09.14.22 Global equity markets plunged yesterday, and interest rates rose in response to a hotter-than-expected consumer inflation reading. The CPI increased 0.1% in August, disappointing economists who were predicting a 0.1% decline for the month. The inflation index slipped to 8.3% year over year, down from 8.5% over the 12 months ending in July.
Disappointed investors sold stocks and bonds. The Dow fell nearly 1,300 points, or about 3.9%, yesterday, suffering its worst day since June 2020, according to the Wall Street Journal. The tech-heavy NASDAQ slid more than 5%. Bond investors now predict that the Fed’s overnight rate could reach 4.3% by April 2023 in their quest to quell the pricing spiral.
While we understand the market reaction, we believe it was overdone. There are several factors in place that we believe that point to lower inflation readings ahead, including a precipitous decline in manufacturing input prices, as depicted by the ISM prices paid index, and a decline in the share of small businesses raising prices.
Consumer inflation expectations play an enormous role in spending behavior. Historically, expectations are self-fulfilling. Fortunately, consumers believe the inflation we’re experiencing is temporary and will likely defer large discretionary purchases, like autos and appliances, if they believe prices will subside. The Federal Reserve monitors consumer expectations carefully. The most recent study conducted by the Fed, shows consumers’ inflation expectations are declining for both 1-year and 3-years out.
Shelter costs and rising rents are exerting an outsized influence on CPI readings. Last month, shelter costs spiked 0.7% and are more than 6% more expensive over the past 12 months. The problem is shelter accounts for nearly one-third of the CPI basket. Yet rental costs are a lagging indicator that tend to reflect previous year costs with some future expectations. That means that inflation may have understated early last year and overstated now. The good news is the Fed understands this. Shelter costs represent only about 17% of the PCE deflator, the Fed’s preferred inflation gauge, and housing accounts for only about 10% of GDP.
With inflation readings near the highest level in over 40 years, many investors worry that what we’re entering an inflation period eerily similar to the wage and price spiral of the 1970s and early 1980s. Between 1972 and the middle of 1973, the S&P 500 lost more than 40% of its value in the face of double-digit inflation. The good news is the economic environments are vastly different. The 1970s market plunge was precipitated by the OPEC oil embargo that pushed energy costs and inflation skyward. Inflation reached 12.3% in June 1974. What should have been a one-time price shock turned into a wage-price spiral. That’s because of cost-of-living adjustment (COLA) clauses built in union wage contracts. In the 1970s, America was a manufacturing economy and unions represented about a quarter of the workforce. Breaking the inflation grip in the early 1980s was a difficult, and painful task. We expect the Fed’s job this time around to be easier. We believe current Fed tightening expectations are likely sufficient to tame inflation over time. Waiting for monthly numbers in a market that want answers in minutes could prompt further frustration in the near term.