Experts react to the October CPI report

[00:00:00] Speaker 1: Right now we want to bring in Jason Trenert, who is chairman and CEO of Baird Strategas, and Matthew Hornbach, who is global head of macro strategy at Morgan Stanley. [00:00:09] Speaker 2: Becky, let me interrupt real quick just to tell you that the two-year note is moving again. It was, we went in at 4.62, we're at 4.66 right now. The 10-year at 4.92, we went in at 4.90. And I'll check those Fed probabilities. They were already at 100% for December, and we were toying again with a March hike. It had been at 67%, and I'll check on that in just a second. [00:00:33] Speaker 1: Okay, we're going to continue to watch this and see how the market reacts to this. But Jason and Matt, obviously this is a little hotter than had been anticipated. What do you make of that? Matt, we'll start with you. [00:00:42] Matthew Hornbach: Yeah, I mean, these are supposed to be, like, the next three prints, including the one we just got today, are supposed to be the best prints we get of the year. The residual seasonality that the Bureau of Labor Statistics has not been able to sort of correct for suggests that these should be the best numbers we get of the year. The fact that they are looking like they're not going to be the best numbers that we get may very well have implications for the Fed. [00:01:06] Speaker 1: Yeah, it's having implications for the equity markets now, too. It looks like the S&P futures have turned negative after being basically flat through most of the morning. The Dow futures turned briefly negative as well. We'll continue to keep an eye on that. Jason, the only thing I'll point out is that oil prices have come down precipitously. They've kind of crashed out over the last six or seven trading days. [00:01:25] Jason Trenert: Well, that's true. And I think you have to obviously keep that in mind. But as Steve was saying before, you know, the food prices are also kind of very important. I'm going to be looking at the breadth of increases in the CPI among all of the items. Because at a certain point, you know, a supply shock becomes a normal state of affairs. And while oil prices have come down off the boil, they're still significantly higher than they were a year ago. [00:01:50] Speaker 1: Right. And look, this is a temporary decline. We don't know how long this lasts. I guess my question would be, you know, Steve pointed out that food prices rise typically three to four months after diesel prices go up. I don't know how, even if oil prices come down, how quickly diesel prices might follow. And you do have the situation that distillates have been not moving lockstep with oil prices anyway because of all the problem with refined products. [00:02:13] Jason Trenert: Yeah. So as you're saying about, I think about a third of refining capacity in the world is shut down between the two wars, between Russia, Ukraine, and obviously what's happening in Iran. So there is a good chance the commodity comes down, but all of the refined products stay quite high. And that's, to be honest with you, that's one of the reasons why we're overweight the energy sector, because we think the prices are going to be sticky there. [00:02:37] Speaker 1: Yeah. Matt, what do you think about that? [00:02:40] Matthew Hornbach: Yeah, I mean, so for us, I mean, the real issue with this report and the reports that we're going to get between now and the January FOMC meeting is how many more of these reports are we going to get before the Fed decides that this leisurely hike that they've embarked on, right? So invoking the imagery from Chairman Warsh's Jackson Hole speech, how many more of these are we going to need to see before they decide that a leisurely hike around the mountains of Jackson Hole is not appropriate any longer, right? [00:03:11] Speaker 1: Well, I think the answer is today, if you're listening to what Fed Governor Christopher Waller said, you know, if you get hotter numbers here, he was saying he'd be prepared for a 50 basis point hike. Do you think that the rest of the committee goes along with that or anybody else in the committee? [00:03:24] Matthew Hornbach: I mean, to my mind, that's taking it too far. The real question is, do they continue to hike rates at a meeting to meeting cadence or do they continue with this once a quarter cadence? Going from 25 with a prior being that will go every quarter from that to 50 is so aggressive. [00:03:46] Speaker 2: I want to go back and translate what Matthew was saying earlier for people who may not be familiar with things like residual seasonality, OK, and why that matters and how the Fed may be thinking about it. [00:03:58] Speaker 1: I know from your earlier hit. [00:03:59] Speaker 2: You know from your earlier hit. In case people weren't tuned into The Genius at 7 a.m. this morning, and I don't mean myself. But here's the thing. We have had lower inflation numbers in the fall. Generally, the government would correct for it. Yeah. Generally, the government would correct for that. Tell me if I get this wrong, Matthew, through its seasonal adjustments. They have done the seasonal adjustments. They have not corrected for it. That's not the worst part. The worst part is that we have had higher inflation in January because this thing called the January effect, where because we don't exactly know why. But the theory is because of price pressures in the pipeline, companies have been waiting until the beginning of the year to try to pass along price pressure. So there's just natural inflation coming. [00:04:42] Speaker 1: My guess is because it's been so hard. It's been it's fluctuated so rapidly. It's like I got to give this a few months or half a year before I figure out what I'm going to do with this. It's been hard to get your arms around. [00:04:53] Speaker 2: Again, again, the government should correct for a repeated thing, but it hasn't been doing. And that's where we get this term residual seasonality, which means seasonality that we did not correct for, even though it's seasonal. [00:05:03] Speaker 1: So the numbers are going to look a lot hotter starting in January is basically. [00:05:07] Speaker 2: They could be looking hotter unless, of course, the government caught up with it now. I feel like I'm in the middle of an explanation. I didn't make things any clearer, but maybe I did. I don't know. Jason, do you want to pick up on that? I'll just say I tell me I'm wrong about that. [00:05:19] Jason Trenert: No, I think you're absolutely I think you're both absolutely right, although we all may be making it more complicated than it needs to be, because I didn't see the year over year number. Well, there is none because of these government shutdowns last year. There we go. So but the last one was three seven. We have a measure of inflation called the common man CPI, which just includes things that people must buy. So it's almost reverse core. It's just food, energy, clothing, utilities, insurance. [00:05:45] Speaker 1: That's useful. [00:05:45] Jason Trenert: And that grew at three point nine percent. [00:05:49] Speaker 2: Stuff that makes people angry. [00:05:50] Jason Trenert: You mean, well, just that's I mean, the affordability stuff, you know, it's discretionary versus non discretionary. [00:05:56] Speaker 2: And guys, let's let's interrupt again. If we look at the issue, look at that second hike in March now, Jason, at 81 percent. So there's the market getting very aggressive. I'm guessing that now January and February could be hotter as well in terms of a second hike coming along. Sorry, Jason. [00:06:11] Jason Trenert: Yeah, no, just the last thing I would just say is that I think Chairman Walsh is very serious about the two percent target. I, you know, I in my own opinion, just, you know, having a relationship with him for quite some time. I think he's being underestimated. I was about to say, misunderstood, but but underestimated. And as far as his commitment to getting inflation down. And I think that obviously has pretty big implications for the capital markets. [00:06:38] Speaker 1: Yeah. Jason, let's talk a little bit more about stocks and what this means from an investing perspective. What do you do differently based on these numbers if you think the Fed's going to hike more aggressively? [00:06:48] Jason Trenert: It largely comes down to multiples. I think earnings look pretty good by any normal standard. It looks like they'll be up about roughly 30 percent year over year this quarter, which is probably not sustainable. But we have earnings up about 14 percent next year. But if short rates are moving higher and I think the central tendency for long rates is to move higher, to my own opinion, it's hard to get really bullish about multiples. And then you layer on top of that just the political uncertainty for a very important part of the market, which is the A.I. trade. And I just think it's it. [00:07:22] Speaker 1: That's that's good. [00:07:23] Jason Trenert: Yeah. So so I just think it's hard to make a lot of forward progress. I can't say I'm particularly bearish. But the last time I was on about a month ago, I was cautious for those reasons. And again, I'm just trying to keep it simple, which is to say higher rates and slowing earnings growth is probably not the best setup for big increases in the market next year. [00:07:42] Speaker 1: Well, you bring up a very valid point, too, which was the next thing I was going to get to, which is the A.I. trade. If rates are higher, what does that mean for the technology trade, but specifically the A.I. trade? [00:07:53] Jason Trenert: You know, one of the things I hear a lot on the road and maybe it's just my age, but it annoys me, which is simply the idea that the economy is less interest rate sensitive than it's ever been. And I don't really buy that. But I also think even for the hyperscalers who are hitting the bond markets pretty regularly right now, they're interest rate sensitive, too. It's hard to say you're not interest rate sensitive when you're raising debt capital every other week. Right. So it again would would speak to the idea that that capital spending may at some point be closed. [00:08:27] Speaker 1: That it might slow down. Matt, are we getting near that point for your concern or not? [00:08:31] Matthew Hornbach: Well, the way that we're starting to see the data come in is suggesting that the A.I. CapEx build out that's been going on for some time now is really starting to broaden into the wider economy. You're starting to get a sense of that from these last two inflation reports. You're starting to get a sense of that in looking at the labor market data. I mean, I think the real risk to dramatically higher interest rates next year is we start to see the unemployment rate trend lower. It's been roughly stable for 18, 24 months now. But if you start to see the labor market tighten, bringing that unemployment rate below 4 percent because the A.I. trade is really broadening into different corners of the economy that maybe it hadn't impacted before. Then you take the Fed certainly into a more aggressive hike around Jackson Hole. [00:09:21] Speaker 2: And I want to interrupt with a few other movements in the markets here now pricing in a 12 percent probability of a 50 in December, which is not surprising. There's a lot of volatility here. We don't want to go crazy with it. But zero. There was no even after a while there was a point eight that people did not take Waller to mean that a 50 was in it. But he did say conditionally if the October data were hot, he would vote for a 50 or support a 50. So now that's. But more importantly, I think what's happened is now the potential pricing of consecutive hikes here where it's 54 percent probability of a January hike, which is still a flip of a coin, but there was very little probability before that. A couple of pieces of data here. There were some outlying numbers here. Motor vehicle insurance up zero seven repairs up zero point six. Used cars did decline one point two percent, which is unusual because the car dealers want to offer me a ridiculous amount of money for my 2018 Jeep. I don't understand it, but whatever the reason food away from home up zero point five percent. That was something that was driving. And so we're seeing this increase in food. Look, it's just a tenth on the hot side. But I think the way to think about this is Chair Warsh has said, I need confidence that we're moving back towards the two percent target. Otherwise, quote, we have work to do. And this suggests there's no confidence and we have work to do or they have work to do. [00:10:47] Speaker 1: Is that work to do the 25 basis points? The market's already basically factored in at 100 percent expectation for December. Or are we talking deeper? [00:10:55] Speaker 2: Can I do a deep tease here, which is now you've got to tune into the PPI, right? It's I think it's what is it, Matt, Thursday or is it this week? Yes. I'll figure it out. It's one day this week. I didn't have to worry about it today. So I didn't worry about it today. But anyway, and that's going to tell us the PCE. Maybe you get a little relief on the PPI, but I will tell you what's been concerning about the PPI is not just the headline numbers there. It's the pipeline pressure that if you look at goods in less processed states, there have been increases in those areas, too. So that's another concern. Plus, don't want to make we don't usually don't make a lot of this. But when you read the NFIB report this morning and you see a six percentage point increase in small business owners plans to increase prices. That's another factor. Matt. [00:11:42] Matthew Hornbach: Yeah, I mean, I think to my mind, there's two questions here. One is, do we transition from hiking once a quarter to hiking once a meeting? And then number two, is it sufficient just to take back the insurance cuts that we received in 2025? Or do we need to go beyond just taking back insurance cuts? I mean, recall, we had rate cuts before 2025, taking the funds rate down 75 basis points. Do we need to take those back as well? These are the types of conversations that I expect to be having with institutional investors for the next several weeks as a result of this number. PPI is Friday. [00:12:18] Speaker 1: Friday. Jason, what else do you hear from investors when you're on the road? [00:12:24] Jason Trenert: Well, I'd say, you know, it's somewhat separate to that. Obviously, the big questions are the Fed, long rates and also the sustainability of AI CapEx. Those are the three things that dominate all the discussions I've had in the last four or five weeks. [00:12:38] Speaker 1: In answer to the third question, what is the sustainability of AI CapEx? [00:12:41] Jason Trenert: I don't think anyone knows. And I have to say, that could get me into a bar fight in, you know, half the country, right? We'd say, like, listen, you're crazy. This thing is leaving the station. You know, you don't get it. But I also think with a lot of open-weight models out there, there are real questions about the pricing power of artificial intelligence for most companies. [00:13:02] Speaker 1: Is it commoditized? Is there going to be a race to? [00:13:05] Jason Trenert: So, you know, if you're an aerospace and defense company or running a nuclear reactor or, you know, something like that, you need the latest and greatest model. And you would want those people to pay up for the frontier models. But for a little company like mine, you know, you could probably get away with stuff that already exists. And so that, to me, is a question that hasn't been asked enough. And there's no question this is transformational. There's no question that the hyperscalers are probably going to spend every dime they get their hands on, whether it's internally or externally generated. But free cash flow year over year is down for the MAG-7 pretty meaningfully. And so that means you're going to have to hit the capital markets more. [00:13:47] Speaker 1: Matt, we've got to run. Quick last word. [00:13:49] Matthew Hornbach: Yeah. So for our perspective at Morgan Stanley, we're very bullish on the AI CapEx spend for next year. We're penciling in $1.6 trillion worth of spend. That's up 60% year over year. We're confident that we're going to end up seeing that. And the trade will continue.