MARKET COMMENTARY

Rising core inflation gave markets a rude wake-up call this week, throwing cold water on the market’s recent narrative that the Federal Reserve would soon pivot to a less aggressive posture. Core CPI surprised to the upside, jumping 0.60% in August. That was above estimates of a 0.30% rise. The month-to-month increase pushed the core inflation rate up 6.30% from year ago levels. Headline inflation didn’t fare much better, rising at an annualized rate of 8.30%. While this eased somewhat from July’s 8.50% rate, it is still well above acceptable levels. After a summer of spending, broad-based inflation seems to have finally taken a toll on consumers’ budgets as aggregate sales excluding autos fell -0.30% for the month. Friday’s trading session compounded what was already a tough week for the market as industrial bellwether, FedEx, issued a profit warning and withdrew guidance for the year citing slowing global economic demand.  The market grappled with a host of negative readings this week, which could now put Q3’s once rosy earnings outlook at risk. With the FOMC meeting next week, and some question on whether the Fed will raise 0.75% as expected or go even larger, traders decided to take off risk and lock in any remaining profits from the recent rally. For the week, the S&P 500 tumbled -4.77%.

The Terrible No Good Inflation Report

The August inflation report was not what markets were expecting. As recently as Monday, talking heads were touting that peak inflation had arrived and signs were emerging that the Fed would be successful in orchestrating a soft landing. What we got instead was a report showing an acceleration and broadening of inflation throughout the economy despite a large drop in energy prices. Headline inflation rose 0.10% month-to-month even as gas prices tumbled -10.60%. The month-to-month rise means that the overall inflation rate increased 8.30% on a year-over-year basis. What really caught markets off guard was the 0.60% rise in core inflation (excludes volatile food and energy prices), which rose an annualized 6.30%. That’s well above the Fed’s 2.00% target level and a significant jump from July’s 5.90% reading.  Setting aside some relief at the gas pump, everywhere else consumers were hit by high prices. Medical care and new vehicle prices led the way, up 0.80% month-to-month each. Shelter costs, which include rents and various other housing-related expenses climbed 0.70% for the month. Food prices also moved higher, bringing that component’s annualized increase to 13.50%. That was the category’s largest increase since March 1979. With roughly three-quarters of the CPI components above 4.00% yoy, the concern is that inflation is now broadly entrenched, requiring the Fed to raise rates more and to hold them there for longer. The picture at the wholesale did not show much different. The PPI Index fell -0.10% in August, pushing the annualized rate to 8.70%. The drop was mainly driven by a decline in energy prices, down -6.00% for the month. Meanwhile, core PPI prices were up 5.60% from the year ago period. With the decline in demand being seen in retail sales and the growing number of cautionary comments from company CEOs, markets were optimistic some of this anecdotal evidence would begin to percolate into last month’s inflation readings. That expectation was not remotely close to the reports’ reality.

High Prices Sting Consumers

Retail sales rose 0.30% in August to $683.3 billion, driven largely by a jump in motor vehicles and parts. Excluding autos, sales fell -0.30% for the month. The headline sales figures was driven by a 2.80% jump in sales at motor vehicle and parts dealers which helped to more than offset the -4.20% decline in gas station receipts that were impacted by the decline in oil prices. Restaurants and bars also managed to ring up more sales in August, which were higher by 1.10% as consumers squeezed in some last-minute summer get-togethers before back to school and back to office. However, consumers were forced to cut back elsewhere as high prices hit their wallets. Online shopping took the hit, down -0.70%. In another blow to Q3 economic growth, July sales figures were revised downward to reflect a -0.40% sales decline. High prices seem to have finally forced the consumer to tap out and to be more careful when considering their spending habits.

Final Thoughts

The summertime rally hit a brick wall this week as high core inflation, weakening consumer spending, and a potentially tough earnings season weighed on sentiment.  All three of these items are tethered together by interest rates, and we suppose there is some good news in that markets won’t need to anguish over the inflation report for long since the Fed will issue its rate response on Wednesday. Coming out of their Jackson Hole Economic Symposium, the Fed had prepared markets for a 75-bps bump following September’s meeting. The Fed should leave itself some flexibility when it telegraphs rate hikes, but if the previous message was based on the belief that the higher interest rates were beginning to have some impact on inflation, it raises the question of whether the Fed now feels it needs to be even more aggressive given August’s inflation surprise. Will the Fed stick to the expectations they set, or will it go big in order to arrest future inflation expectations? That is the answer markets will anxiously await next Wednesday.

The Week Ahead

It will be a big week for markets as the Federal Reserve convenes its September FOMC meeting. Markets are currently pricing in a 75-bps point hike which will bring the benchmark lending range to 3.00%-3.25%. With core inflation running hot, the central bank could surprise with a 100-bps hike which could add more volatility to the markets. In economic news, we turn to the housing market. The Fed’s monetary tightening has sent 30-year mortgage rates surging past 6.00%, throwing more cold water on the red-hot housing market. A further slowdown is expected in existing home sales and housing starts.