Inflation takes a first step in the right direction

Last week both CPI (consumer price index) and PPI (producer price index) inflation data for the month of July moved lower. After surprising to the upside last month, markets welcomed the lower-than-expected headline and core readings. However, inflation remains elevated compared with almost any period in history, and we would expect the Federal Reserve to continue to push rates higher in this backdrop. Nonetheless, investors cheered this first step in the right direction. While we may see increased volatility in the weeks ahead, if inflation continues to moderate consistently, markets could be poised for a more sustained rally longer-term.

Headline CPI was notably lower than last month, while core CPI came in largely in line

As many expected, headline inflation came in nicely below expectations for the month of July, largely driven by lower fuel and energy prices. In July we had seen average U.S. gasoline prices fall by around 8% and WTI crude oil down by 11% over the month of June1. This supported a headline CPI inflation that came in at 8.5%, versus expectations of 8.7%, and below last month's 9.1% reading1. But perhaps the more pleasant surprise for markets was the lower-than-expected core inflation reading, which came in at 5.9% year-over-year, versus a forecast of 6.1%. This was driven by lower prices in areas like used cars, select apparel, and airline fares. However, we continue to see inflationary pressures remain sticky in components like shelter and rent pricing (about one-third of the CPI basket), as well as services inflation, which has been driven higher by elevated wage growth as well. Over time, we would expect the impact of a cooling housing market and a potentially softening labor market to continue to put downward pressure on core inflation, albeit with a lagging impact.

Figure 1. The move lower in commodity and energy prices supported a July headline CPI inflation figure below expectations

 Commodity and energy prices move lower in recent weeks.

Source: FactSet. Past performance does not guarantee future results. Market indexes are unmanaged and cannot be invested into directly.

This chart shows the recent fall in oil prices and the S&P GSCI commodity index as increased oil supply and supply chain issues iron out.

PPI figures were similar – elevated but moving in the right direction

Like the CPI reading, U.S. PPI figures also came in below expectations, although they remain elevated versus history as well. Headline PPI came in at 9.8% year-over-year, versus an expectation of 10.4%, and well below last month's 11.3% reading, benefiting from the lower energy prices1. Core PPI came in at 7.6%, also below forecasts of 7.8%. Producers generally are also benefiting from gradually improving global supply chains, as evidenced by measures like better delivery times, lower shipping-container rates, and a decline in the Fed's Global Supply Chain Pressure Index. Over time, if both the demand and supply drivers of inflation move in the right direction (softer demand and improved supply), prices may be able to move more sustainably back toward pre-pandemic levels.

Figure 2. Increasing measures point to gradually improving global supply chains, including the New York Fed's Global Supply Chain Pressure Index

 Global supply chain pressure shows signs of easing.

Source: New York Federal Reserve Bank

This chart shows the supply chain index which reached record levels during the pandemic, but has recently started to roll-over and come down as manufacturing ramps up.

How will the Fed react? It will need to see more data before pausing rate hikes

Overall, while this month's inflation readings were an encouraging step in the right direction, prices continue to remain elevated by almost any historical measure. Keep in mind that the Federal Reserve has told us that it would need to see "clear and convincing" evidence that inflation is moderating before it would consider altering its rate-hiking path. We would likely need to see two to three additional moves lower in inflation before considering it a trend, and thus we would not expect this week's inflation data to materially alter the path of the Federal Reserve.

What we have seen as a result of this month's inflation readings is a shift in the market expectations of the magnitude of Fed rate hikes. Markets now expect a 50-basis-point rate hike (0.50%) at the September meeting versus a 75-basis-point hike just earlier this week1. The expectation now is for another 50-basis-point hike in November, followed by a 25-basis-point hike in December, bringing the fed funds rate to a 3.50%-3.75% range before pausing. In our view, this is a reasonable terminal fed funds rate, as it brings interest rates into more restrictive territory and will continue to put downward pressure on demand and consumption, particularly in interest-rate-sensitive parts of the economy.

Figure 3. Markets expect the fed funds rate to climb to the 3.50% - 3.75% range in 2022, before pausing in 2023

 Market expectations by fed funds rate meeting.

Source: FactSet.

This chart shows the Fed Funds rate rising to 3.75% in December from the current 2.5% rate.

Where do markets go from here? We don't expect a straight line higher

Since the beginning of the third quarter (June 30), equity markets have had a stellar move higher, with the S&P 500 up over 12%, cutting its losses for the year nearly in half. Similarly, the technology-heavy Nasdaq is up about 17%, bringing its losses for the year down to about -17%1. And this week's inflation readings have only helped add to the positive momentum we have seen over the past six weeks or so.

However, we would not expect markets to continue this rally in a straight line higher through year-end. In our view, markets are likely to experience some volatility, driven in large part by the ongoing rate hikes by the Fed in the months ahead. In addition, the Fed's balance-sheet reduction program will start to ramp up in the second half of the year, which may add upward pressure to bond yields and continue to remove excess liquidity from the system. Finally, we are heading into September and October – historically volatile months in markets – as economic and earnings estimates may continue to soften, which could also exacerbate market volatility.

Remember that midterm elections are upon us this year as well

Nonetheless, investors could use any periods of market volatility to position themselves for a potentially more sustained rally ahead. We would expect this rebound to happen if and when inflation shows consistent signs of moderating, and economic and earnings measures have stabilized. Also, keep in mind that this may coincide with the period after midterm elections in the U.S. (which will occur on November 8). Historically, markets tend to do well in the six to 12 months after midterm elections, regardless of which party wins or who is in power at the time. And markets generally tend to prefer a "gridlock" outcome (split branches of government by party), as this poses less risk for corporations around the passing of new or restrictive legislation.

Figure 4. Markets tend to perform well in the six and 12 months after midterm elections, regardless of which party is in power

 S&P 500 returns after mid-term elections; Returns tend to be positive, regardless of election outcomes.

Source: FactSet. Past performance does not guarantee future results. Market indexes are unmanaged and cannot be invested into directly.

This table shows average returns before and after mid-term election with the average 12 months return before the election coming in at 0.3%, while the 12 months after the election at 16.3%. The table also includes periods where the house and senate flipped control between democrats and republicans.

Overall, while the first half of the year was challenging for investors, we are starting to see early signs of market stabilization. We would expect bouts of volatility in the weeks ahead, as economic and earnings fundamentals may be revised lower, and as the Fed continues to raise rates, but we would not expect another bear market or 20%+ downturn ahead. In our view, much of the work to the downside happened in the first half of the year, and markets broadly should hold up better in the second half and into 2023. We would thus use any volatility to review portfolios – either to rebalance, help to ensure proper diversification, or ultimately add quality investments at potentially lower prices.

Within U.S. equities, we continue to favor a slight tilt towards value and defensive sectors for now. But for long-term investors, there are opportunities to gradually add to technology and growth sectors as we advance, especially as economic growth may bottom, and investors look for a potentially more durable rebound ahead. Within bonds, we favor U.S. investment grade, which can offer better income opportunities today and help to act as a diversifier in periods of market volatility.

Mona Mahajan,
Investment Strategist

Source: 1. Bloomberg

Weekly market stats

Weekly market stats
Dow Jones Industrial Average33,7612.9%-7.1%
S&P 500 Index4,2803.3%-10.2%
MSCI EAFE *1,9702.4%-15.7%
10-yr Treasury Yield2.85%0.0%1.3%
Oil ($/bbl)$91.903.2%22.2%

Source: Factset. 08/12/2022. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * 4-day performance ending on Thursday.

The week ahead

Important economic data being released this week include the LEI index and Retail Sales growth.

Review last week's weekly market update.

Mona Mahajan

Mona Mahajan is responsible for developing and communicating the firm's macroeconomic and financial market views. Her background includes equity and fixed income analysis, global investment strategy and portfolio management.

She regularly appears on CNBC and Bloomberg TV, and in The Wall Street Journal and Barron’s.

Mona has a master’s in business administration from Harvard Business School and bachelor's degrees in finance and computer science from the Wharton School and the School of Engineering at the University of Pennsylvania.

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