Inflation strikes again – Recovery delayed, not derailed
Inflation remains the kryptonite of financial markets this year. Last week's hotter-than-expected consumer price index (CPI) for the month of August triggered the biggest daily decline in the S&P 500 in over two years and drove interest-rate expectations higher1. The broad price pressures challenge the Fed to keep going and suggest that the road to the 2% target will likely be long, and could include some economic pain along the way. But there are glimmers of hope that the underlying inflation trend will likely be down in the quarters ahead. We offer the following perspective on four key questions about the recent market-moving inflation data:
What was in the August inflation report?
Despite expectations for a small monthly decline in headline inflation, the CPI surprised to the upside, rising 0.1% in August from July. The year-ago rate of inflation moderated from 8.5% to 8.3% but was still higher than the 8.1% expected. More concerning and a key focus for central banks was that the so-called core index, which excludes the volatile categories of food and energy, accelerated from 5.9% in July to 6.3%1.
The graph shows the U.S. consumer price index (CPI). While the year-ago headline inflation moderated, core inflation accelerated in August.
The small moderation in the headline index is welcome. Yet it is unlikely to provide much comfort about the outlook because it has been largely driven by the drop in energy prices (gasoline prices fell 10.6% in August). Price increases elsewhere remain broad. To this point, core services inflation, and shelter in particular, continue to add upward pressure. Shelter, which makes up nearly a third of the CPI weighting, increased by 0.7% from the prior month and by 6.2% from a year ago, both of which were the highest readings since the early 1990s1. And trends in goods inflation failed to provide much help. Used car prices declined 0.1%, but new car prices rose 0.8%.
The graph shows how inflation for goods has rolled over, but prices for services continue to accelerate driven by higher shelter prices and wage pressures.
What's the outlook from here?
The persistence and breadth of inflation suggest that the road to the Fed's 2% target will be a long one. Housing inflation remains stubborn, and higher wages are putting upward pressure on other parts of services inflation. Yet, there are signs that the labor-market tightness is slowly easing, supply chains are normalizing, commodity prices are continuing to soften, and consumer demand is moderating as the Fed's rate hikes slow the economy. For these reasons, we expect the trajectory of inflation to be lower in the coming months, though not in a straight line. The August data are no doubt disappointing, but we shouldn’t forget that are preceded by a downside inflation surprise in July.
In the coming months we expect a tug-of-war between services and goods inflation. The factors that support further easing in goods inflation include
- Relief from falling energy prices, which has continued through September so far. The average retail gasoline price has fallen to $3.70 from a peak of $5.051.
- Evidence that supply chains continue to improve, while demand for goods is softening as consumers spend less on discretionary items.
- Delivery times are improving, as reported by the Purchasing Managers' Index.
- Shipping rates from Asia to the U.S. are 60% off their peak but still elevated1.
- The New York Fed's Global Supply Chain Pressure Index has fallen for four straight months to its lowest since Jan-20211.
- Prices paid by manufacturing firms for inputs dropping to their lowest since June 2020 and prices paid by services firms to their lowest since Jan 20211.
- Greater inventory is starting to put downward pressure on used car prices. The Manheim index recently recorded its largest monthly drop since the depths of the pandemic1.
The graphs show the sharp decline in shipping costs and prices paid which signal that supply chains are improving, helping inflation pressures ease down the road.
On the flip side, housing inflation could linger at a higher rate for a while, as it tends to be slow-moving and persistent. Historically, and as shown in the graph below, shelter inflation has lagged the change in home prices by several quarters. Leases are most commonly set for a year, and even when they are up for renewal, landlords are sometimes hesitant to adjust prices much higher on existing tenants. Therefore, we expect that the sharp rise in prices that has occurred over the past year will continue to drive the shelter component of the CPI higher, at least through the end of the year.
Yet, we know that housing activity is already cooling, implying it likely won't be long until prices start to soften. Last week the 30-year fixed mortgage rate hit 6% for the first time since 2008, which is double what it was a year ago. With borrowing costs rising sharply, mortgage applications to purchase a home are about 30% lower than they were a year ago1.
Source: Bloomberg, Edward Jones
The graph shows that shelter inflation tends to lag the change in home prices.
What’s next for the Fed?
The August CPI report suggests the Fed has more work to do in its fight against inflation. We expect the FOMC to hike rates by another 75 basis points (0.75%) when it meets this week, bringing the fed funds rate to 3.00% - 3.25%. While market pricing suggests a 25% probability of a full-percentage-point hike, we think the Fed won't choose to shock markets with a jumbo hike, but rather add more hikes in future meetings if deemed necessary2.
After the upside inflation surprise, market expectations repriced to project a longer tightening cycle and a higher peak rate, which seems appropriate given the Fed's determination to bring inflation back to target. The bond market now expects that the Fed will stop rate hikes at around 4.5% from 4.0% before, with the last hike occurring in March 20232. In response, the 2-year Treasury yield hit a new cycle high, and the 10-year is back near its mid-June high1.
The graph shows the recent rise in 10- and 2-year Treasury yields in response to shifting expectations for Fed tightening.
Another glimmer of hope in the data last week was that consumer inflation expectations, which policymakers also follow closely, appear to have rolled over. The New York Fed's Survey of Consumer Expectations showed that inflation expectations declined over the one-, three- and five-year horizons. And along the same lines, the University of Michigan survey showed that perceptions of inflation among consumers are not deteriorating further, and, in fact, the one-year inflation expectation of 4.6% is the lowest in a year1. We suspect that price pressures will ease enough for the Fed to slow its pace of tightening later this year and then pause next year, but not enough to start cutting rates. A key risk to this view would be another rally in commodity prices. But, so far, it is encouraging that oil prices have stabilized below $1001.
Source: Federal Reserve Bank of New York
The graph shows the recent decline in consumer inflation expectations as measured by the New York Fed survey.
What are the market implications?
Higher uncertainty on how quickly inflation will cool means higher volatility in financial markets. But investors shouldn't overreact to any single report. While the August CPI data move us a bit further away from the best-case scenario, it does not necessarily change the likelihood that the rate of inflation will slow in the coming months, driven by improved supply-and-demand dynamics. Last week was clearly a setback, but not a full reversal of the peak inflation narrative that will likely gain steam later on.
In the near term, the upward pressure on bond yields could trigger some weakness in the growth segments of the market. Until a pattern of lower inflation readings is established (likely three or more needed), equities are going to have a hard time mounting a sustainable rebound. But long-term investors should consider the following:
- There likely is more downside in earnings estimates (FedEx withdrew its profit forecast, dragging the broader market down on Friday), but the bulk of the adjustment lower in valuations might be behind us. Over the past 26 years price-to-earnings ratios (P/E) have contracted 24% on average during sizable market downturns and bear markets. This year's 26% decline in the S&P 500 P/E ratio appears to adequately reflect the downside risks3.
- Stocks are forward-looking and historically tend to bottom before the data starts to improve.
- The average bear market since World War II has lasted about 11 months. At nine months, the current bear is maturing3.
- This year's painful drawdown in both bonds and stocks has improved future long-term returns. The starting points in both bond yields and equity valuations are now very different vs. the beginning of the year.
The bottom line: With the Fed firmly on the brakes and growth slowing, the macroeconomic backdrop remains challenging, requiring patience from investors. Markets might stay rangebound for a while, but should eventually start recovering as central banks become less hawkish. We think investors can use any further pullback triggered by last week's inflation data as an opportunity to rebalance portfolios and add quality investments at more favorable prices.
Source: FactSet, Edward Jones
The graph shows the year-over-year decline in S&P 500 valuations which is in line with major downturns in the past.
Angelo Kourkafas, CFA
Sources: 1. Bloomberg, Edward Jones, 2. CME watch tool, 3. FactSet, Edward Jones
Weekly market stats
|Dow Jones Industrial Average||30,822||-4.1%||-15.2%|
|S&P 500 Index||3,873||-4.8%||-18.7%|
|MSCI EAFE *||1,788.60||-2.7%||-23.6%|
|10-yr Treasury Yield||3.45%||0.1%||1.9%|
Source: Factset. 09/16/2022. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * Morningstar 09/19/2022
Angelo Kourkafas is responsible for analyzing market conditions, assessing economic trends and developing portfolio strategies and recommendations that help investors work toward their long-term financial goals.
He is a contributor to Edward Jones Market Insights and has been featured in The Wall Street Journal, CNBC, FORTUNE magazine, Marketwatch, U.S. News & World Report, The Observer and the Financial Post.
Angelo graduated magna cum laude with a bachelor’s degree in business administration from Athens University of Economics and Business in Greece and received an MBA with concentrations in finance and investments from Minnesota State University.