Don’t be fooled by the hotter-than-expected consumer price inflation, or CPI, report for January. It is a head fake. Inflation is falling. The Federal Reserve will cut interest rates soon. Corporate profits are growing at a slightly faster-than-expected rate.
Equities remain attractive for investors. Save for Tesla, the so-called Magnificent 7 — Alphabet, Amazon, Apple, Microsoft, Meta, and Nvidia — also remain attractive. The noted companies are growing earnings and revenues many times faster than their peers in the S&P 500 index. The S&P 500, excluding the Magnificent 7, is selling at a price-to-earnings ratio of about 17, slightly below the five-year valuation average.
The January CPI report’s headline increase was 0.3%. The market was expecting 0.2%. The core reading was a very hot 0.4%, 0.1% higher than anticipated. Year on year, the CPI is up 3.1%. Shelter (housing/housing amenity-related) prices largely explain the higher-than-expected report, climbing 0.6% and accounting for more than half of the upside surprise. On a 12-month basis, shelter is up 6% plus. The Bureau of Labor Statistics, or BLS, reports shelter inflation with a lag. Various real estate companies, including Zillow, report shelter inflation on a real-time basis, not a lag. Shelter inflation is measured by rent inflation. For homeowners, owners equivalent rent, or OER, is used. What rent would a homeowner pay to rent an equivalent property?
According to Zillow, however, real-time rent inflation is running at under 2%. And real time housing prices are stable to falling. In plain language, shelter inflation is not rising at a 6% annual rate. It is flat to down. More importantly, the CPI is not the Federal Reserve’s preferred inflation gauge. The Federal Reserve focuses on inflation as measured by the personal consumption expenditure price index, or PCE, particularly the core metric, which excludes highly volatile food and energy prices.
For the most recent six-month reporting period, the BLS says that the core PCE is running at 1.9%, which is below the Federal Reserve’s 2% inflation target. Very importantly, after the hot January CPI print, premier investment banks such as Morgan Stanley and Goldman Sachs extrapolated from the CPI data and concluded that when the January PCE inflation data is released on Feb. 29, core PCE inflation will be running at or near Federal Reserve’s 2% target.
The Federal Reserve prefers the PCE inflation metric because it is a better gauge of inflation. For example, in the real world, when the price of beef spikes, consumers eat more chicken and less steak. That is called the “substitution” effect. The PCE captures the substitution effect. The CPI does not.
What now?
Well, the market has pushed out the timing of the first interest rate cut by the Federal Reserve. Still, traders are confident that the Federal Reserve will begin to reduce interest rates before July 1, 2024. The economy is growing faster than expected. There is no recession on the horizon. Earnings of the constituents of the S&P 500 index are coming in slightly better than expected. Price-to-earnings ratio valuations are not unreasonable based on historical data and future growth projections.
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The Federal Reserve continues to achieve its goal: a soft economic landing, 2% inflation without a recession.
Stay the course. Investing in a diversified portfolio of high-quality equities is the best way to build wealth.
The writer owns shares in Alphabet, Meta, Microsoft, and Nvidia.
James Rogan is a former U.S. foreign service officer who later worked in finance and law for 30 years. He writes a daily note.