August inflation figures disappoint markets

Investors appeared prepared for today’s Consumer Price Index (CPI) report to come in better than expectations. The S&P 500 Index had rallied sharply since the first week of the month (yes, markets can go up in September) and S&P 500 Index futures were higher this morning.(1) Alas, it wasn’t meant to be. The headline CPI climbed 0.1% in the month of August, even with oil and gasoline prices continuing to fall. The core CPI, which excludes food and energy, climbed 0.6% for the month with all categories coming in above expectation and driven by the costs of shelter and medical devices. Travel-sensitive prices were more subdued, as airfares declined significantly, and hotel lodging prices were up modestly.(2)

How is the market responding?

As of this morning, Sept. 13:

• Interest rates surged on news of the report.3 The 2-year rate was up to 3.74% this morning.(4) The spread between the 2-year and 10-year US Treasury rates fell into deeper inversion.(5)
• Stocks once again sold off, led by longer duration growth assets.(6)
• The US dollar, amid expectations of further policy tightening and greater yield diversion between the US and the rest of the developed world, was up meaningfully against a trade weighted basket of currencies.

What do we make of this?

• Candidly, the report is disappointing on the heels of a July report which signaled that pricing pressures were easing. There was some hope that a continuation of that trend would provide a lift to markets as investors began to price in the prospect of the Federal Reserve beginning to back off its tightening stance.
• The report reinforces expectations that the US Federal Reserve will likely raise interest rates by 75 basis points at the September meeting. The market now expects the terminal rate to be 4.25% by the middle of next year. Before the report, the market had priced in a 4% terminal rate by the beginning of 2023.(7)
• Market volatility is almost always the result of policy uncertainty. The report confirms that policy uncertainty is to continue and will likely be with us into at least the beginning of next year.
• The likelihood of a recession is elevated, given that cycles tend to end with high inflation and policy tightening. If an official recession were to occur, we would expect it to be relatively mild given the fundamental strength of corporate balance sheets and the healthy nature of the US banking system.
• We continue to believe that inflationary pressures will moderate over time. The bond market tends to agree. Inflation breakevens, the difference between the yield on the nominal US Treasury rate and the rate on Treasury Inflation Protected Securities, were rising across the curve this morning but remained below or near 2.5% across the 1-, 3-, and 5-year maturities, well within the Fed’s comfort zone.(8) Further, retailers have been reporting inventory builds,(9) mortgage rates have risen meaningfully(10) and are starting to bring the boil down on the housing market,(11) and consumer sentiment remains weak.(12)
• While we had hoped that the August CPI report would show further progress in easing inflation pressures, we also know that hope is not an investment strategy. Our proprietary leading indicators have been signaling a contractionary environment for the US economy, led in part by policy tightening. (Related podcast: The contraction has begun). As such, we favor a more defensive overall risk profile, from a tactical perspective, with a focus on higher-quality bonds and more defensive equity positioning.
• Ultimately, we expect this period to resemble 1980 more than 1973. In 1973 the Fed had lost control of long-term inflation expectations. Markets were subsequently challenged for a prolonged period. In the early 1980s the Fed was able to successfully break inflation. Yes, there was a recession in 1981, but for long-term investors who were able to ride it out, it was of little consequence. Investing when inflation peaked proved to be a sound strategy. Investors who allocated capital in 1980 were likely pleased over the subsequent 1-, 5-, and 10-year periods, as the S&P 500 Index had cumulative returns of 40.1%, 127.1%, and 409.5%, respectively.(13)

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1 Source: Bloomberg, 9/13/22

2 Source: US Bureau of Labor Statistics, 8/31/22

3 Source: Bloomberg, 9/13/22, as represented by US Treasury rates across all maturities

4 Source: Bloomberg, 9/13/22

5 Source: Bloomberg, 9/13/22

6 Source: Bloomberg, 9/13/22. As represented by the S&P 500 Index. Longer duration growth assets are represented by the NASDAQ Composite Index, a broad-based capitalization-weighted index of stocks in all three NASDAQ tiers: Global Select, Global Market and Capital Market.

7 Source: Bloomberg, 9/13/22, as represented by the federal funds implied rate

8 Source: Bloomberg, 9/13/22

9 Source: US Census Bureau, 8/31/22, as represented by the retail inventory-to-sales ratio

10 Source: Bankrate.com, 9/13/22

11 Source: S&P Case Shiller, 8/31/22, as represented by the year-over-year percent change in the 20-city home price index, which seeks to measures the value of residential real estate in 20 major US metropolitan areas.

12 Source: University of Michigan, 8/31/22

13 Source: Bloomberg, 12/31/21. Time periods beginning 3/31/80. As represented by the S&P 500 Index.

Important information

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This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.

All investing involves risk, including the risk of loss.

Past performance does not guarantee future results.

Investments cannot be made directly in an index.

The S&P 500? Index is a market-capitalization-weighted index of the 500 largest domestic US stocks.

Index futures are contracts to buy or sell the stocks in a financial index today, to be settled at a date in the future.

Tightening is a monetary policy used by central banks to normalize balance sheets.

A basis point is one hundredth of a percentage point.

The US Consumer Price Index measures change in consumer prices as determined by the US Bureau of Labor Statistics.

Treasury Inflation-Protected Securities (TIPS) are US Treasury securities that are indexed to inflation.

The terminal rate is the anticipated level that the federal funds rate will reach before the Federal Reserve stops its tightening policy. The federal funds rate is the rate at which banks lend balances to each other overnight.

Inventory-to-sales ratio depicts the relationship between a company’s end-of-month inventory values and monthly sales.

The opinions referenced above are those of the author as of Sept. 13, 2022. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.