Written by Jim Welsh
Macro Tides Weekly Technical Review 19 July 2021
There is a good chance that inflation peaked in June. The headline CPI increased to 5.4% the highest since 2008. In the last three months the CPI has risen at an annualized clip of 9.7% and higher than May’s reading of 8.4%. Airfares in June were 24.6% higher than a year ago and hotel prices were up 16.9%. Both items remain below where they were in June 2019 so higher prices are likely.
Please share this article – Go to very top of page, right hand side, for social media buttons.
New cars are about 5.1% above where they were two years ago, but Used car prices are up 41.3%. In June new car prices were up 2.0% from May while used car prices soared 10.5%.
.
.
These increases are unsustainable and there are signs that the surge in used car prices has topped. In June the Mannheim Used Car Vehicle Value Index fell -1.3% to 200.4 and the first decline since December. The Mannheim Index is still up 42% from two years ago, but is likely to moderate more in coming months. Used car prices represent 3.1% of the CPI and New cars are 3.7%. If the Mannheim Index falls to where it was in January 2021 (165) in the next few months, it will shave -0.55% off the CPI. If New and Used car prices were excluded from the Core CPI in June, the increase would have been 3.0% versus the 4.5% reported.
Of course, if every category that is contributing to inflation is removed, there would be no inflation! The Core CPI doesn’t include food or energy but most family budgets can be materially impacted by changes in the cost of food and energy. Gasoline has a weighting of 3.7% and the national average is likely to fall from $3.16 a gallon in coming months to $2.85 as oil prices drop. If the national average falls to $2.85, it will lead to a -0.37% drop in the CPI.
Food at home is 7.6% of the CPI and prices have been climbing. Although the Y-O-Y increase was just 2.4%, the monthly gain in June was 0.8% after rising 0.4% in April and May. As noted last week:
“Grocery stores have been maintaining inventory that is 15% to 20% above normal since they expect more price hikes.”
If grocers are correct, the cost of eating at home will continue to increase in coming months and offset some of the declines in other categories within the CPI. It is easy to see the headline CPI dropping to 4.0% to 4.5% from 5.4% in the next few months.
In June the Core CPI jumped 4.5% from June 2020 and the highest level since September 1991. Of the 0.9% increase from May, 0.7% came from New and Used car prices, lodging away from home, and transportation services. If New and Used car prices soften in coming months as expected and the increase in airfares and hotel prices moderates as expected, the Core CPI can be expected to fall to near 3.5% in coming months. There is a high likelihood that any decline in headline and core inflation in the next few months will be heralded as proof that inflation will be transitory. That conclusion may prove premature if Core inflation holds at a high level after dipping in the next few months.
In June the Core CPI jumped 4.5% from June 2020 and the highest level since September 1991. Of the 0.9% increase from May, 0.7% came from New and Used car prices, lodging away from home, and transportation services. If New and Used car prices soften in coming months as expected and the increase in airfares and hotel prices moderates as expected, the Core CPI can be expected to fall to near 3.5% in coming months. There is a high likelihood that any decline in headline and core inflation in the next few months will be heralded as proof that inflation will be transitory. That conclusion may prove premature if Core inflation holds at a high level after dipping in the next few months.
The largest component in the Core CPI is Owner’s Equivalent Rent (OER) (23.7%) with Rents adding another 7.7%, and lodging away from home at 5.1%. In June OER was up 0.32% from May and 2.34% from June 2020. There are factors that will push OER up to 3.2% before the end of 2021 and could exceed 4.0% in 2022 if Goldman Sachs is right.
If OER rises by 2.0% over the next six months it would add at least 0.5% to core inflation. Rents have been going up aggressively in recent months. If the rent moratorium ends on July 31, the amount of rent not being paid will reverse and be accretive rather than a subtraction. The Rent component within the Core CPI could add another 0.15% to 0.25% by October. The Core CPI will get a boost from its largest components especially in the fourth quarter. This boost is also expected to limit the decline in the Core CPI from 4.5% to 3.5% in the next few months.
The Core CPI increased by 0.54% in July 2020 and 0.32% in August. Those increases will limit how much the Core CPI rises in the next two months and are likely to contribute to a drop, if the Core CPI rises by less than 0.52% in July 2021 and 0.32% in August. After August the hurdle rate drops since the Core CPI in 2020 rose 0.18% in September, 0.08% in October, November and December gained 0.05%, and 0.10% in January 2021.
These small takeaways will make it easier for the Core CPI readings in 2021 to add to the Year-Over-Year increase. This is why the Core CPI is expected hold near 3.5% and far above the FOMC’s target of 2.0%. Will the markets be willing to give ‘transitory’ such an extended life? Maybe, but I doubt it.
Chair Powell appeared before the House and Senate Banking Committees last Wednesday and Thursday, which gave him an opportunity to reassure markets after the CPI and Producer Price Index (PPI) came in much higher than expected. Chair Powell for the most part stuck to the Fed’s mantra that inflation will be transitory. The only difference is that he acknowledged that inflation is running hotter than expected and appeared to stretch the definition of transitory to six months:
“Inflation is not moderately above 2.0%. It is well above 2%. The question will be, where does this leave us in 6 months or so, when inflation, as we expect, does move down.”
Wall Street wants to believe that Chair Powell will be right, and charts that show how much lower inflation is without New and Used cars prices may it easy to embrace. There is also career risk. If an analyst goes against the FOMC and is wrong, they may find themselves out of a job. It is easier to go along with the Fed’s narrative and if inflation is not transitory, analysts have the perfect cover. Who’s going to lose their job agreeing with the Chair of the Federal Reserve? This is why there are few analysts willing to go against the crowd. For now most Wall Street analysts would prefer not to hear any data that conflicts with the widely accepted narrative.
The Beige Book, which will be used by FOMC members at the July 27 – July 28 meeting, noted that while some businesses think inflation will be transitory, the majority of businesses surveyed expect input costs and selling prices to climb in coming months, as this excerpt shows:
“While some contacts felt that pricing pressures were transitory, the majority expected further increases in input costs and selling prices in the coming months.”
The June survey by the National Federation of Independent Business (NFIB) found that 47% of small businessesraised their average selling price in June. This was the highest percentage since 1981.
This kind of momentum isn’t likely to reverse on a dime so price pressures will continue in coming months. In 1981 the federal funds rate was 20.0% and the real funds rate was north of 5.0% compared to a negative -5.0% now. With monetary policy so tight in 1981, the U.S. quickly entered a deep recession. Nothing like that is on the horizon with monetary so accommodative based on the Financial Conditions Index.
The wild card is the Delta variant which is spreading in all 50 states with percentage increases in recent weeks that are impressive. The 7-day average of Covid-19 cases in the U.S. was 26,011 on July 18, up a whopping 115.0% from the low of 12,093 on June 22. There is no doubt cases will continue to climb but some perspective is warranted. Hospitalizations per 100,000 people have dropped from 4.97 in January 2021 to 0.91 on July 17 a decline of 81.6%. The 7-day average of deaths through July 18 was 246 up 10% from 223 on July 9 but down 92.9% from the January 2021 high. Although cases have jumped the number of infected people requiring hospitalization remains low and the increase in deaths is small. This is what could be expected with 66% of Americans having received at least one injection and another 10% to 15% having natural immunity. The media has been making a big deal of the increases in cases without mentioning how much they are below the January peaks. The Biden administration is no doubt putting as much pressure as they can on the major networks to spur the undecided to get vaccinated.
.The emphasis on the increase in cases has raised concerns that the U.S. economy could be vulnerable to a sinking spell. The decline in Treasury bond yields has added credibility to the headlines in a form of circular logic, i.e. Treasury yields wouldn’t be so low if Delta wasn’t a legitimate threat. So far these fears seem overblown based on the data. That of course could change. Delta does pose a threat to Emerging Markets that have minimal vaccination rates and the prospect for global growth in general.
Stocks
The stock market is at an interesting juncture. The majority of cyclical sectors peaked in the first half of May so these sectors have been correcting for two months. The weakness in cyclical sectors was overshadowed by the strength in the Mega Cap stocks as noted last week which pulled the S&P 500 to a new high:
“The strength in the S&P 500 and Nasdaq 100 has masked the rotational correction that has occurred in many cyclical sectors. Basic Materials, Industrials, Financials, Midcap stocks, and the Russell 2000 topped in the first half of May and have trended lower, as investors interpreted the decline in Treasury yields as an indication of economic weakness. The net result is that the percentage of stocks above their 50 day moving average has fallen from 91% in early May to 54% last week.”
The charts of the Industrials (XLI) and Basic Materials (XLB) highlight the under the surface correction these sectors have undergone after hitting their highs in May. The RSI (Relative Strength Index) in the bottom panel for each is nearing 30 which show these sectors are becoming oversold. At their lows on July 19 XLI if was down -7.5% from its May high while XLB was off -11.8%.
.
.
The Russell 2000 has declined -10.8% since its peak in May and was one of the major averages cited in recent weeks that seemed to be telegraphing that a pullback was likely. The DJ Transports on July 19 was down -12.9% after peaking in May.
Now that it has become obvious that the market is vulnerable to a real correction it is important to keep in mind the bifurcation within the market. Since cyclical stocks have been correcting for 2 months they are likely to bottom before the S&P 500 and Nasdaq 100 which just hit their highs last week.
With so many sectors approaching double digit declines, the internals of the stock market have quickly become oversold as measured by the 21 day average of Advances minus Declines. The Net Advances minus Declines fell below -400 (green horizontal line) on July 19 for the first time since March 2020! This suggests that some of oversold cyclical sectors are likely to bounce soon as more investors notice how far they’ve fallen.
The Mega Cap stocks are likely to run into some selling as investors rotate out of the big name growth stocks and into the cyclical sectors in the short term. After a short term bounce, my guess is that cyclical stocks are likely to retest the lows of July 19. The Mega Cap stocks have just begun to correct and are expected to fall more and drag the S&P 500 below the low on July 19 (4233). The S&P 500 could drop to 4165 – 4185 before a more tradable low develops. Once Treasury yields hit their lows cyclical stocks should get a lift as Delta worries diminish.
Traders can take a 33% position in XLI at $98.85 and XLB at $78.80. XLI was sold in May at an average sell price was $103.60 and XLB was sold at $84.34.
Treasury Yields
The Perfect Storm has enveloped the Treasury bond market. Awful inflation news failed to boost yields as logic would suggest. The FOMC has continued to stubbornly reiterate that inflation will be transitory no matter how high it goes in the short term, and investors want to believe the FOMC will be right. The Delta variant has incited fears of a larger than expected slowing in the U.S economy that will allow the FOMC to keep buying $80 billion of Treasury bonds every month. The Treasury’s balance at the Fed is still high so the amount of Treasury bond issuance is almost completely absorbed by Fed purchases.
One other factor has played a role. Large Speculators were long 173,400 contracts in mid June but quickly sold them after the May CPI was reported. Large Speculators then established a short position of -59,960 contracts on June 28. As Treasury bonds zoomed higher in July Large Speculators have covered and are now long +55,987 contracts on July 13. The swing of 115,947 contacts in just 2 weeks represents a lot of buying. The 10-year Treasury yield has plummeted from 1.415% on July 13 to 1.176% so many more shorts have been covered and long positions established. The spike in prices suggests short covering has played a major role in the plunge in yields in the last four trading days.
It is certainly possible that the Delta variant will overrun the U.S. and lead to more mask wearing as was done in Los Angeles. Until the 10-year yield rises above 1.27% I’m wrong. I am looking to add to the TBF position but will wait until the short squeeze has run its course. If I’m correct the reversal higher will happen quickly. The average price for TBF is $16.68.
Dollar
The Dollar made a new recovery high on July 19 further confirming that an important was established in late May. In the short term today’s new closing high was accompanied by a lower high in the Dollar’s RSI. This is a precursor to a pullback in the Dollar to 91.50 or just above 91.00 before a stronger rally begins.
Gold
After rallying $80.70 Gold has pulled back as the Dollar remains strong. The 61.8% retracement from the high at $1832.90 is $1783.00. If Gold is going to rally and potentially test $1900 in August it should hold above $1780. Traders are long the Gold ETF (IAU) at $34.125 and should use a stop of $33.85.
Silver
Today’s decline in Silver suggests wave 5 of the triangle extended with wave c of wave 5 completing today rather than a few weeks ago. Despite the close below the closing low of $25.75 on June 29, Silver’s RSI recorded a positive divergence. If correct Silver should hold above $24.71. Once the Dollar rolls over, Gold should get a lift which is expected to help Silver.
Traders are long the Silver ETF SLV at $24.515 and use a close below $22.70 as a stop.
Gold Stocks
I thought Gold stocks might have another bout of weakness as noted last week.
“GDX has the potential to dip under the recent low of $33.30 before the next rally commences.”
GDX traded down to $32.87 before closing at $33.21, and was clearly dragged down by weakness in equities. Today’s close was below the closing low of $33.64 on June 29 and $33.68 on July 8. Despite closing more than 1% below these prior lows, GDX’s RSI recorded a positive divergence by closing higher. Traders are long GDX at $34.93 and should use a stop of $32.00. GDX is still expected to close the gap at $36.73 and potentially test the blue trend line near $37.40.
Gold has held up well even as Silver and the Gold stocks have been weaker than expected. I’m willing to be patient since inflation is going to be an issue and seasonality is positive for the metals in August. It may be that the next rally only records lower peaks in the metals and Gold stocks, but that should still be higher than current prices.
Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking
The MTI generated a Bear Market Rally (BMR) buy signal when it crossed above the red moving average on April 16, 2020 as the S&P 500 closed at 2800. A new bull market was confirmed on June 4, 2020 when the WTI rose above the green horizontal line. Although the S&P 500 exceeded the target of 4315, the underlying weakness in the overall market suggested the S&P 500 was nearing a top.
The weakness on Friday and on July 19 increases the odds that the high has been confirmed. Since the S&P 500 traded higher than expected the downside targets may not be reached. The S&P 500 is expected to decline to at least 4165.
The ‘buy the dip’ mentality isn’t going to disappear and the rotation between cyclical stocks and Mega Cap stocks could help support the S&P 500 in coming weeks. If the S&P 500 closes under 4150 then a decline to 4000 becomes possible. The S&P 500 could drop to 3725 in the fourth quarter if Treasury yields 12 spike higher to 1.90% or higher as expected. The increase in Treasury yields would likely cause Mega Cap and cyclical stocks to fall together.
The primary 10 sectors for the S&P 500 with the Russell 2000 and Midcap included.
Caption graphic photo credit: From Skitterphoto, Pexels.
.
include(“/home/aleta/public_html/files/ad_openx.htm”); ?>