Troubling Inflation Data Puts Pressure on Markets

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Data releases this past week confirmed what many on Main Steet have known for some time: Rising prices are impacting everyday life. The latest Consumer Price Index figures from the Bureau of Labor Statistics showed inflation up 8.6 percent year over year, with notable price surges in food and gas — up 10.1 percent and 49 percent year over year, respectively. Not surprisingly, pain at the pump and the grocery store has consumers feeling pessimistic. The latest University of Michigan Consumer Sentiment Index dropped to 50.2 for June, down from May’s 58.1 reading. Additionally, the report showed expectations for inflation 5 to 10 years into the future now stand at 3.3 percent. The uptick in expectations likely caught the Federal Reserve Board’s attention given that they want to make sure that expectations for future inflation remain anchored instead of drifting higher.

As we‘ve recently noted, investors remain focused on how quickly inflation will recede and whether pressures will subside fast enough that the Fed won’t be forced to tighten to the point of inducing a recession. The most recent data has raised the stakes for this two-part question and the market will continue to watch each and every inflationary data point to see if the Fed still has room to engineer a soft landing. We continue to believe that core inflation will moderate, but this latest reading is concerning.

But while this week’s numbers highlighted what consumers have already known for a while, a closer look also shows that core inflation — one of the areas the Fed monitors closely in its battle against rising prices — shows signs of easing. That reading, which strips out volatile energy and food prices, came in at 6 percent year over year, down from April’s reading of 6.2 percent. It should be noted that the Personal Consumption Expenditures Price Index, which will come out in a few weeks, is the reading the Fed primarily focuses on and has eased in the last two months.

None of this is to gloss over the very real sting consumers are feeling at the cash register; however, there continues to be more to the story. Inflation is caused by an imbalance between supply and demand. Supply disruptions against normal demand can create an imbalance just as overheated demand that outpaces normal levels of supply can cause prices to spike. Thanks to COVID, the U.S. economy is facing distortions on both sides of the equation. Supply chain upheavals created a scarcity of goods, and fiscal and monetary policy led to a significant spike in demand for products. The Fed is doing its part to rein in demand through the blunt instrument of rate hikes, and inflation is showing signs of dampening demand for big-ticket items like houses and used cars. Meanwhile, supply chain bottlenecks are easing; China’s manufacturing is back online; and as the most recent ISM data shows, backlogs for manufacturers are improving. In other words, the supply part of the equation continues to heal.

We’ve long said the return to normal will be anything but smooth, and the last few weeks for investors have proven that. However, despite the slow pace of progress, we continue to believe the Fed is making strides in its battle against inflation, and the financial strength of consumers will help the economy inch higher for the year.

Wall Street wrap

Recent data continue to show incremental progress in righting the supply/demand imbalance that has fueled higher prices and reaffirms our belief that inflation will begin to recede.

Mortgage applications down. Signs are emerging that rising mortgage rates may be pouring cold water on demand in the overheated housing market. Mortgage applications for new purchases of homes were down 7 percent last week, according to the latest data from the Mortgage Bankers Association’s seasonally adjusted index, and are down 21 percent year over year. Higher rates have made housing less affordable and appear to be causing some potential buyers to rethink their plans. As demand continues to cool, we expect the growth of housing prices to slow.

Financially fit consumer. The latest data from the Federal Reserve show household balance sheets are in the best shape they’ve been in since 1970, with households having $9 in assets for every $1 in liabilities. The balance sheet strength gives consumers a cushion to tap into should inflation linger — or it could be tapped to fuel further growth as prices ease. The overall strength of the U.S. consumer gives us comfort that any potential future recession would likely be mild in nature.

The week ahead

We have a busy week of potentially market-moving activity ahead. Here are some of the things we’ll be keeping an eye on.

Tuesday: NFIB Small Business Optimism Index readings for May will be out before the opening bell. The report should provide insights into the path forward for labor costs as well as signs of the direction of prices at both the consumer and wholesale levels.

Also out on this day are the latest readings from the U.S. Bureau of Labor Statistics on its Producer Prices Index. This may offer additional insight into inflationary pressures as the report is a front-line view of changes in costs for buyers of finished goods. It can provide insights into how changes in input costs, such as raw materials and commodities, are impacting the prices of goods bought by end consumers.

Wednesday: All eyes will be on the Federal Reserve as it releases its statement following its monthly meeting. The Fed has been nimble in its efforts to curb inflation, and we expect a hike of 50 basis points as a base case and will be watching for a statement leaving the door open for a 75-basis-point hike in July, depending on the direction of future data. All in, the market now expects the Fed Funds rate to be at 3.5 percent by February 2023.

The U.S. Census Bureau will provide its report on retail sales for May. We’ll be watching for further signs that demand for goods is softening as consumer spending migrates toward services.

Thursday: New residential construction numbers for May will be released before the markets open. We’ll be watching for additional signs that elevated mortgage rates are dampening demand for new homes.

Weekly jobless claims will be announced. We’ll be watching for any signs that the job market is softening, which could help ease payroll costs for businesses.

Friday: The Conference Board’s latest Leading Economic Index (LEI) survey will be a key release to watch on a busy day of reports. Last month’s report showed a decrease caused largely by a deterioration in consumer sentiment. We expect high gas and food prices will once again weigh on consumer readings but will be digging into each of the indicators to weigh their impact on economic growth going forward.  

Capacity utilization data will also be out Friday morning. An improvement in utilization could provide welcome news on the inflation front.

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