Inflation continues to be the main driver of investment markets, and the consumer price index (CPI) report for August suggests that any relief may still be a long way off.
Here are our thoughts on what this report says and how it could impact your investment portfolio.
What happened: Inflation accelerated in August
According to Bloomberg, economists were expecting inflation to come in fairly slowly due to lower gasoline prices in August.
It happened. The headline CPI rose just 0.1% in August, largely due to an 11% drop in gasoline prices.
The problem is that almost everything else has grown faster than expected. Excluding food and energy, consumer prices rose 0.6% from 0.3% last month, in line with troubling CPI reports for May and June. The increases were broad-based, with items like clothing, cars, housing and medical care all rising faster in August than in July.
What you need to know: Inflation may have peaked
Although this CPI report was disappointing, we still believe that the inflation rate may have already peaked. Looking at a broader range of data, many forces appear to be opposing a reacceleration in inflation.
- Crude oil prices are down 27% since the peak in June.
- Gasoline prices have fallen 26% since June.
- Used car prices have fallen 11% since January.
- consumer spending slowed, rising at an annualized rate of 6.7% in the last three months, compared to 12.9% for the first four months of the year
- Sales of new homes are down 33% compared to the monthly average for 2021.
- Employment growth slowed, with the economy adding an average of 378,000 new jobs per month over the past three months, compared to 493,000 from December to May.
The slowdown in all of these elements is encouraging. Note that the way the CPI is calculated sometimes results in certain price changes that are only reflected in the report after some lag.
For example, the Manheim Used Car Index, which tracks used cars sold at auction, shows prices are down 11% since January. However, the used car component of the CPI only fell 1.6% over the same period.
Likewise, one of the main contributors to inflation this month has been the “equivalent owner’s rent”, which is a somewhat complicated estimate of the cost of housing for owners. This component accelerated in August, when most estimates of house prices decline slightly or barely increase.
All in all, inflation is an imbalance of supply and demand, i.e. there is more spending than the economy can support. Therefore, we do not think it is reasonable to expect inflation to decline without spending slowing.
That’s why things like lower consumer spending and new home sales are actually good news. Furthermore, consumers are likely to continue to spend at a healthy pace as long as wage growth is exceptionally strong.
Perhaps if the demand for new workers slows, it will also slow wage growth.
Once Money Is Tight, Inflation Will Likely Come Down
As we said above, inflation occurs due to an imbalance between supply and demand. Therefore, the Fed’s job is to limit spending enough to bring the economy back into balance. They are doing this by raising interest rates (which they have done at a historic rate so far this year).
When interest rates are raised, large purchases could potentially become unprofitable. For example, businesses typically borrow money from banks to pay for things like construction projects and equipment purchases, while consumers borrow money for big-ticket items like houses and cars. If borrowing costs become too high for consumers, spending will slow.
It’s hard to know exactly how much spending needs to slow down to achieve that balance. However, we believe that inflation should decline steadily once equilibrium is reached.
Think of it like melting an ice cube. If the temperature is 30 degrees, the ice will not melt at all. But once you get it above 32 degrees, it will steadily melt until it disappears.
The Fed simply needs to cross the threshold where rising interest rates slow spending enough to be balanced with supply. Like the melting ice cube, inflation will not suddenly disappear. But once they see it start to melt, the Fed will know it has risen enough.
What does this mean for the Fed?
Based on this CPI report, the Fed doesn’t see any water out of this ice cube just yet, so we can probably expect a few more rate hikes in 2022. Fed Chairman Jerome Powell recently saidspeaking of inflation, “We will continue until we are satisfied that the job is done.”
He says the Fed is committed to bringing inflation down regardless of other consequences. Fed Governor Christopher Waller recently said that “the consequences of being cheated by a temporary slowdown in inflation could be even greater now if another misjudgment damages the Fed’s credibility.”
We think this CPI report likely removes any doubt that the Fed will rise 0.75% at its September 21 meeting. This will be the third consecutive meeting where the Fed has risen by this degree.
The jury is still out on whether the Fed might slow the pace of increases at its November or December meetings. There will be two more reports on the CPI, two reports on core personal consumption expenditures (the Fed’s preferred measure of inflation), and a myriad of other economic indicators.
We believe that the Fed will continue to climb at an aggressive pace as long as inflation indicators remain this high, but also that the Fed could shift gears quickly if inflation declines.
Waller said he would seek a “significant and persistent moderation” in inflation before halting rate hikes. Fed Chairman Powell and others have used similar language.
So what would constitute “significant and persistent?” It’s probably not just one statistic. The Fed would like to see that the actual measures of inflation have come down, but other related economic statistics have also slowed, lending more credence to the idea that inflation has peaked. This likely includes consumer spending, house prices and wage growth.
As for what “persistent” might mean, Fed officials have hinted that they will likely rise for the remainder of 2022. This likely tells us that “persistent” must be a 5-6 month period.
Between now and the first Fed meeting of 2023, there will be four more CPI reports. The Fed will therefore have six months of data to review at this meeting to determine whether “meaningful and persistent moderation” has occurred.
What this means for you
Stock and bond prices in the United States fell sharply immediately after the release of this report. As we said above, the Fed needs to slow overall spending growth to bring down inflation. This certainly poses risks to corporate earnings, as slower spending likely means less revenue for companies, all else being equal. We think investors are already expecting a significant slowdown in earnings growth in the second half of 2022, but the more aggressively the Fed has to fight inflation, the greater the risk of a slowdown in earnings.
However, looking at the data more holistically, the right things seem to be happening for inflation to come down. Of course, the Fed will maintain its aggressive inflation-fighting tone, but that could suddenly change if the data cooperates.
In addition, stock prices are already reflecting a significant slowdown in corporate earnings, which we believe means there is considerable upside whenever the Fed finally suspends rate hikes.
In conclusion, our optimism regarding the 2023 US economy is growing and we recommend that clients remain fully invested.
Above all, don’t panic. Stay the course and in the long term the market will likely correct.
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