Trading Color
Stocks enjoyed a broad if unspectacular rally to start the week past, although it came on small volume and can be largely chalked up to positioning ahead of the start of key economic data for the rest of the week.
On an index level, the Russell 2000 rose 0.83% while the Nasdaq gained 0.84%, as both continue to
recoup last Thursday’s declines. The Dow Industrials and S&P 500 both rose 0.6%.
Bottom line, absent any substantial news, and amidst light volume, markets did trade in reaction to the Chinese stimulus news and in positioning ahead of the key data later this week. But in sum, yesterday was very much a “digestion” day and the looming data will determine if markets can extend last week’s rally this week.
Why Could CPI Be Poised to Drop Further?
Throughout 2023, CPI, consumer price index. has been the most important economic indicator as the sharp drop in CPI so far this year has been a major contributor to the YTD rally, while some anxiety that the decline in CPI might now “level off” has contributed to this recent pullback. But while those concerns of a potential stall in disinflation can’t be dismissed, the statistical reality is that downward pressure on CPI might actually increase in the coming months, and it has to do with how CPI is constructed.
More than 40% of monthly CPI is housing and housing related costs, making housing the single biggest influence on the headline (and core) CPI readings. More specifically, “shelter costs” (which is the cost of owning or renting a home) are about 33% of CPI, while “housing operation” costs such as utilities, insurance, etc., account for about 9% of CPI. The shelter readings are split into two different metrics, “Owners Equivalent Rent” and “Tenants Rent.” It’s Tenant’s Rent that I want to focus on here, because the bottom line is rent inflation is falling quickly, and that could weigh on broader CPI soon.
Changes in housing costs are often delayed in the CPI report, resulting in CPI (for a time) understating broader inflation during a time when housing costs are rising and overstating inflation (for a time) when housing prices are not rising (or falling), and this is partially by design. Tenant’s Rent is only sampled every six months, so it’s very delayed in picking up increases or decreases in rents.
The reason for this is because most rents are annual, so they only reset every 12 months or more. By sampling rents every six months, the Bureau of Labor Statistics thinks it can generate a more accurate picture of trends in rental prices. The tradeoff, of course, is that rapid increases in rental costs are understated for a time, as are rapid decreases. We saw that in real life via the delayed response in CPI to the rapid increases throughout 2021 and are now starting to observe the delayed response to the leveling off of rental inflation that’s occurred over the past year.
To that point, starting about a year ago, rent price increases began to stabilize, and in some cases, reverse. Rents turned negative month over month back in the summer of 2022 and since then we’ve seen minimal monthly gains (numbers much more like the pre- pandemic readings). The lack of monthly gains is finally showing up in the year-over-year data, as year-over-year rental increases have moved from a high of more than 16% March 2022, to 3.57% in July, the smallest annual increase since March 2021 (at a time when headline CPI rose just 2.62% y/y). And we should expect the year-over -year gains in Tenant’s Rent to continue to decline in the coming months (and possibly turn negative).
This disinflation in rents is indeed more important than it may seem, even after that explanation. Remember, Tenant’s Rent is just one part (and the smaller part) of over- all shelter costs. The other, larger part is Owners’ Equivalent Rent. OER is derived from a survey. The Bureau of Labor Statistics calls homeowners and asks them what they would charge for rent for their current home. But ultimately, that number is based on the local rental market, so as rents decline, so too will OER, and that means that a full 1/3rd of CPI should begin to act as a downward force on the metric in the coming months.
Bottom line, we must always be vigilant to a rebound in inflation, as they can and have happened (see 1970s and early 1980s). But the statistical reality is that shelter costs, which again reflect 33% of the CPI report, should begin to weigh more heavily on the headline index in the coming months. If that does occur it’ll be a welcomed positive for markets and help to push yields lower (so clearly positive for bonds across the curve).
Speaking of the yield curve, until the yield curve changes for an inverted yield curve to a normal yield curve, the markets remain risky. Over the next three months, I expect that reversal to appear. It will only move in that direction if the Fed is done with interest rate increases. It remains a question as to their next move. Until then we remain cautious.
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