Continued fast inflation and market volatility are a painful mixture, so at times like this, it is best to think long-term.
Ouch. Yesterday’s CPI report showed preliminary US inflation at 8.3% y/y in August, and the stock market got angry. The S&P 500 dropped approximately -4.3% in price terms, with the NASDAQ dropping -5.1% for the day.
There is no debate that the CPI print was disappointing, but the 8.3% rate is but a whisker faster than the 8.1% expectation and a 0.2% decrease from July’s 8.5%. But maybe the world’s expectations heading into yesterday were too optimistic because, during the past two months, the financial world’s overall take on US inflation was that it peaked. We saw this same issue 6 months ago when the inflation rate hit a previous high in March—before May eclipsed the March high.
Inflation resisting expectations doesn’t mean the situation suddenly took a major, unforeseen turn for the worse. Instead, it could mean the crowd made a collective mental error of presuming that a two-month trend would continue at the same decline. Unfortunately, data have never worked like that. Whether you are looking at inflation or GDP, all economic indicators are subject to monthly variability and short-term disappointments. Over time, wrinkles even out into a trend, but it is messy and only clear with sufficient hindsight.
So, instead, recognize that while data surprises can affect sentiment in a big way in the heat of the moment, the sentiment itself is a short-term market force and can flip the other way quickly. Remember, stocks tend to look about 6 – 18 months out, with the gap between expectations and reality as the driving force. If economic data creates lower expectations, it lowers the bar for future expectations. So, it takes less good news to deliver positive surprises and lift stocks over the medium and longer term.
That bar looks relatively low today, not just because August’s preliminary inflation report took the wind out of investors’ sails. July’s deceleration from June’s peak created expectations that the worst is behind us, which creates a risk that investors get caught up in a “the worst is over” mindset and then possibly get blindsided when inflation continues to remain high, raising the temptation for knee-jerk portfolio moves. Today’s market reaction is likely a prime example.
Markets aren’t narrow-minded, and such inflection points will only be evident in hindsight. Remember, monetary policy moves take time before they get into the system—anywhere from 6 to 18 months (or more). Even if current inflation stemmed from excess money supply growth, it would be unrealistic to expect the move in rates since March to significantly affect inflation at this point. Likewise, if inflation stems from “too much money chasing too few goods,” the only way the Fed might fight inflation would be with severe destruction in demand for that limited supply of goods. Several hikes of 0.75%, creating an inverted yield curve, could destroy said demand. Possibly creating a future Fed-induced recession.
That is the bad news. The good news: Non-energy commodity prices have experienced a sharp decline since earlier this year, at about the same time the market began to expect the Fed to raise rates aggressively. This matters because commodity prices can help us decipher inflationary pressures. If we see continued stabilizing energy costs, it will benefit goods and services prices alike, as it should render the passing-on of energy costs to consumers.
Furthermore, if you look at 5-year nominal and real Treasury yields, it can help provide you with what the market’s expectation for CPI will average over the next five years. Yes, inflation expectations moved up of late, but they remain far below the current level of inflation. Accordingly, the bond market tells us the Fed does not seem to be on the verge of an inflationary mistake. Although, the Fed might be getting close to being too restrictive if it keeps hiking rates 0.75% at each meeting. If the Fed continues reacting in a big way to incoming data rather than taking a more measured, long-term approach, then it raises the likelihood of overshooting.
Additionally, 5-year real yields on TIPS have been relatively stable at about 0.5% for roughly the last year. This is consistent with a view that the economy will continue to grow but at a relatively modest rate—even with headwinds.
People near-universally expect inflation to be quite harmful for the next 18 months, and markets are pricing in that fear. Yesterday’s large drop extends this year’s one constant: Sentiment seems detached from reality. So, when stocks sink on emotional days rather than a materially negative shift in incoming information, it is a strong signal that staying cool remains the astute move. Tuesday set us up for when we see “not-quite-as-bad inflation” it will be a significant mental relief and good for stocks. This remains a probable scenario because a recovery—a new bull market—is close by if it isn’t already underway.