many high yield investment grade REITs, utilities and infrastructure businesses, midstream businesses, BDCs ( BIZD ), miners, and asset managers trading at deeply discounted levels that should soar higher if/when rapidly falling inflation becomes apparent and the Federal Reserve finally pivots. Moreover, these businesses are generally quite defensive in nature and pay out attractive dividends, making them strong candidates for riding out a recession.

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