Two “Data” items today:
#1: Is it a “market of stocks” or a “stock market”? Grizzled finance veterans always like to say it’s the former as a reminder to stick to the fundamentals. In truth, however, when volatility hits it really is a “stock market” – everything goes up and down in unison.
Take as an example two S&P sectors we currently like: Energy and Health Care. The former is a classic cyclical play: rising demand plus higher commodity prices equals better corporate earnings power. Our call on the latter is more secular: Health Care is currently 13.4 pct of the S&P 500, cheap against its 10-year average weight (13.7 pct) not to mention its obvious current relevance.
We pulled the daily returns for XLE (S&P large cap Energy ETF) and XLV (Health Care) and ran the 30-day trailing correlations to the S&P 500 for each back to 2015. Here’s what we found:
- The most recent 30-day correlations to the S&P for each sector are almost identical: 0.68 for Energy and 0.67 for Health Care. That translates to r-squares of 45 – 46 percent, which is where you’d expect any given sector to trade. As a rule of thumb, half a sector’s returns come from its own fundamentals and the other half comes from general market conditions.
- Since 2015 large cap Energy has had a 0.6 correlation to the S&P 500, so the most current reading of 0.68 is actually slightly higher. That makes sense: both the S&P 500 and Energy are banking on a continued US and global economic recovery.
- Health Care sector correlations are showing the opposite: this group’s long run average correlation is 0.77 and the current reading of 0.67 is lower than that. Again, that makes sense: Health Care is a classic defensive sector rather than cyclical.
Takeaway: we’ll split the difference in the old trader’s aphorism and say we’re in a market of sectors, with both Energy and Health Care showing attractive, but very different, investment merits.
#2: July’s US Consumer Price Index inflation report. Breaking down the numbers to get to a clean(er) reading of underlying price changes:
- Headline inflation of 5.4 percent, core inflation of 4.3 pct.
- Energy represented 1.7 points of headline inflation. Used cars and trucks were another 1.4 points.
- Used cars and trucks added 1.8 points to core inflation.
Adjusting for these two categories, July’s headline inflation was 2.3 percent and core was 2.5 percent. We think it’s fair to exclude both energy and used car inflation from any assessment of true inflation trends. Gasoline prices were depressed last year, for all the obvious reasons. Used cars and trucks have seen artificially high demand due to chip shortages which have limited new vehicle production.
That’s the good news (underlying US inflation is in the 2s, not the 4-5s), but the July CPI report did bring one worrisome observation: US food inflation has picked up. This chart shows CPI food inflation over the last decade. It rose dramatically during last year’s pandemic-related supply chain problems, then started dropping in 2021 as we anniversaried those comps. July’s reading of 3.4 pct was against a tough comp (3.9 pct, as noted) but still showed the highest levels of food inflation since February 2021’s 3.5 pct reading. Since consumers tend to anchor inflation expectations around purchases they make regularly, food prices matter.
Thinking now about structural US inflation, we need to touch on housing. “Shelter” is a third of headline CPI and 41 pct of core. In this chart we break down “shelter” inflation into its component parts – owners’ equivalent rent (blue line) and rent (red line) – and compare those to core CPI inflation (black line).
As you can see, OER (blue) and rent (red) inflation are the only reasons core US CPI has been able to hold around the Fed’s 2 percent core inflation target since 2000. These have run 2-4 percent for the last 20 years, adding 1 point of core inflation in all but the 2010 – 2012 period. Without shelter inflation, in other words, core CPI would have been more like 1 percent over most of the 2 decades.
July’s OER/rent inflation readings (2.4/1.9 pct, respectively) were lower than much of the last 20 years, but they seem to be turning higher. We assume this is a lasting trend, since house prices continue to increase and the US labor market is still recovering.
Takeaway: aside from food inflation, today’s CPI report is a good reminder that the US economy is not one prone to generating structurally higher prices. That’s what 10-year Treasuries yields have been saying since March, of course. In fact, if measured shelter inflation does not start to pick up in the next 12 months we could be talking about deflationary pressures soon enough.