- The Consumer Price Index for August was higher than analysts predicted.
- High inflation increases the likelihood of more and longer-lasting rate hikes.
- Short-term Treasury yields are increasingly competing with stocks for assets.
- Gasoline is a bright spot, but shelter remains stubbornly expensive.
Investors came into this week hoping that declines in gasoline and agricultural prices would translate into tamer than expected inflation last month. However, the August Consumer Price Index (CPI) report released Tuesday showed inflation remains stubbornly high.
The volatile headline inflation figure, which includes energy and food, was 8.3%. That was lower than the 8.5% reported in July but above 8.1% expectations. Core inflation, which removes energy and food, was 6.3%, above July’s 5.9% rate and analysts’ 6.1% prediction.
Stocks reacted poorly to the news because it suggests the Federal Reserve’s aggressive rate hike policy isn’t likely to change soon. The S&P 500 was down over 4% today, while the technology-heavy NASDAQ 100 fell by over 5%.
This year, the Federal Reserve has increased the Fed Funds Rate four times. Following today’s CPI release, odds of another 0.75% increase next week jumped to 82%, up from 45% one month ago. Similarly, the probability of bigger increases at the Fed’s meetings in November and December surged.
If short-term interest rates continue climbing, updates to discounted cash flow models will force valuation lower, especially for speculative stocks dependent on future cash flows. In addition, the hot inflation print reinvigorated the U.S. Dollar, which had been under pressure after the European Central Bank raised rates last week. If the Dollar stays strong, it will remain a headwind to companies heavily dependent on sales overseas.
We also shouldn’t underestimate the impact of higher rates on investors’ willingness to shift to the guaranteed returns associated with short-term Treasuries from highly-volatile stocks. As Real Money Pro’s Doug Kass points out, the steady march higher in short-term yields upends the “there is no alternative” (T.I.N.A) to stocks argument. With the 1-year Treasury yield flirting with 4%, Kass suggests that Treasuries are the alternative (T.A.T.A).
Don’t fight the Fed
The likelihood of higher rates is discouraging. As we’ve discussed, stocks struggle when the Federal Reserve is on a mission to quell inflation.
Martin Zweig’s Winning on Wall Street included the following table showing average returns when the Fed’s easing versus tightening. When the Fed’s actions are bearish, stocks suffer. Zweig’s Fed Indicator gives a negative point for every rate increase, removing their impact after six months. Currently, the indicator is at -4, which rates as “extremely bearish."
If inflation had fallen, it could have increased the chance the Fed pauses future rate increases, conceivably allowing Zweig’s indicator to go neutral in March. However, given new probabilities for hikes in November and December, June may be the soonest we could go neutral unless other inflation measures, such as the Personal Consumption Expenditures Index, fall.
What’s causing inflation
Lower gasoline prices put downward pressure on August’s headline CPI, causing it to retreat from July. However, while gasoline prices historically account for 63% of the variability in headline inflation, it has a much more muted, lagging impact on core inflation. This is because the core calculation removes the energy index, but energy still has an indirect impact as a cost input for goods and services. Gasoline accounts for 7% of core CPI changes, according to the Dallas Fed.
As a result, a 5% decline in the energy index “mostly offset” increases in the shelter, food, and medical care indexes on the headline number, according to the Bureau of Labor Statistics. However, it only mutedly impacted year-over-year changes in core inflation. The energy index was 24% higher last month than in August 2021, so it’s still negatively pressuring corporate operating margins and indirectly causing higher prices.
Last month, two discouragingly sticky inflation inputs were food and shelter, which account for 14% and 33% of the CPI, respectively.
Despite agriculture futures falling, the CPI food index increased 11.4% year over year, the most significant increase since 1979. Meanwhile, the shelter index was the biggest drag on core CPI. It rose 6.2% from last year, “accounting for about 40% of the total increase in all items less food and energy,” according to BLS.
Core CPI was also negatively impacted by household furnishings, up 9.9%, medical care, up 5.4%, and new vehicles, up 10.1%. Used cars were up 7.8% year-over-year too, but that’s a much lower increase than earlier this year.
The Smart Play
Bear markets are messy and prone to disappointment, so investors shouldn’t expect a light-switch bottom. It takes time to shake out weak-handed and trapped investors eager to sell rallies, so you should expect anxiety-producing pops and drops. It's more common for bottoms to happen when investors are exasperated than hopeful.
As for inflation, I’m reminded of the adage that the cure for high prices is high prices because of demand destruction.
We’re already seeing the impact of inflation and GDP-busting rates. For example, gasoline prices have retreated partly because high prices are causing fewer fill-ups. According to the EIA, the four-week average gasoline demand was 8.78 million barrels per day through September 2, down from 9.52 million barrels per day one year ago. If gasoline prices stay where they are now, they’ll flip to a year-over-year decrease in March 2023.
Housing prices also show signs of declining, including rising cancellation rates and more frequent price cuts, because of higher mortgage rates. Housing deflation may take more time to flow through to CPI, but there’s progress. According to John Burns Real Estate Consulting, home prices are falling in 98 major regional markets. Similarly, food prices may be stubborn, but if the Invesco DB Agriculture ETF DBA stays near current levels, year-over-year food input pressures could go negative in February.
Last week, Bespoke released research to help put in perspective how easier comparisons next year could pave the way to inflation that's running below the Fed Funds rate. Specifically, they said that if the month-over-month change in CPI ranges between 0% to 0.3%, then CPI will undercut rates "sometime next spring."
Of course, this is guesswork. Oil could exert itself again this winter (gasoline prices are seasonally highest in summer and weak in winter, though), and additional geopolitical instability or weather could cause agricultural prices to climb again. Admittedly, nothing is written in stone. But that’s the point. We must be wary of extrapolating good and bad from the current to the future. Keeping an open mind to various outcomes positions you best to profit.