Written by: Steve Majoris | Advisor Asset Management
Markets have been rallying and taking a risk-on tilt over the past few months for a number of reasons. One of the biggest could be the 3.0% year-over-year CPI (Consumer Price Index) print we got on July 12. This is down from 4.0% the prior month and showed meaningful progress in the Fed’s battle to get inflation back to their 2% target. Recent optimism is being driven by the assumption that the Fed is all but finished with hiking rates and will soon pivot back to a more dovish/easy monetary policy. Fed funds futures markets are currently pricing in rate cuts in early 2024 driven by all the inflation fury moving markets since early 2022 entering the rearview. However, many investors believe the current environment is reminiscent of the 1970s. Those who lived through or who are familiar with that unprecedented round of inflation are a bit weary of recent optimism as “sticky” components might be hard to bring down and a second wave of inflation could be coming.
Although a 3% headline CPI print is welcome, Core CPI (commodities excluding food & energy commodities and services excluding energy services) came in at 4.8% and remains elevated, which is problematic as it’s one of the biggest weightings in the headline number. This also marks the 1-year anniversary of the high we saw last July of approximately 9% for the headline number, which naturally means a year-over-year comparison was all but certain to come down. Moving forward, the trend lower might be more challenging. The Cleveland Federal Reserve came out with estimates of their own that show a rebound in CPI in the coming months under multiple scenarios and this may catch the market a bit off guard. Even under a 0% inflation scenario from here, year-over-year CPI is likely to rebound; however, it is our opinion this “best case scenario” might be wishful thinking.
Past performance is not indicative of future results.
Based off the most recent economic data, the economy remains strong especially when it comes to the labor market. The unemployment rate currently sits at 3.6% and Job Openings are still coming in over 9 million. According to the Atlanta Fed, the latest Q3 GDP estimates came in at 3.9%, up from 3.5% on July 28. If 3.5%+ GDP ends up being in the cards, it is unlikely that inflation will continue to trend lower. If these expectations come to fruition, we can only assume it will embolden the Fed to remain hawkish and continue to hike and hold for an extended period. Similar once again to the '70s, a lengthened policy stance in restrictive territory will likely be required as Fed officials seem to be aware that a second wave of inflation is possible. One could argue that the '70s had three waves of inflation, and as a result, multiple episodes of restrictive monetary policy.
Source: Strategas.
It appears, based on leading indicators such as commodities, a second wave of inflation may have already begun. Energy, Food and Core are the three categories that make up the broad headline CPI number. When looking at commodities, the most significant factor with “Energy” is illustrated with a chart of the past year showing a consistent downtrend which has partially helped with headline CPI, but there has been a sharp rebound in prices over the past two months. Oil is now trading back around $80 dollars a barrel, pushing the average gas price per gallon at the pump to $ 4.15, the highest since November. Broad commodity prices, some actively traded ETFs are up over 13% since late May. If China decides to enact stimulus measures for their economy, that could put further upward pressure on the space.
Source: Factset.
“Food,” another segment of broad CPI, appears to be heading higher as well. Broad Agriculture ETFs are up some in excess of 11% since January. We believe geopolitics will continue to play a role with this trend, such as Russia pulling out of the Black Sea Grain deal or India, which accounts for more than 40% of world exports, banning future rice exports.
There might not be any ETF to track how “core” is doing, but we are a consumer-driven economy and when the consumer is strong…they tend to spend. With the unemployment rate near all-time lows and strong wages persisting due to the tightness of the labor market, we might be able to check the box on consumer strength. Another indicator might be recent earnings announcements, outlooks and comments made by executives. Marriot CFO told the Wall Street Journal, “Demand for travel is continuing to heat up, as stateside strength holds steady and international markets join in” and “revenue per available room continued to grow in North America, driven by both occupancy and price, a sign of healthy demand.” Visa CEO Ryan McInerny had enthusiastic comments on the company’s recent earnings call, "We reported another quarter of strong results, reflecting stable business trends. Consumer spending remained resilient, driving growth in payments volume and processed transactions. Cross-border volume continued to be a tailwind, fueled by travel growth from the ongoing recovery and summer tourism.” CEO of Bank of America Brian Moynihan, who recently dialed back his call for a recession, talked about the resiliency of the consumer and mentioned, "People are working, and they are getting paid more, and they are spending.” The CEO of popular restaurant chain parent company Bloomin Brands, David Deno, said on their earnings call that the consumer is “hanging in there” despite the economic backdrop and projects an uptick in traffic in Q3 and Q4.
For inflation to continue to come down, the consumer would have to slow spending and we are just not seeing that. As long as the economy remains strong, the Fed will need to remain hawkish to get inflation back to 2%. We have heard Federal Reserve officials, multiple times, mention they are trying to avoid a “stop and go” approach. Jawboning of course, but this further reinforces the Fed’s beliefs that to prevent further “waves,” they will need to “hike and hold” and hold for some time. We believe that the months ahead could unfortunately have some inflation surprises to the upside and spur volatility across financial markets. Couple that with a downgrade of U.S. debt and Christmas might come early for those looking for buying opportunities.