Inflation Reading Better Than Expected
The consumer price index rose 8.5% in July, while analysts had been expecting an 8.7% rise. The rise, albeit steep, points to a peak in inflation that is behind us, with price growth beginning to slow in the face of falling oil prices and aggressive Federal Reserve policy. Prices rose a mere 5.9% if you strip out volatile food and energy, a measure dubbed "core" inflation. A few key familiar drivers kept inflation high, however, with food, housing and used cars still posting significant year-on-year gains. Another concerning trend was that service price growth is increasing, as the shift in consumer demand from goods to services continues. On the whole, though, the latest CPI reading is a positive sign that the Federal Reserve could be having an impact on inflation, and that there is at least light at the end of the tunnel. Here's how we think this report will impact markets and the economy:
- Good news is good news: Equities were up sharply today on the news that inflation could be easing. Equity markets could be pricing in higher global consumer demand as inflation fades, i.e., demand-reduction concerns are easing. Bond yields also fell, and the yield curve steepened somewhat, indicating that fixed-income investor sentiment around an imminent recession might have already bottomed, as investors gauge the impact on Federal Reserve rate hikes in the months ahead. We don't think we are out of the woods yet, though, as there are still significant headwinds to the market, including higher borrowing costs and a still-volatile geopolitical landscape. We expect further market volatility as inflation and economic growth data plays out over the rest of 2022 and into early 2023.
- Not yet "significant progress": The latest CPI report will likely do little to dissuade the Federal Reserve from hiking rates aggressively at its September meeting, with markets currently pricing in a 50-basis-point (0.5%) hike. The Fed has been looking for signs of "significant" progress on the inflation front before pausing its rate-hiking cycle, and the current "real" interest rate is still well into negative territory, even after the lower CPI reading. Additionally, a strong labor market likely gives the Fed the cover it needs to raise rates, while also avoiding a recession in the short term.
- Economic growth: Investors have been concerned that historically high inflation will reduce demand in the mid- to long term, as higher prices lead to lower purchasing power for consumers. Demand reduction can lead to contracting periods of GDP growth and recessions, but the latest reading lowers that concern somewhat and likely boosts sentiment for global growth, in our view. Further declines in inflationary pressures could prove to boost consumer demand as wages rise. However, many things need to go right for inflation to fall without the economy slipping into a recession, and global headwinds, like slow-to-return oil production, are still mounting. We think GDP growth will be below the long-term average for the rest of this year, with recessionary risks rising in early to mid-2023 as restrictive Fed policy bites.
- Equities pull back on tech earnings disappointments - U.S. stocks finished lower, with the Nasdaq lagging after Micron Technology, the largest U.S. maker of memory semiconductors, warned that revenue may fall short of its prior guidance. Treasury yields rose, pressuring the growth segments of the market, with the consumer discretionary and technology sectors down the most. On the flip side, energy stocks were higher, as oil prices held above $90. The economic calendar was light and sentiment cautious, as investors await Wednesday's inflation report to gauge the path of rate hikes ahead.
- Investors await July CPI reading - The highlight of the week and a likely key driver for the short-term direction of travel for the markets will be the release of the July consumer price index (CPI) tomorrow morning. Friday's blowout July jobs suggested that more rate hikes are needed to cool the still-tight labor market. Investors will be looking at tomorrow's CPI to determine whether another 0.75% rate hike in September is coming, or the Fed can pivot to tightening at a slower pace. Given the broad decline in commodity prices over the past month, the headline inflation will likely slow from June's pace; however, there is a lot of uncertainty about how quickly prices will moderate over the coming months. Consensus expects headline CPI to decline to 8.7% from 9.1%, but expects the core CPI, which excludes food and energy, to accelerate to 6.1% from 5.9%. There are plenty of encouraging signs that goods inflation is easing, driven by slower demand, lower commodity prices, and easing supply-chain bottlenecks. However, services inflation is likely to stay elevated, supported by higher wage pressures and shelter costs.
- Markets could be entering a choppy phase - Equity markets have rallied about 13% since the mid-June lows, aided by reduced recession fears, hopes for a Fed pivot, and lower bond yields. With last week's outsized job gains suggesting that the Fed has to stay aggressive in its fight against inflation, additional near-term momentum for this rally might be difficult to achieve, and markets could be entering a choppy phase in the months ahead. Yet, the worst of the valuation declines might be behind us, and corporate earnings are proving more resilient than feared. Despite some of the recent disappointments in the tech space, 75% of the S&P 500 companies have reported results that exceeded analyst estimates, which is about in line with the historical average, but lower than the prior quarters.
- Stocks tread water – Equities bounced between positive and negative territory in a narrow range before finishing little changed on Monday. It was a quiet start to the week after last week's gain that extended the S&P 500's winning streak to three weeks, lifting the index more than 8% over the last month. With no major headlines driving today's action, markets remain fixated on the Fed's approach for rate hikes in the coming months. Last Friday's employment report provided a dose of optimism, as strong job growth in July signaled that the economy is holding up despite the headwinds from tightening monetary policy and elevated inflation. Small-caps outperformed today, suggesting a hint of that economic optimism in Monday's trading. Electric-vehicle and solar stocks also saw a boost from the potential environmental spending initiatives contained in the latest bill working its way through Congress. Interest rates were broadly lower on the day, with the 10-year Treasury yield falling below the 2.8% level.
- Waiting on the inflation report – We expect markets to be in a bit of a holding pattern early this week ahead of the July consumer price index (CPI) report on Wednesday. The pace of headline inflation is expected to moderate below the 9% threshold we saw in June, helped principally by the recent sharp drop in commodity prices. While lower headline inflation will be welcomed by consumers given the needed relief on food and gasoline prices, the trend in core CPI (excluding energy and food prices) will be closely watched, as that is the measure that dictates Fed policy. We expect core inflation to trend gradually lower, though upward influence from shelter prices may temper the rate of decline in coming months. We think we'll need to see three or four consecutive months of notable moderation in inflation before the Fed can begin to chart a course for less restrictive policy. This will be important for the markets, as we believe this shift by the Fed is a necessary element of a more enduring stock-market recovery.
- Washington back in the spotlight – The Senate passed the Inflation Reduction Act over the weekend, with the bill now headed to the House. The core tenets of the package center on climate, health care and taxes. Although the $700 billion bill targets spending and investment on climate and health care initiatives, the direct impact on GDP is likely to be minimal. Thus, markets will probably be most interested in the tax elements, which include a proposed 15% minimum corporate tax, as well as a new tax on company stock repurchases. We don't expect this to cause a dramatic hit to corporate profit growth ahead, but we do think this could add to the margin pressures companies are already enduring due to rising labor and input costs. While corporate earnings should grow at a decent clip in the year ahead, we expect some downward revisions to EPS estimates, which could be a catalyst that would disrupt the momentum in this current stock market rally. Political and policy uncertainties heading into midterm elections may be another source of volatility as we advance this year.
- Markets mixed following strong jobs data – Equities logged a mixed finished on Friday, with the S&P 500 closing just below the flat line, while the Dow posted a small gain, as a very strong July jobs report was balanced by worries that further tightness in the labor market will require the Fed to keep policy tighter for longer to quell inflation. The bond market took a similar view, with interest rates moving notably higher. Ten-year Treasury yields topped 2.8%, while two-year yields rose above 3.2%, as cold water was thrown on the recent bourgeoning market view that a Fed pivot away from aggressive rate hikes may be approaching. Small-caps, energy and financials were among the leaders today, indicating a slightly optimistic cyclical tone, while the Nasdaq and technology sector lagged due to the jump in interest rates. Overall, this tepid reaction to a categorically positive jobs report confirms that the equity market remains fixated on upcoming Fed actions, putting us in a phase where good news is periodically treated as bad news, insofar as it delays the point at which the Fed can let its foot off the brake. Nevertheless, equities have rallied sharply off the June lows, and interest rates are well below their recent highs, reflecting the balance of headwinds and tailwinds that are likely to persist as we advance through the year.
- Jobs data indicates the labor market is still healthy – The U.S. economy added a whopping 528,000 jobs in July, far exceeding consensus expectations for a 250,000 gain. Payroll gains were particularly strong in the leisure & hospitality sector, a good sign that the post-pandemic shift back toward spending on services (versus goods) remains on track. The unemployment rate ticked down to 3.5%, a 50-year low, while average hourly earnings rose at a very strong 0.5% month-over-month pace. The combination of strong job and wage growth indicates to us that the labor market remains quite supportive of consumer spending – the lion's share of GDP. This was an interesting employment reading given it comes amid a vigorous debate around whether the economy is or is not in recession. Regardless, this supports a case that the economic slowdown can be mild, though the path ahead for the economy will be dependent upon the path of inflation, as this will dictate just how aggressive and prolonged the Fed's tightening campaign will need to be. We suspect the labor market will show some wear and tear as we advance this year, given the actions companies are taking in response to slowing demand. But this jobs report was a clear piece of good news, arguing that the economic outcome does not have to be as bad as the depths of this year's equity-market pullback may have suggested.
- All eyes now shift to the inflation report – Markets will now key in on the upcoming July consumer price index (CPI) report due out on Wednesday. The pace of headline inflation is expected to moderate, helped principally by the recent sharp drop in commodity prices. While lower headline inflation is welcomed by consumers given the needed relief on food and gasoline prices, the trend in core CPI (excluding energy and food prices) will be closely watched, as that is the measure that dictates the Fed's monetary policy actions. We expect core inflation to trend gradually lower, though upward influence from shelter prices may temper the rate of decline in coming months. We think we'll need to see three or four consecutive months of notable moderation in inflation before the Fed can begin to chart a course for less restrictive policy. This will be important for the markets, as we believe this shift by the Fed is a necessary element of a more enduring stock-market recovery.
- Markets close mixed today: The S&P 500 moved modestly lower today, while the Nasdaq closed higher, after rebounding nearly 15% this quarter already. This comes as oil prices continue to head lower, with WTI crude oil moving below $90 for the first time since the Ukraine crisis began. Yields moved lower once again as well, with the benchmark U.S. 10-year Treasury yield down to 2.66% levels. The yield curve, the difference between the 10-year and two-year yields, remained inverted at about -36 basis points (-0.36%), close to the lows of this year. An inverted yield curve can be a leading signal for recessionary conditions ahead, although there is usually a lead time of about six to 18 months before an economic downturn begins.
- Initial jobless claims continue to move higher: U.S. initial jobless claims came in at 260,000 this morning, in line with expectations and above last week's 254,000 reading. Jobless claims are now near the highest levels of the year, and over 50% above the lows of the year set in March at 166,000. This softening may be a leading indicator of potential weakening in the U.S. labor economy, which continues to see tight conditions and record-low unemployment rates. All eyes will be on tomorrow's U.S. jobs report for the month of July, where expectations call for an additional 250,000 jobs to be added, and the unemployment rate to remain at 3.6%. Wage growth is expected to tick lower to 4.9% year-over-year in tomorrow's report, below last month's 5.1% figure, supporting the notion of moderating inflationary pressures. In our view, the U.S. labor market started from a position of strength, and while we may see some softening ahead, the initial robustness will provide some cushion against higher rates and a weaker economic backdrop.
- Earnings season rolls on with continued resilience: We are now well into the second-quarter corporate earnings season, with about 82% of S&P 500 companies having reported revenues and earnings already. Among these, nearly 75% have reported an upside surprise to earnings growth this past quarter, perhaps supporting the ongoing equity rally we have seen over the past several weeks. Nonetheless, in our view, the second-quarter earnings reports had not yet captured the full extent of Fed and central-bank rate hikes, nor taken into account the Fed's quantitative-tightening program, which may remove excess liquidity from the system. We would continue to expect earnings expectations to be revised downward, particularly for 2023 estimates. We have already started to see this, with forecasts for 2023 earnings growth now calling for 8.2% year-over-year, down from 10.6% just at the end of March. While markets may remain volatile as earnings and economic data continue to be revised lower, we expect this to be part of a longer "U-shaped" bottoming process for equity markets.
- Stocks up sizably on strong economic data: Stocks were up sizably today after key economic data likely eased recession fears. Treasury yields were little changed after comments from key Federal Reserve governors seemed to ease concern that a recession is imminent, but that more aggressive rate hikes are still on the horizon. The U.S. 10-year yield finished near 2.73%. The price of oil was sharply lower today after an announced increase in output from OPEC+ and an unexpected build up in U.S. gas inventories. Mortgage demand inched higher last week with mortgage rates moving slightly lower, pointing to still-strong demand from would-be homebuyers. Internationally, European and Asian shares also traded higher.
- Fed governor comments calming recession fears: James Bullard, the St. Louis Fed President, has said he doesn't see the economy falling into a recession despite aggressive Federal Reserve policy. However, comments from Bullard and other Fed presidents are raising the probability of another 75-basis-point (0.75%) hike in September, while the market had originally expected only a 50-basis-point hike. Fed Chair Jerome Powell has had similar comments about the economy and a recession, indicating that a strong labor market and resilient consumer demand will provide enough cushion to keep the economy out of a recession. However, we think the path forward for a soft landing is narrowing and becoming increasingly more difficult as inflation remains high. The Federal Reserve has already hiked rates aggressively this year, and we have seen that impact in the more interest-rate-sensitive sectors of the economy, like housing. However, even with higher rates, inflation has remained stubbornly high, as the mix of shortages and supply-chain congestion has persisted much longer than originally expected.
- Energy supplies remain tight after OPEC+ meeting: Today's OPEC+ meeting today revealed a mere 100,000-barrel-per-day increase, far fewer than hoped, as the price of oil remains historically high amid strong demand and tight supply, exacerbated by the war in Ukraine. Many of the OPEC+ members have very little excess capacity after shutdowns during the pandemic. With Russian oil being shunned by developed nations, additional supply would need to be provided from other members, such as Saudi Arabia. In the U.S., the oil-rig count has inched higher, but additional supply has been slow to return amid calls for a rapid transition to renewable energy and funding concerns. The latest so called "inflation fighting" bill supported by Joe Manchin would allow more drilling on federal land, but making use of that will take time if the bill passes. Even though output increases disappointed, oil prices fell today, as cracks in the demand picture seem to be forming as gas inventories saw an unexpected rise, which is very rare during the summer. Demand for durable goods has been shifting to services, which could be contributing to lower shipping and oil demand.
- Surprise rebound in U.S. services sector helps boost equities: The U.S. service sector posted an unexpected rebound in July, gaining despite disappointing GDP data for the second quarter. The data likely eased fears that a recession is imminent, but also pointed to supply-chain pressures loosening up, which has been a key contributor to persistently high inflation. The release helped to boost stocks today, as investors interpret inflation that might be falling and economic activity that remains strong amid aggressive Federal Reserve monetary policy.
This chart shows the drastic reduction in oil rig counts during the pandemic and the subsequent recovery as the economic expansion has taken shape.
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