To my clients:
It was a down week for North American stock markets with the Canadian TSX falling 4.7%; the U.S. Dow Jones Index down 4.0%; and the U.S. S&P 500 down 4.6%.
Heads up to readers: I’m going to dig around in the weeds (and rant a little bit) in this week’s update. I think it is an important update, and I’d encourage clients to do their best to follow along, but I understand if many choose not to.
In last Friday’s update I noted that the Federal Reserve’s interest rate announcement and accompanying speech by Jerome Powell would be a market moving event this week. And market moving it was. Unfortunately (as seen above), the move was to the downside as the Fed stuck to its guns, raising rates 0.75% for the third consecutive meeting AND forecasting still higher rates to come. With the Fed maintaining this aggressive path, recession grows ever more likely… and it doesn’t need to be.
I’ll be bluntly controversial and assert: inflation is already defeated. Let me explain:
Headline inflation sits near 4 decade highs at 8.3% year-over-year. Bad right? Absolutely it is bad when comparing the price of a basket of goods and services today to where it was on September 23, 2021. But guess what? Two months ago headline inflation on a month-over-month basis came in at 0.0% - meaning that prices were the same as the month prior. One month ago prices rose just 0.1% on a month-over-month basis. So 0.0% (i.e. flat) one month followed by just a 0.1% increase the next month. If you annualize these rates, headline inflation is now tracking at LESS than 1.0% annualized - BELOW THE FED’S ANNUAL TARGET RATE OF 2.0%, AND BORDERING ON DEFLATION.
Now the more economically fluent in my audience (and there are several) will say “but Nick, your previous paragraph focuses only on headline inflation which includes food and energy costs and we all know that energy costs in particular have come down a ton and remain volatile. Shouldn’t we be focusing on “core” inflation which strips out these more volatile measures?” This is a valid argument, and with core inflation most recently rising at a 0.6% on a month-over-month basis (this month-over-month rate annualizes to 7.4% year-over-year) it would seem to be a good point. But even here we need to dig a bit deeper to get a clear picture.
“Core” inflation is dominated by housing costs ("rents" for when a home is unowned by the occupant, and “owner-equivalent-rents” when a home is owned outright) which contribute 39.8% to the measure. Rents are easy to calculate as it is a cash cost. But owner-equivalent-rents (which are the far bigger component of the rents + owner-equivalent rents measure) are an ESTIMATE made by surveying 50,000 home owners across the country as to what their home would rent for if put up for rent. In other words, it is NOT A CASH TRANSACTION. There are many problems with this methodology, most particularly that owners don’t actually put their home up for rent and are merely guessing what it might rent for and this, in turn, tends to be based upon recent peak prices for their homes. Theoretically, as home prices decline (AS THEY ARE NOW DOING down 2.2% month-over-month in August), owner-equivalent-rent estimates should decline in lockstep. But they don’t. In fact, the correlation between home prices and owner-equivalent-rents tends to peak after applying an 18-MONTH LAG! This lag is entirely attributable to human nature and our tendency to overestimate what we might receive for an asset declining in value when we don’t actually put the asset up for sale in the real market… or, in this case, up for rent.
Look, I’m just a Portfolio Manager based out of Vancouver, Canada. The U.S. Federal Reserve is made up of intellectuals far smarter than me with much better access to information. If I can see this, surely they can too… right? I’d expect so, but I’ll add that the U.S. Fed’s ability to accurately forecast where rates are heading is actually very poor. To wit, last year at this time the Fed was forecasting rates one year hence (i.e. now) to be 0.3%. In fact, rates now sit at 3.0 – 3.25%... roughly 10 times higher! By the same token, I think the Fed’s estimates of where rates might be next year will prove similarly off base.
Bottom line: after suffering through a 12-month stretch of uncomfortably high inflation, I think inflation in the here and now is much more benign than the current narrative being put forth by the Fed. The Fed continues to talk aggressively, but I think the bite will not match the bark. I’d anticipate a pivot on the stated policy at some point – hopefully soon.
That’s it for this week. All the best,
Nick
Nick Scholte, CIM, FCSI
Senior Portfolio Manager
Scholte Wealth Management
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
3200-1055 West Georgia │ Vancouver, BC │ V6E 3P3
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