What happened?
Stocks and bonds initially fell on Thursday after US consumer prices rose again more-than-expected. But stocks reversed course and bonds recouped early losses as risk sentiment stabilized.
The S&P 500 fell as much as 2.3% and the Nasdaq 3.2% before both rallied to close down 2.6% and 2.2% respectively. The 10-year US Treasury yield, while edging below daily highs, rose 6 basis points and the 2-year yield rose 18 basis points. Futures markets priced further monetary tightening, taking the Federal Funds Rate to its peak of 4.92% in March, 26 basis points higher than priced ahead of the inflation data.
The headline consumer price index for September rose 0.4%m/m, while the core CPI, which excludes food and energy prices, rose 0.6%. Year-on-year, headline CPI fell 0.1% to 8.2%, but the 12-month change in core CPI inflation rose to 6.6% in September from 6.3% in August — via the month High of 6.5% from March.
The US dollar also initially strengthened following the CPI data, but the DXY index later reversed to close 0.8% lower. Oil prices recouped early losses with Brent crude closing 2.4% higher at $94.69/bbl
What do we expect?
Inflation data shows that consumer spending continues to shift away from goods, helping the supply side of the economy keep up with demand and reducing inflationary pressures. Core commodity prices were flat in September and we expect them to trend lower in the coming months. Used car prices, which are down 1.1% mom, still have a long way to go before they reach normal levels.
However, the same shift in consumer spending increases inflationary pressures on services, with core service prices rising 0.8% compared to August. More than half of the increase was driven by rents, which also accelerated to 0.8% mom. Housing is a lagging indicator in the CPI calculation, and while other data sources suggest that rental price inflation peaked a long time ago, it is likely to show further large increases in the coming months.
However, the Federal Reserve cannot argue about the intricacies of data accuracy. Inflation remains way too high, the Fed’s credibility is at stake and it will have to continue to rise aggressively until official inflation measurements slow down.
Thursday’s data does not change our expectation that the Fed will hike rates by 75 basis points at the next FOMC meeting on November 2nd, but does raise the risk that it will hike again by 75 basis points in December. Also, should the data continue to surprise to the upside, there is a greater risk that the rate hike cycle will continue into 2023 and the federal funds rate will rise above the FOMC’s current peak median estimate of 4.6%.
Against this backdrop, Thursday’s stock rally may come as a surprise. However, the rebound may reflect that selling ahead of the data may have been overdone. In the CPI report, the S&P 500 had fallen for six consecutive sessions, returning to its lowest level since November 2020. A seventh straight decline would have been the longest losing streak since the COVID-19 pandemic began in February 2020.
A better day for UK assets may also have helped allay underlying concerns about the strains on the financial system. In the UK, the combination of central bank tightening and unfunded fiscal expansion to deal with the energy and livelihood crisis has destabilized markets. Sterling was up 2% against the US dollar on Thursday and 30-year gilt yields closed at 4.54% after hitting 5.1% on Wednesday.
How do we invest?
With the core CPI still moving in the wrong direction and the labor market strong, the conditions are not in place for the Fed to turn monetary policy, which would be one of the conditions for a sustained rally in the stock market. As inflation stays elevated longer and the Fed hikes further, the risk that the cumulative effect of monetary tightening will push the US economy into recession and undermine prospects for corporate earnings increases.
Against this backdrop, and as today’s price action clearly demonstrates, we expect markets to remain volatile. We tilt our preferences towards more defensive areas of each asset class, including consumer staples and healthcare stocks, as well as quality bonds. Our preferred currencies include the US dollar and Swiss franc, two traditional safe havens that also experience compelling rate hike cycles. We also like global value stocks, the energy sector – which should be supported by higher oil prices in the coming quarters – and the value UK market. As stocks and bonds have often performed in tandem in recent months, we also recommend that investors seek uncorrelated sources of return, for example by diversifying into hedge funds, particularly macro strategies.
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