To The Moon

Beware of a potential risk-off move

As I rightly anticipated, US October CPI came in below market expectations. October US CPI rose 7.7%, below estimates of 8.0%. Core CPI advanced 0.3% for the month, below estimates of 0.5%. On an annual basis, core CPI increased 6.3%, below expectations of 6.5%.

The soft inflation figures sparked a strong rally in risk assets. The Nasdaq 100 Index had its best day since April 2020 with a jump of 7.5%. Treasury yields plunged with the 10-year yield declining 0.3% to 3.82%, below the critical 4% level.

Here are my insights:

• The Good, Bad and the Ugly of October CPI
• Follow the November Fed meeting playbook

The Good, Bad and the Ugly of October CPI

The Good 

Not only did both CPI and core CPI came in below expectations, but the October CPI is even below the lowest estimate in Bloomberg’s panel survey.

The Bad

In response to the October CPI, Dallas Fed President Lorie Logan acknowledged that it is a “a welcome relief”.

However, she cautioned that inflation is “much too high” and “far above the FOMC’s 2 percent target”. She remarked that inflation has repeatedly come in higher than forecasters expected, with aggregate demand continuing to outstrip supply.

She also reiterated that “high inflation is a drag on our economy. The longer it continues, the worse the drag gets, the greater the risk that high inflation becomes entrenched and the greater the cost that must be paid to bring inflation down.”

Hence, we believe that the fight against inflation is a continuing battle. This is especially since the 7.7% October inflation is still far above the Fed’s inflation target.

The Ugly

Looking deeper into the CPI data, it is not a complete rosy picture.

Inflation continues to remain sticky. A closely watched indicator, services CPI (excluding Food and Energy), remained elevated at 3.9% year-on-year. On a monthly basis, it rose 0.29%. This is a sign that inflation will continue to trend higher, as these items are non-commodity related and more to do with expectations.

Another indicator is the Cleveland Fed’s trimmed mean CPI which measure the underlying inflation trends by removing volatile items. It is still showing that inflation will remain sticky with an annualized growth rate of 4.5%, more than double the pace of the pre-pandemic level.

With inflation expected to remain elevated, this will make the Fed’s fight against inflation a prolonged one. This is also in line with the recent Fed meeting where Fed Chairman Jerome Powell hinted that the current interest rate cycle could go on longer, and potentially reach a higher peak.

Follow the November Fed meeting playbook

Remember what happened during the November Fed press conference. It was a tale of two halves:

• Risk-on in response to the dovish bias of Fed opening statement
• Risk-off in response to the hawkish bias of Fed question-and-answer session

Risk-on in response to the dovish bias of Fed opening statement

Risk assets initially rose during the opening statement of Fed Chair Powell when he hinted of a possible downshift in the pace of rate hike by taking into “account the cumulative tightening of monetary policy”. The markets were cheered by the dovish tilt that they will likely go for a smaller rate hike of 50bps in the December meeting, instead of a 75bps rate increase.

Risk-off in response to the hawkish bias of Fed question-and-answer session

However, risk assets took a dive during the Fed question-and-answer session. Powell effectively made irrelevant the downshift in the pace of policy tightening, and he hinted that rate hikes could go on longer, and potentially reach a higher peak.

The switch from a dovish to hawkish stance resulted in a swing of 4.6% from high to close in Nasdaq 100 Index that day.

We believe such a similar scenario could happen to risk assets in the coming months:

• Risk-on in response to the soft October CPI
• Risk-off in response to the ongoing fight against inflation by Fed

Risk-on in response to the soft October CPI

Similar to the opening statement of Fed press conference, the risk rally on Thursday is in response to expectations that the Fed will step down from its 0.75% rate hike trajectory to a less painful 0.5% rate hike in December. This is shown in the Fed swaps market which all but eliminated the chance of a 0.75% rate hike in December. The odds are now at a tiny 5%.

Risk-off in response to the ongoing fight against inflation by Fed

After the strong Thursday rally, the next move could be a risk-off one, similar to the nosedive that happened during the Fed question-and-answer session.

The Fed is unlikely to pivot with inflation still way above its inflation target of 2%. The Fed is only stepping down its rate hike to 0.5%. It has not stopped raising interest rates. In fact, Fed Chairman Powell is guiding that the current interest rate cycle could go on longer, and potentially reach a higher peak.

In addition, the S&P 500 Index is overvalued using the “Rule of 20” by legendary US fund manager Peter Lynch. The “Rule of 20” states that: fairly value P/E = 20 – Inflation Rate. Hence, the right valuation of S&P 500 Index should be 12.3x P/E (= 20 – 7.7 (Oct CPI)).

Currently, S&P 500 Index is trading at 19.1 P/E, far above the fair value of 12.3x P/E. This also much higher than the 30-year average of 16% deviation from the fair P/E value. So, based on this metric, the S&P 500 Index is overvalued.

In summary, we urged investors to remain prudent. The fight against inflation is not over despite the softer October CPI. There are also further data points that Fed needs to gather before it could turn less hawkish. The current risk-on rally could be an opportunity for investors to de-risk and be more defensive.