Lagging Inflation Index Shows Signs of Cracking

Lighter than expected inflation readings sent the markets surging for the week, with equities having their best weekly showing since June. Bond markets also rallied as yields moved lower. Investors saw glimmers of hope in the data that suggest the Federal Reserve may have room to temper the size of future rate hikes. The latest Consumer Price Index (CPI) reading showed easing in the pace of both headline and core readings, with both measures coming in below Wall Street’s expectations. Headline inflation rose 0.4 percent in October and was up 7.7 percent on a year-over-year basis. The monthly increase was unchanged from September; however, the year-over-year rate was the lowest reading since January and marked a solid improvement from the 8.2 percent registered in the last report. Core inflation, which excludes volatile gas and food prices, rose 0.3 percent compared to a 0.6 percent increase for September and is up 6.3 percent year over year — down from last month’s reading of 6.6 percent. 

Federal Reserve Chair Jerome Powell noted in his press conference two weeks ago that members of the Federal Open Markets Committee wanted to see a series of improving inflation reports. And while last week’s CPI reading was a first step, details in the release suggest that the improvements we’ve noted over the past few months in the forward-looking data are beginning to register in lagging indicators, and the improving trend is likely to continue. For instance, on the goods side of the economy, inflation was down 0.4 percent for the month, with declines in prices for used cars and trucks (down 2.4 percent) and apparel (0.7 percent). After peaking at 12.3 percent year over year, goods inflation is now at 5.1 percent year over year. We believe prices will continue to ease on the goods side, as demand has moderated, inventories and supply chains have healed, and consumers have shifted their spending to the services side of the economy.  

As demand has shifted to services, so have inflationary pressures as reflected in the 0.5 percent month-over-month increase in the latest survey. However, that figure is down from the 0.8 percent climb registered in September, as medical services showed a decline of 0.6 percent for the month. Year over year, services inflation is up 6.7 percent but is beginning to plateau. When considering readings on the services side of the economy, it is important to note that shelter has a significant weight in calculating the overall number. The latest reading shows shelter was up 0.8 percent month over month and is 6.9 percent higher during the past 12 months. The uptick in shelter accounted for the bulk of the monthly increase, but as we’ve noted in previous commentaries, there is as much as a 12-month lag time for moderating housing costs and rents to filter into the CPI reading. Given that rent increases peaked in February, and we have seen a rapid unwinding of housing prices during the past few months, we believe significant improvements in the inflation rate for shelter are on the near horizon. 

Despite the welcome signs that cracks are showing in some lagging inflation indicators, we believe the path forward for investors will remain bumpy. The narrative from inflation hawks — that the Fed is doing too little to control rising prices — is likely to morph into concerns that the aggressive rate hiking cycle will push the U.S. economy into a deep recession. While we are in the camp of those who believe the economy already is (or may be on the cusp of) contracting, we believe any such recession would be short, shallow and uneven given the overall strong state of the U.S. consumer.  

While the path forward for the markets remains unsettled, we believe diversification remains the best approach for managing the risk of an uncertain future. Each asset has a purpose in a portfolio and plays a role against different economic backdrops. And while it has been a bruising year for most asset classes, the risk/reward profile of various investments has diverged, creating attractive opportunities. For example, longer-duration fixed income has been hurt by the Fed’s aggressive rate moves; however, selling pressures have pushed yields on high-quality, intermediate- and long-term bonds significantly higher, resulting in opportunities for investors to earn positive real returns as inflation eases. Similarly, the dollar has strengthened as a result of the Fed acting sooner and more aggressively in raising rates than other major central banks. The dollar strength has been a drag on dollar-denominated performance for international equities; however, performance has been strong when measured in local currencies. Should the dollar weaken, we believe overseas markets will be a prime beneficiary. Indeed, the dollar lost strength last week as investors began to anticipate less aggressive moves by the Federal Reserve, and international developed markets shot up 8 percent and are now up 17 percent for the quarter.   

Of course, none of this is to say that simply because an asset class has sold off, it now represents a compelling opportunity. We have long avoided crypto due to the lack of regulation and the Wild West nature of its markets. The implications from the lack of oversight and rules were on full display last week when a leading crypto exchange filed for bankruptcy, taking valuations for various cryptos down along with it. Despite the significant sell-off, we continue to view the crypto market as highly speculative with near unlimited risk and continue to advise investors to steer clear. Over the past months the crypto market has fallen from more than $3 trillion to now around $800 billion. Despite the rapid loss in value, we currently do not believe its downfall provides systemic risk to the U.S. economy but will continue to monitor the situation.

Wall Street wrap   

While investors cheered the latest CPI report, other data out last week shows business owners and consumers alike are growing increasingly uneasy about the path forward for the economy. 

A subdued outlook from small businesses: The latest survey from the National Federation of Independent Business showed sales are softening, and business owners continue to temper their forecasts for the coming months. Of those surveyed, more than half reported flat or declining sales over the past three months, and the number who expect increasing sales in the coming month declined three percentage points to a net -13 percent. Inflation, tight hiring conditions and weak sales expectations continue to take a toll on owner optimism, with the measure registering the 10th consecutive month of readings below the 49-year average for the survey.  

Consumers’ outlook darkens: Concerns about the direction of the economy have taken a toll on consumer expectations, according to the latest from the University of Michigan Sentiment survey. The gauge of economic expectation for the next six months fell to 52.7 in the preliminary report, down from October’s reading of 56.2. Likewise, sentiment on the current state of the economy fell 7.8 points, to 56.8 from October’s level of 65.6. Of note for Fed watchers, inflation expectations for the coming year edged up 0.1 percent, to 5.1 percent. Longer term, respondents expect inflation five to 10 years from now to come in at 3 percent, which is an increase of 0.1 percent. While inflation expectations are one of the things watched by the Fed as it strives to control price pressures, the latest tick higher on long-range expectations remains in line with “normal inflation” readings prior to the period between 2014 and 2020, when the Fed was concerned about a deflationary (or negative inflation) spiral.  

The week ahead 

Tuesday: The latest readings from the U.S. Bureau of Labor Statistics on its Producer Prices Index will offer a detailed look at changes in costs for buyers of finished goods. It can provide insights into how easing input costs, such as for raw materials and commodities, will filter into the prices of goods bought by end consumers. 

The Empire State Manufacturing Index (released before the opening bell) will provide a look at the health of manufacturing and general business conditions in the influential New York state region. Of particular interest will be data on hiring and costs for manufacturers in the region. 

Wednesday: A week heavy on housing reports kicks off mid-morning with the Home Builders Index from the National Association of Home Builders.  

Thursday: We will get October housing starts and building permits from the U.S. Census Bureau. This data along with the Homebuilders Index released on Wednesday will provide a clearer picture on demand for housing as mortgage rates remain elevated. 

Friday: Updated numbers on existing home sales will be released mid-morning by the National Association of Realtors. This report along with the new homes data released earlier in the week should provide a clearer picture of whether the rapid cooling of the real estate market is continuing due to higher mortgage rates and growing concerns about a potential recession. 
 
The Conference Board’s latest Leading Economic Index (LEI) survey will be a key release during the week. Recent reports have suggested the U.S. economy may be on the cusp of a recession. We will be scrutinizing the data for any indications of a change in the pace of softening. 

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