Still Dancing
In July of 2007, Citigroup CEO Chuck Prince laid out his strategy for running Citigroup amid a growing recognition of risks on the eve of what would soon become the Great Financial Crisis. In a financial hall-of-fame highlight-reel moment that hasn’t exactly aged well, Prince infamously said that “When the music stops, in terms of liquidity, things will be complicated…but as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Ever after, Prince’s comment has come to symbolize the reckless attitude of bold risk indifference often prevalent on Wall Street at exactly the wrong time. A few months later, Prince was out of a job, never to hit the dance floor again.
On Wall Street, as in Shakespeare, the past is often prologue. Today, a risk-indifferent Wall Street is back on that dangerous dance floor once again. As financial assets made new all-time highs this week, and the Buffet Indicator (a valuation indicator that’s a ratio of the Wilshire 5000 to GDP) boldly reached heights (195%!) no Buffet Indicator has ever reached before, State Street Global Advisors Chief Investment Strategist Michael Arone channeled his inner Chuck Prince. In a note to clients, Arone wrote, “A restrictive Fed won’t stop the music this time around because the economy’s moving to a new rhythm…a prolonged and unprecedented [AI] productivity miracle.”
Before rushing out to buy the closest AI stock on Arone’s “it’s different this time” reassurance, balance the urge with comments from Goldman Sachs. This week the GS trading desk wrote, “Positioning, earnings expectations, and valuations are high, breadth is low, and the data is starting to age more like milk than wine.” Then recall the wisdom of Dr. Benjamin Anderson, cited in HAI two weeks ago with the timeless observation that, “Every era of speculation brings forth a crop of theories designed to justify the speculation… The term ‘new era’ was the slogan for the 1927-1929 period. We were in a new era in which old economic laws were suspended.” Remember, the past is often prologue on Wall Street.
The spotlight for economic news this week was undoubtedly fixed on consumer prices. Notably, the June headline Consumer Price Index (CPI) actually deflated month-over-month (M/M) for the first time since COVID lockdowns in May of 2020. June headline CPI came in at -0.1% M/M vs. estimates for a 0.1% increase and below the previous 0.0%. Year-over-year (Y/Y), headline CPI increased at a 3% clip vs. a 3.3% pace in May.
While Core CPI (ex-food and energy) still increased M/M, it also came in weaker than expected. Core CPI was up 0.1% M/M vs. 0.2% expected and down from a 0.2% increase previously in May. June’s 0.1% M/M increase for Core undershot all but four of 71 economist predictions. Year-over-year, Core CPI also increased less than expected at a 3.3% rate vs. a 3.4% clip in May. It was the lowest Y/Y increase for core inflation since April of 2021.
The biggest contributor to overall weakness in June’s CPI figures was a tumble in gasoline and broader energy costs. In fact, the CPI story has evolved of late. Consumer prices have broken down into deflation in durable goods and energy while rents and services remain sticky hot. After peaking two years ago at 18% Y/Y, durable goods and energy are now deflating at -4.4% and -3.1% rates respectively. Meanwhile, rents are still inflating by 4.9%, while services ex-rent are also running too hot at 4.5% Y/Y.
The weaker CPI readings immediately boosted market-based odds that the Fed will start cutting interest rates in September, and bolstered the narrative that the acceleration in inflation seen in the first quarter of the year was an anomaly. Interest-rate futures moved to an almost 100% probability of two Fed rate cuts by December, and increased the odds of three cuts by year-end to 28%.
After the cooler-than-expected CPI data seemed to neatly set the table for year-end rate cuts, Friday’s Producer Price Index (PPI) release seemed somewhat anticlimactic. PPI often leads CPI. A weaker than expected PPI would have cemented the trend towards an easing of inflation and effectively slam-dunked year-end rate cut expectations. Instead, PPI threw something of a curve ball with a hotter-than-expected print.
Headline PPI came in at 0.2% M/M, vs. the expected 0.1%, and May was also revised higher, pushing the Y/Y print up to 2.6%—well north of the 2.3% expected. Core PPI was even hotter. Core PPI registered a 0.4% M/M increase that doubled the 0.2% bump expected. Year-over-year, Core PPI jumped up to 3.0% vs. 2.5% expected, and was up significantly from May’s 2.4% reading. Notably, both the June headline and core PPI readings were the strongest Y/Y prints since March of 2023.
Like CPI, the June PPI broke down along the lines of goods vs. services. PPI registered a 0.6-percent M/M increase in prices for services. In contrast, the index for goods decreased 0.5 percent M/M.
As a category, goods are usually more volatile than services and much more subject to price momentum in commodity markets. While the inflation picture has generally improved over the last three months, the fact that the progress is from goods and not services leaves the present disinflation trend vulnerable to any broad-based commodity rally. In something of a catch-22, however, the now-firming expectations for a barrage of year-end rate cuts could re-stoke commodity markets and put a charge back into goods inflation. After all, it was that exact same process that just led to a rebound in Q1 inflation following Powell’s December 2023 verbal pivot towards rate cuts.
In short, all eyes on commodity markets. If commodities don’t play nice, market sentiment may quickly swing right back toward the need for a higher-for-longer policy and a trapped, frozen Fed before we ever even get to September. There is a real risk we could be caught in this recurring cycle until either the Fed cuts rates (despite inflation) to take the edge off debt-spiraling government interest expenses, or recessionary deflation triggers emergency rate cuts for an additional set of all-too-unpleasant reasons.
Further on the commodities front, a recent Dallas Fed survey just offered more reasons to expect tightening supply-side dynamics in the oil patch. According to the survey, U.S. shale oil production (responsible for up to 90% of global oil supply growth over the last decade) could be squeezed by further industry consolidation. In the survey, industry executives reported that, “Consolidation by E&P firms has curtailed investment in exploration,” and confirmed that “The last few years of mergers and acquisitions have decreased activity in the oil patch.” According to the survey, 54% of industry executives responding to the survey expect further consolidation that will translate to lower shale patch production going forward.
We already have the hard geological reality of steep shale decline rates hitting production and keeping the supply-side pressure on in oil markets. We have North American natural gas prices below the average break-even cost of production. And we have sharp supply deficits on the horizon for silver, copper, and uranium. Add to that backdrop growing geopolitical risks, resource nationalism rearing its ugly head, and ongoing, chronic over-regulation and under-investment crimping supply across commodities broadly. The result: commodity markets are an overstuffed powder keg, and rate cuts could be an explosive match.
Furthermore, it’s not just a supply-side story setting up secularly over the next decade. This week, in their annual “Energy Outlook” report, BP said “The world is in an ‘energy addition’ phase of the energy transition in which it is consuming increasing amounts of both low carbon energy and fossil fuels.” According to BP, “The challenge is to move—for the first time in history—from the current energy addition phase of the energy transition to an ‘energy substitution’ phase, in which low carbon energy increases sufficiently quickly to more than match the increase in global energy demand, allowing the consumption of fossil fuels, and with that carbon emissions, to decline.” BP continued, “The longer it takes for the world to move to a rapid and sustained energy transition, the greater the risk of a costly and disorderly adjustment pathway in the future.” In other words, the longer it takes to establish a sustained energy transition, the more fossil fuels we will need to supply the demand from the global “energy addition.”
News out this week offered the latest in a long list of clues that, indeed, a sustained energy transition is going to take much “longer” than most realize. This week, Ford Motor Company announced that it will suspend its new EV models after its EV division reported a $1.3 billion loss. Ford said, “We will not launch a second-gen [EV] product unless it’s profitable within the first year and we are going to get a return on that capital we’re investing.” To be sure, if a return on capital is suddenly a new requirement necessary to propel the energy transition, then yes, it’s going to take much longer.
No surprise then that this week, in their Energy Outlook report, BP revised higher all of its forecasts for oil, natural gas, and even coal consumption. In their “current trajectory” scenario, BP goes so far as to anticipate that even coal consumption (the most hated of all fossil fuels) will be greater in 2050 than it was in the year 2000!
Again, unlike Chuck Prince or State Street’s Michael Arone, HAI isn’t interested in “still dancing” in high flying financial assets at record all-time high valuations just before the music stops, the bubble pops, and things get “complicated.” HAI prefers to cut some rug in the new secular bull market in hard assets. That’s a bull for whom the music is just getting started.
Weekly performance: The S&P 500 was up 0.87%. Gold was up 0.96%, silver dropped 1.66%. Platinum was off 3.13%, and palladium was crushed by 6.47%. The HUI gold miners index surged 5.93%. The IFRA iShares US Infrastructure ETF was strong, up 4.98%. Energy commodities were volatile and mixed on the week. WTI crude oil was down 1.14%. Natural gas was up 0.43%. The CRB Commodity Index was off 1.02%. Copper was down 1.27%. The Dow Jones US Specialty Real Estate Investment Trust Index popped 5.08%. The Vanguard Utilities ETF gained 4.08%. The dollar index was down 0.73% to close the week at 103.78. The yield on the 10-yr U.S. Treasury was off 10 bps to close at 4.19%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
