Oil Raised the Question, CPI Delivered the Answer

Key takeaways

• Oil prices briefly topped $100 a barrel as unresolved Middle East tensions kept energy markets on edge.
• August core CPI rose 0.3% month-over-month, the biggest increase since April, adding to concerns that inflation pressures are broadening beyond energy.
• We think policymakers will be less willing to look past supply-driven inflation, with markets now assigning a 90% chance to a September Fed rate hike.
• The Fed doesn't appear to be as far behind the curve as it was in 2022, suggesting any tightening cycle from here could be more limited, in our view.
• Strong corporate earnings still support the case for stocks, even as rising yields and oil prices test investor sentiment.

Heading into what is likely to be the year's most anticipated and debated Federal Reserve meeting, oil prices briefly moved into triple digits, with U.S. WTI crude crossing $100 a barrel and Brent approaching $110 before retreating some late in the week. That surge posed a question: would rising oil be enough to tip the Fed into hiking rates?

Friday's CPI report suggests the answer is yes, in our view. A hotter-than-expected core reading showed inflation pressures spreading beyond energy, strengthening the case for a near-term policy response and reviving the "higher for longer" narrative. The question is no longer simply whether the Fed hikes next week. It is whether this is the start of a longer tightening path, and what that means for portfolios.

August CPI shows firm inflation against a backdrop of rising energy prices

All eyes were on the consumer price index as the key data point with the potential to tip the scale toward a September rate hike, and we think the data did exactly that.

On an annual basis, headline CPI held steady at 3.4%, while core CPI, which excludes the volatile food and energy categories, ticked down to 2.4% from 2.5%. Both figures came in as expected, and the core reading marked the smallest annual increase since 2021. That is where the good news ended. The disappointment came from the monthly figures: core CPI rose 0.3%, the biggest monthly gain since April, showing that progress toward the Fed's inflation target has stalled. That 0.3% pace is notable for a specific reason: it is the threshold Governor Waller recently suggested he would need to see to support a rate increase, and the line in the sand for many market participants' expectations.

The underlying components tell a similar story. Core goods prices rose a muted 0.1%, but core services accelerated, driven by higher wireless phone plan prices, rising airfares, and increased hotel and education costs. The report also showed early evidence of the AI buildout's economic footprint, with computer software and accessories prices climbing at a record pace. Costs fell for medical care and motor vehicle insurance, providing some offset.

Taken on its own, the August data would not be overly alarming. But paired with the renewed rise in energy prices, it suggests more inflationary pressure may be in the pipeline. The average retail price of diesel fuel topped $6 a gallon, a record high, and that increase could filter through to other components as consumer demand remains solid and companies begin passing higher costs on to customers.

The Fed is running out of reasons to wait

When policymakers meet this week, they will have to weigh a healthy labor market against still-elevated inflation. On employment, the picture is solid: the August jobs report showed a labor market consistent with full employment, as Fed Chair Kevin Warsh recently noted. Unemployment sits at 4.1%, job gains were broad, and 3.1% wage growth isn't inflationary once the productivity pickup is factored in. That side of the mandate looks largely achieved.

Inflation is the harder half. It has now run above the Fed's 2% target for more than five years, and recurring shocks, from supply chains to tariffs to energy, aren't helping. Rate hikes won't solve higher oil prices, but policymakers may be growing less willing to look through supply-driven inflation pressures after years of running above target.

Interest rates also don't appear to be restricting the economy much beyond housing at current levels. Looking ahead, high oil prices effectively act as a tax on consumers, potentially weighing on discretionary spending and broader activity. Still, the economy retains important buffers. The labor market continues to support consumers, with layoffs remaining subdued, as reflected in timely jobless claims data, while structural changes in the U.S. economy have reduced its sensitivity to oil-price shocks compared with prior decades. The ongoing AI infrastructure buildout is also helping support growth and business investment.

Put simply, the Fed may be running out of patience, and market pricing is starting to reflect that, with the probability of a September rate hike rising to 90%. The Fed is not alone in this shift: the ECB has already hiked a quarter point, and other central banks are becoming more hawkish as well.

Is the Fed behind the curve, and if so, by how much?

If the Fed's patience for looking through shocks is fading, the practical question becomes how much ground it actually needs to make up. The good news is that the Fed may not need to tighten as aggressively as it did in 2022; a mid-cycle adjustment more like 1997 may be the better comparison. Short-term Treasury yields have long signaled that Fed policy needs to move higher, but the gap between the 2-year yield and the fed funds rate suggests the Fed is not dramatically behind the curve.

Before the Fed's first hike in March 2022, the 2-year yield sat 1.6% above the fed funds rate, implying roughly six to seven quarter-point hikes, while headline inflation was already above 7% and still accelerating. Today, that gap is roughly 0.9%, or about three to four hikes' worth, while headline CPI is running close to the fed funds rate itself. We read that as a sign the Fed is not far off from where it needs to be. In the meantime, higher short and long-term yields are already tightening financial conditions, raising borrowing costs and helping keep inflation expectations contained.

The upside of a weaker bond market is that short-term yields already reflect expectations of further tightening, meaning they may not need to rise much further even if the Fed moves. Counterintuitively, a hike this week could prove favorable for long-term bonds, as it would reinforce the Fed's inflation-fighting credibility and boost confidence that price pressures will ultimately be brought under control. Should the Fed instead choose to hold rates steady, it risks inviting fresh questions about its independence and its resolve to bring inflation back to target.

Market implications of "higher for longer"

Rising bond yields and oil prices are testing the market's resilience, but stocks retain their key pillar of support: fast-rising earnings. After S&P 500 profits grew 50% year-over-year in the second quarter, analysts now project 27% growth in the third quarter, a faster pace than expected just a few months ago and the eighth consecutive quarter of double-digit growth.

History also favors the bulls. The rally has lost some steam in September as macro headwinds mount, but over the past 50 years, only one year, 1987, saw the S&P 500 peak in August. In every other year, stocks either had already peaked earlier or absorbed the seasonal weakness and went on to new highs.

None of this means oil and rates don't matter. They will likely remain a key driver of sector and asset-class leadership. But rather than betting on a single outcome for oil or the Fed, investors are better served by positioning for a range of scenarios.

Sector history offers a useful guide. During past episodes of fast-rising yields, technology led both in absolute and relative terms, while health care and industrials also held up well. Telecom (before the sector became more tech-heavy and was renamed communication services), utilities, consumer discretionary and materials lagged, and financials posted positive but unremarkable returns. The takeaway is that higher yields alone are not a reliable signal to rotate out of growth. With that in mind, we see two paths from here:

• If energy stays elevated and inflation proves sticky, mega-cap technology should remain in favor. The Magnificent 7's strong balance sheets make them less sensitive to elevated borrowing costs than the broader market. A gradual tightening path is unlikely to derail the expansion, but elevated yields will likely remain a headwind for valuations more broadly. We favor pairing mega-cap tech leadership with select cyclical value exposure, positioning for a higher-for-longer backdrop while staying invested in the expansion and manufacturing upcycle. A slow, gradual hiking path should also keep the U.S. dollar supported.
   
• If energy eases and the inflation scare fades, market pressure should ease with it. Yields would likely stabilize or decline, financial conditions would loosen, and the rally would have room to broaden into mid- and small-caps that have lagged over the past month, as well as international equities. This is the more constructive path, though it hinges on developments in the Middle East that are inherently difficult to forecast.

On the fixed-income side, a higher-for-longer backdrop keeps bonds under near-term pressure, but as we discuss in our Monthly Fixed-Income Focus, today's elevated starting yields also lay the groundwork for stronger returns over the long run.

The bottom line

Oil raised the question of whether inflation could still be dismissed as temporary, and this week's CPI report suggests the answer is no, at least for now. That doesn't upend the bull case, but it does raise the bar. With earnings still strong and history on the market's side, we'd use any hike-related volatility as an opportunity to add to quality, rather than retreat to the sidelines, while staying diversified across sectors and styles for whichever path oil and the Fed take from here.

Angelo Kourkafas, CFA
Senior Global Investment Strategist

Sources for all data in commentary: Bloomberg, FactSet

Previous weeks' weekly market wraps

9/4: Three Datapoints the Fed Is Likely Watching Ahead of the September FOMC Meeting

8/28: A Clearer Path into September

8/21: A roller-coaster week for rates: Separating opportunity from risk

8/14: Cooling inflation supports the case for Fed patience

8/7: Easing headwinds clear the way to new highs

7/31: Fed and tech earnings take center stage

7/24: Will the rise in oil prices force the Fed's hand?