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Morning Notes — Deflation


November 17, 2022

If you exclude shelter from last week’s core CPI print, you get a negative MoM core number, which implies deflation. Shelter and rent inputs in particular have experienced well-documented lags of 9-12 months.  Anecdotal evidence of disinflation is everywhere including labor markets with CSCO unveiling a restructuring plan last night and AMZN proceeding with plans to cut 10,000 jobs. Yesterday, TGT became the first major company outside of Tech to announce a large cost cutting plan and was highly promotional (so was WMT) during the quarter. Meanwhile, supply chains continue to improve with CSCO’s recent beat attributed to shipping more product out of its backlog. WMT and TGT’s polar opposite quarterly reports were largely due to improvement in TGT’s supply chain.  Media outlets and casual investors tend to lump these two retailers together, but they’re very different.  Roughly 70% of WMT’s revenue comes from food, prescription drugs and cold medicine. Most of these items are sourced in North America. TGT gets ~55% of revenue from general merchandise (electronics, home décor and toys) that is mostly sourced from Asia with supply chain problems pushing lead times out by as much as ~9 months. This is why it’s taking TGT longer to obtain clean inventory and why their margins are under more pressure than WMT’s at the moment. This won’t last forever; when a retailers inventory cleans, the stocks rerate higher, like WMT shares did on Tuesday.  

SPX: There are three components to the terminal rate cross market that has been driving the S&P 500 (SPX) since late April: 1) when the terminal rate is reached; 2) the actual terminal rate and; 3) the implied rate cuts 24 months forward.  Equity direction is negatively correlated to the first two components and positively correlated with implied rate cuts.  While all there components are currently driving equity markets, the SPX has recently become more sensitive to implied rate cuts. Bullard’s hawkish slide show this morning pushed terminal rates from May to June and pushed terminal rates up ~11bp to 5.01%, while also pushing implied rate cuts up ~13bp.  If the Fed hikes well beyond neutral (a higher terminal rate) it makes intuitive sense for the market to price an increased amount of easing on the back end. The key to increased SPX upside is to see the terminal date pull forward, terminal rates to fall and implied rate cuts to rise.  This is exactly what happened last Thursday after the weaker October CPI print pushed the SPX up +5.6%. It seems that only realized inflation and labor market data will have the ability to move all three components of terminal rates in an equity friendly/unfriendly direction, which makes next Friday’s Jobs Report and November CPI on 12/13 the most important near-term catalysts.

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