Equities Ready to Declare Victory in Inflation Battle

Stocks extended their rally this week, making it four consecutive winning weeks for the S&P 500. This marked the index’s longest winning week since November. Sentiment remained strong as investors cheered signs inflation may have peaked, providing not only much needed relief for cash-strapped consumers but also stoking hopes that the Federal Reserve won’t need to be as aggressive as once anticipated. The July CPI report showed inflation rising 8.50% from the year ago period, lower than June’s 9.10% rate. Prices to producers showed further signs of relief, dropping -0.50% in July alone. That brought the PPI index’s annualized rate down to 9.80% from 11.30% in June. With investors focused on U.S. inflation data, markets seemingly ignored China’s strong export rebound as the country attempts to recover from a weak second quarter. Markets closed the week on a high note with the S&P 500 up 3.26%.

Peak Inflation. Are We There Yet?

Signs continue to emerge indicating better days ahead for consumers’ wallets. The July CPI Index rose 8.50% year-over-year, down from June’s 9.10% rise. More encouraging was that month over month, prices were flat. July’s stabilization was driven by a -7.70% drop in gasoline prices which helped to more than offset a 1.10% rise in food prices. Meanwhile, core CPI, which excludes volatile energy and food prices, held steady at a 5.90% annualized rate. Core prices are the focus for the Fed since they are better predictors of future inflation than the more volatile, headline figure. Core prices eased slightly in July by increasing only 0.3% with declines in prices for used cars and apparel offsetting increases in healthcare and housing costs. Rising housing costs continue to factor heavily in the CPI reading, where consumers are facing limited supply and higher mortgage rates. Housing costs are not only a big part of consumers’ budgets, but they also account for 40% of the core CPI index. In July, the housing price component rose 0.50% or 5.70% higher from a year ago. Since March, housing costs have risen an average of 0.54% monthly. The Fed has attempted to rein in the hot housing market by hiking rates, which has only served to force consumers to pivot to the rental market where they are now bidding up apartments as they await the Fed to slow its rate of tightening. Investors also cheered signs that additional price relief could be on the horizon for consumers. The July PPI index, a gauge of wholesale prices, fell -0.50% month-to-month, bringing the annualized rate to 9.80%. That was the lowest annualized rate since October 2021. Most of the monthly decline was driven by a -9.00% drop in energy. While the reported headline inflation data shows signs of easing, broad-based inflation pressures are still likely to keep core prices elevated for some time. While this week’s data may have shown that we’ve reached peak levels of inflation, the stickiness and broadness of core inflation is likely to keep the Fed on a tightening path despite what markets may wish.

China Trade Booms

Exports boomed as China attempted to get back on its feet after a dismal Q2 showing. Exports surged 18.00% year-over-year in July, their fastest pace of growth this year. That was in line with their June rise of 17.90% but it served as a positive sign by showing additional follow through. Export growth was driven by Chinese factories resuming normal operations following their closures and interruptions during the first half of the year due to Covid. Meanwhile, China’s consumption of imports remained sluggish, higher by just 2.30% from the year ago period. That was slightly higher than June’s 1.00% rise, however. The surge in exports gives China a stronger footing to kick off Q3 GDP, but it also indicates that the strength is coming from international demand and not so much from their domestic consumption. Domestic consumption continues to be hampered by their depressed real estate market, high inflation and rising global interest rates. Absent strong domestic consumption, China remains vulnerable to a global recession should developed economies slow.

Final Thoughts

Equity markets managed to post solid gains in response to this week’s inflation report, but the reaction may ultimately prove to be premature. Equity investors’ conviction comes on the belief that peak inflation has now passed, which will result in the Fed reducing the number and magnitude of future rate increases. Traders now believe the Fed will only increase rates in September by 0.50%, rather than the 0.75% previously expected. While equity investors focused on signs that we are beyond “peak” inflation, bond investors focused on the fact that core inflation remains well above levels acceptable to the Fed. Inflation has proven to be far stickier than originally thought, driven by a confluence of forces including scarce commodities, supply chain constraints, low housing inventory, and a tight labor market. Furthermore, inflation appears to be broad within the economy, making stamping it out more difficult. This week’s CPI report indicated that core CPI is still rising at a 5.90% annualized rate. Other, private estimates suggest core inflation is rising at a rate of 4.0-5.9%. No matter what measure you choose, they all indicate that core inflation is far higher than the Fed’s 2.00% target level. Monetary policy takes time to work, and it is understandable that equity markets have been encouraged by seeing the inflection in price growth. With core prices still highly elevated, the Fed’s job is still a long way from being complete in our minds.  The NASDAQ has rallied over 20% since it’s mid-June low, leading some investors to declare a new bull market for equities. Judging by the 10-Yr treasury’s performance, bond investors don’t see it that way and we agree. The 2-10 spread remains inverted, meaning investors think that rate increases are still on the horizon as well as a potential recession. The fact that the growthiest parts of the market are leading the rally should be a sign to anyone just how quickly prices in general can reaccelerate if the Fed takes the foot off the pedal. There is simply a great deal of capital and demand waiting to pounce, which is a reflexive instinct the Fed will want to stamp out – particularly while core price growth remains above target levels. This week’s data was certainly a positive in that it shows that the war on inflation is starting to work, but equity markets are likely being premature in declaring victory when so much work remains.