Yesterday’s Producer Price Index followed-up a better-than-expected CPI print with a major beat of its own. Economists were looking for an increase in producer prices of 0.2% for July, but instead costs declined by 0.5% on the month. Looking to the Core PPI (excludes energy and food producer costs), we got 0.2% vs. 0.4% expected. This was more than enough for the stock market bulls to pile on the narrative of peak inflation against bears such as myself. What is confusing about this release to me is that it tells a completely different story than the Preliminary Nonfarm Productivity and Unit Labor Cost data I covered Wednesday.
I didn’t put my own estimate for PPI, but if you recall I did expect a 0.5% increase in the July CPI. Had I have guessed the PPI number, I would have been looking for a 0.3-0.4% gain also. Since I’m not really sure what the contrast between this month’s producer cost data tells us in each of the releases listed above, I have to put myself in the penalty box here. I would suspect that this month’s Producer Price Index decline was a one-off, and will end up being an anomaly rather than a new trend. If Unit Labor Costs are continuing to increase rather dramatically with lower producer productivity, I would imagine that puts upward pressure on future PPI readings, and pressure on future PPI readings puts pressure on CPI readings even further down the line. However, as stated I’m in the penalty box on inflation right now since I’ve gotten the past few data sets wrong in my forecasts.
Sometimes, you just have to recognize when you don’t understand what the market is telling you. Rather than try and fake my way through it, I would rather be up-front about my confusion on current economic activity and financial market performance. That is why I skipped yesterday’s edit.
Here’s what I do know from the way the market reacted to the PPI data yesterday:
The S&P 500 could not sustain a rally when the market had every reason to rally. The more speculative end of the market, namely the no-earnings stocks and the stocks which comprise the ARKK 0.00%↑ innovation fund, started the morning on a positive note but suffered a sharp turn-around towards the second-half of the day. In general, the market was supposed to be risk-on, because bonds sold-off sharply. This was one of the weakest days I have seen in the bond market in months.
Bonds sold off heavily frankly because of the much better-than-expected PPI data. This is no doubt that this allowed the majority of investors to re-affirm their narrative that inflation is declining enough on its own, and thus the Federal Reserve can start to ease-up on its inflation fight. So the knee-jerk reaction was to sell bonds and re-allocate the money to stocks. Now if I would have gotten the PPI numbers a day prior, before everyone else did, then I would have went and bought up the most riskiest stocks on the market.
Instead, that is not what rallied for most of the day. Rather, it was the value stocks that were generally in favor Thursday, which shows that maybe some investors are not willing to buy the ‘inflation is dead’ narrative just yet. It is also possible that investors are starting to look forward to September, which is now only a few weeks away. Jerome Powell has stated as of late that the Fed will start to sell its bonds much more aggressively in September. I have made this point several times, mostly because I know this to be the biggest systemic risk lurking in the markets - the Fed is the biggest owner of Treasury Bonds, and threatening to start becoming a major seller of them. That means in September, (as long as the Fed sticks to that plan) bond prices will start declining quickly causing yields to shoot up just as quickly. That puts pressure on growth stocks, again most particularly the ones which make-up the ARKK innovation ETF along with the stocks that have yet to produce a profitable earnings quarter. Perhaps this threat of higher future interest rates on bonds is what is keeping gold from rallying back above the $1800 level.
In fact, looking to the Treasury auction on Thursday, the highest yield sold at auction on a 30-year government bond was 3.11%. Economists expected the highest yield in the auction would have been only 2.4%. What this tells us is that dealers (foreign countries, pension funds, etc.) are finding much less of an appetite to buy bonds right now. What this hopefully means is that big players are starting to recognize how highly negative real interest rates are, and that yields need to be much higher to compensate bond holders for the loss of purchasing power due to inflation.
Leaving that alone for now, what I really wanted to get into today was the consumer. The lower, middle, and upper-middle class consumers all seem to be getting affected differently from what has been taking place in the economy for the better part of the past 12-24 months. It really is amazing to see how each of the classes are reacting to inflation, the tight labor market, and the rise and fall of certain asset prices in the tail-end of this business cycle.
Take the above 3-month chart. The two laggards, Walmart & McDonald’s cater to the lower-end consumer base whereas Capri & Chipotle are serving as two comparable businesses industry-wise, and cater to the higher-end consumer. You can see that each of the pairs (Walmart & Capri / McDonald’s & Chipotle) have traded in relatively strong correlation with one another, but there has been clear outperformance from the two stocks that have many more upper-middle class customers. Investors have been betting that the businesses serving upper-middle class consumers as a bigger base have much more room to raise prices and pass costs on, because their customers are much more equipped to handle the price increases.
Thus far, the thesis has been holding true. Walmart & McDonald’s have both cautioned investors that more price increases are coming in the second-half of this year, and investors are somewhat concerned that these price increases will negatively impact sales volumes, especially for the higher margin items that they sell. Certainly, if the job market continues to stay tight and unemployment percentages remain low, a lot of these higher-end consumers will be able to keep spending. This is especially true if interest rates stay low and the Fed fails to get credit conditions to tighten.
*As a sidebar, my wife and I have been using credit cards for cash bonuses for years. We don’t have any consumer debt at all, but what we do is open credit cards that offer cash back welcome bonuses, use the cards for stuff we were already planning to buy, then pay the card off in full and collect the bonus before closing the card out. Since my wife and I don’t plan on ever borrowing money, we frankly don’t worry about our credit scores. But here’s the thing, our credit scores have barely been affected by doing this anyway. I’ve lost count, but so far this year between the two of us, I think we’ve opened at least 12-13 new cards, received $100-$200 cash rewards bonuses for each of them, paid the cards off in full, and closed the cards out.
This probably has a lot to do with the hundreds of millions of new credit cards opened by Americans in the second quarter. This type of credit extended by financial institutions would not happen if not for the Federal Reserve keeping credit conditions RIDICULOUSLY loose. They are not doing the work necessary to jam the credit markets up and create demand destruction to stop inflation. As long as Americans are able to get approved for dozens of new credit cards with extremely generous welcome bonuses, they continue to have additional credit to buy at rates that allow corporations to continue to raise their prices without losing sales volume.
Down to our next example of the divergence of the high and low-end consumers, here is a recent chart of Disney & Six Flags.
Six Flags announced earnings this week, and the stock immediately tanked over 20% on news that park attendance fell 22% in the second quarter. Meanwhile, Disney theme parks continue to have their best year ever both attendance and revenue-wise. Six Flags is not a cheap Saturday family trip by any means, but it is much cheaper to take a family for a day-trip to Six Flags than it is to go on a Disney vacation. This clearly shows that the bottom-half of consumers are struggling severely in comparison with the higher-end consumer base.
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