Inflation’s Terrible, Horrible, No Good, Very Bad Day
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Not Good. Not Good at All
How bad was the August US inflation report? Let me count the ways. It’s a while since a macroeconomic release has come as such a nasty surprise, but on balance the extremely negative market reaction to the numbers was justified; they’re awful.
The headline inflation rate fell very slightly, as had been made more or less inevitable by falling oil prices. But a range of underlying inflation measures actually increased to fresh multi-decade highs. This is far more important to the Federal Reserve, which has limited power to affect oil prices, and also to the rest of us.
The following chart shows:
- The Cleveland Fed’s “trimmed mean” inflation rate, which excludes the components that have moved the most in each direction and takes the average of the rest;
- The Cleveland Fed’s “median” inflation rate, which simply takes the median rate from all the components in the consumer price index;
- The Atlanta Fed’s “sticky” price inflation rate, which tracks goods and services whose prices cannot easily be changed;
- The classic “core” measure that excludes food and energy from the headline CPI, to omit categories over which monetary policy has least control; and
- The Services Excluding Energy Services indicator, which gauges inflation in the cost of services.
All of these measures rose. All except the core inflation measure, which rose but remains below its peak from March this year, are at fresh highs for this cycle, and at their highest in decades. A year ago, the fact that these measures remained largely under control was a key point of evidence for those who believed inflation was transitory. Now, they suggest it could be very much more long-lived:
In another sad echo of the “transitory” debate, the Bureau of Labor Statistics last year started publishing a measure of CPI excluding food, shelter, energy and used cars and trucks. This combination left a basket of goods that few people would find settled all their needs, but it had the virtue of leaving out more or less everything that seemed to be transitory and that people wanted to exclude. Sadly, even this Stepford measure of inflation has hit a new high. This is not at all about just gas prices or used cars, despite the hopes of last year:
Looking on a month-by-month basis, the very disturbing development was the rise in core inflation. Having dipped to 0.31% in July, it returned to 0.57% in August, a level that hadn’t been seen for three decades until this latest inflation scare took hold. There is no way this can be attributed to lasting “base effects,” the distortions to year-on-year numbers when an extreme month drops out of the calculation:
For a final demonstration of how awful the numbers are, here’s a screenshot from the Bloomberg terminal breaking inflation down into fuel, food, and services and goods excluding fuel and food. The expected decline in energy was counteracted by the rise in services inflation, which now accounts for a bigger share of overall inflation:
Some commentators have tried to say that the direction of inflation was still downward, and that the market overreacted. I think such a view is simply wrong. From the point of the view of the Fed, this report could scarcely have been worse, and that means it’s bad for everyone. I think this comment from Neil Dutta, head of US economic research at Renaissance Macro Research LLC, has it right:
The Fed sees this report and likely concludes that 75bps in September is cemented while the pivot to 50 gets pushed off by another meeting. Inflation remains hot, financial conditions have seen some improvement, and the labor markets are humming along. If the goal is to slow things down and create some pain, the Fed is failing by its own standard.
All of this leads to the question of how exactly the market set itself up to step on a rake when the CPI numbers came out....
“Expectation is the root of all heartache.” So the great poet William Shakespeare is supposed to have said — although there’s no evidence that he ever actually did. But it certainly played out in American markets Tuesday, which saw US stocks fall in a broad-based selloff after the CPI announcement. Overconfidence leading into the day created the biggest selloff in more than two years:
Across the board, selling sent the S&P 500 down more than 4.3% to its worst day since June 2020, while the tech-heavy Nasdaq 100 losses reached 5% with the big mega-cap technology names taking the biggest hit. Two-year yields rallied the most in more than a month, while the euro’s brief rebound against the dollar wavered.
“The biggest selloffs always come when expectations and reality collide,” Victoria Greene, founding partner and chief investment officer at G Squared Private Wealth, said. “Not unexpected with the inflation print we got. Expectations of falling inflation were very strong, so an uptick in August was a nasty surprise to investors that had bought into the ‘peak inflation is behind us’ narrative.”
Optimism was high after US inflation decelerated in July by more than expected. That created far more downside than some investors were pricing in, Greene added:
Don’t fight the Fed, and the Fed is actively tightening and reducing liquidity with QT. The world is slowing down and that is a time to play defensive and be patient. Not every rally is the start of a bull market, so don’t fall prey to FOMO on a few trading days. Inflation has proven to be entrenched and may be harder to dislodge than investors were anticipating. That means pivot and Doves are looking like a 2024 event vs. next year.
In the last few days, there had been a “risk-on” move, with the dollar tumbling and equities rallying. But that rally owed much to prior pessimism, and to the belief that the CPI print would be market-positive, and it completely reversed. The dollar is back where it was a week ago (i.e., very strong), with the euro back below parity and the pound sterling back below $1.15.
The latest print managed to have such a negative impact despite coming at a time when pessimism about the economy was already growing extreme. Bank of America Corp.’s latest monthly global fund manager survey, published minutes before the CPI data, illustrates that gloom. Some 72% of fund managers questioned expected a weaker economy in the next 12 months, a rise of 5 percentage points from the previous month and surpassing the previous record pessimism set in July:
On top of that, the share of investors seeing increasing chances of a recession rose further to 68%, the highest since May 2020, when Covid-19 was at its worst. And investors are reverting to cash, as seen in the 6.1% climb in average cash balances last month, the highest since October 2011, when the US was reeling from the downgrade of its sovereign credit rating by Standard & Poor’s:
Still, despite inflation creeping higher, there may be signs that it is abating, said Richard Flynn, managing director of Charles Schwab UK, given that company inventories are rising relative to sales, global economic growth has weakened, and the US dollar remains strong:
There’s a risk that high inflation and rising interest rates could slow economic growth, tipping the US and other major economies into recession. For now, company earnings remain strong. However, investors may follow company earnings particularly closely in the second half of this year.
And indeed, the fund managers surveyed by BofA expect global profits to fall over the next 12 months. They are more negative about the profit outlook than at any time in the 25-year history of the survey:
An unpleasant macro surprise when sentiment was already negative can only be expected to hurt. People are predisposed to believe the worst. With sentiment so poor, any bad news tends to be magnified. And the outlook for the Fed is seen to have darkened. Swaps traders are now fully pricing in a 75-basis-point rate hike when the Fed meets in September, with about a 50/50 shot that they go for a “jumbo” 100-basis-point hike:
More significantly, long-range bets have raised steadily since the last FOMC meeting in July. Using Bloomberg’s World Interest Rate Probabilities function, we can see how estimates of the change in the fed funds rate from now until January 2024 have evolved. Barely a month ago, investors thought the fed funds rate would be lower by then than it will be after this month’s meeting. That belief is now off the table:
What were they thinking? In the last few days (since the BofA survey was completed), there had been a resurgence of equities and a decline in the dollar after a remarkable run. Market investors were also conscious that peaks in inflation have over history overlapped almost perfectly with the beginning of big equity rallies, as the astonishing chart below from Marko Papic of the Clocktower Group makes clear. Growing comfort that peak inflation had happened led to growing confidence in risk assets:
There was further optimism because of the underlying mathematics of base effects. If inflation on a monthly basis could merely slow down to a reasonable rate, it was reasonable to expect it to drop close to the Fed’s 2% target by next summer. The following chart from Bespoke Investment Group shows how the headline year-on-year inflation rate would change from here given different assumptions on monthly inflation:
Unfortunately, core inflation came it at 0.6% for August, a rate that would go far beyond any of these projections, and calls into question whether the peak is in. It also underlines that it will be difficult to bring inflation under control quickly.
“The markets were reflecting a more optimistic scenario of inflation coming down faster and the Fed being able to take its foot off the brake sooner,” Jason Pride, chief investment officer of private wealth at Glenmede Trust Co., said. He adds that while energy prices were cooling in the last two months and gaining much attention, other commodities such as agriculture and industrial metals were not:
Our belief is the Fed’s probably going to end up centering more on those numbers than on the energy pullback. And therefore the more we thought about that, the more we’ve been focusing on core inflation and sticky inflation. Is it rising or is it falling? And this report put a really firm statement on it rising, not falling. It’s moving in the wrong direction from the Fed’s perspective.
That helps to explain the selloff even when investors entered in a defensive crouch. Relative to the last 10 years, fund managers surveyed by BofA are long cash, defensives and energy, while underweight equities, eurozone, emerging markets and cyclicals. September has also seen a majority buy into staples, banks and energy.
More pain could be ahead. The US sees midterm elections in November. Inflation will be a major issue. But the crucial point is that investors thought the worst of inflation was behind them, and now that no longer looks like a good bet. As Alex Chaloff, co-head of investment strategies at Bernstein Private Wealth Management, put it:
All of us have to reset the notion that inflation has peaked over the summer. Sentiment this morning shifted from a modest bull to a modest bear. A lot can happen in the next week and a half. I think this is very much a wait-and-see market. I would expect us to limp into the Fed meeting without any major moves.
—Reporting by Isabelle Lee
What Should We Buy Then?
Stagflation, a combination of recession and inflation that is bad for both stocks and bonds, looks less likely now. The “stag” part isn’t happening as yet, which is why the “flation” part is proving so obdurate.
Bond yields rose today, and bonds are evidently harmed by inflation. But it’s just possible that the market is providing everyone with an opportunity to buy Treasuries, at least as a long-term investment.
In part this is because the mathematics of yield have shifted in favor of bonds. We’ve become accustomed to saying over the last decade that bond yields are supporting equity valuations. Now, the gap between S&P 500 dividend yields and 10-year yields suggests that equity valuations are supporting bonds. Buy a 10-year bond, and you’ll get double the yield you would get from stocks:
Looking at that in longer perspective, this is the spread of bond over dividend yields, going back to the eve of the Lehman bankruptcy 14 years ago. This measure correctly signaled a fantastic opportunity to buy stocks versus bonds in March 2020. It now suggests bonds are more appealing than at any time since early 2011 (the year in which S&P downgraded them):
This is a very crude measure of valuation, obviously. Does it really make sense to buy 10-year bonds? “The world in bonds has changed dramatically. It is a completely different market today than it was in January,” says Chaloff. “And we've never seen this before. Never. So would I be a buyer of bonds today? Yes.”
Luca Paolini of Pictet & Cie. put the logic this way: “Basically the Fed needs to overtighten and trigger a recession, and yields will eventually end up in a 2.5% to 3% range.” Rates will have to rise more in the near term (rendering the short end of the bond market a speculative play), but are more likely to fall in the longer term because the Fed will have to do more economic damage to squeeze out inflation. With sentiment on the Fed so bearish for now, and bond yields back almost to their highs for this year, he suggests the next 12 months or so should provide a great opportunity to buy Treasury bonds. It doesn’t feel like that at present, but he might well be right.
Special Terrifying Bonus Piece
Overlay charts are some of the most spurious and terrifying examples of chart crime out there. That doesn’t stop people from basing their investments on them. So, as the market is hitting trouble at exactly the season of the year when bad things tend to happen (the Lehman bankruptcy anniversary is Thursday), it’s worth sharing a chart that is doing the rounds and shows that apprehension is growing. If the S&P 500 is rebased to its levels on Halloween 2007 (the day world markets peaked before the credit crisis) and Jan. 3 this year, the most recent peak, the similarities are painful. It’s not encouraging:
Does this prove anything at all? No. But it’s as well to be aware that others are nervous.
Disappointment is part of life. To recover after a nasty shock like the CPI numbers, maybe try listening to: I’m A Loser by the Beatles, Everybody’s Got To Learn Sometime by the Korgis and later Beck, Tubthumping (I Get Knocked Down) by Chumbawamba, George III’s song You’ll Be Back from “Hamilton,” You Learn by Alanis Morisette, It’s A Hard Life by Queen, or The Bitterest Pill (I Ever Had To Swallow) by The Jam. Or if you need something more escapist, there’s Lovely Day by Bill Withers, or Don’t Worry Be Happy by Bobby McFerrin, Happy by Pharell Williams or Three Little Birds by Bob Marley & the Wailers.
Bloomberg News provided this article. For more articles like this please visit bloomberg.com.
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