Inflation Exceeds Expectations; Rinse, Repeat

Jul 18, 2022

By Ben Norris, CFA, Securities Research Analyst, Associate Vice President

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Equity markets finished last week slightly lower while bonds were mostly positive. However, if you were following the news last week, you would be forgiven for assuming that markets might have fared much worse. The list of developments that could have seriously shaken investor confidence got longer each day last week with the Consumer Price Index (CPI) headlining a tough week in economic news. June CPI numbers came in higher otter than expected as inflation remains stubbornly high. CPI increased 9.1% versus a year ago, much higher than the 8.8% increase expected and the 8.6% increase we saw in May. This was also the highest year-over-year reading in more than 40 years. Gasoline and electricity prices were notable culprits in the readout as they saw year-over year-increases of 60% and 14%, respectively. Core CPI, which removes the effect of food and energy prices (thought to be more volatile than other goods and services), was a mixed bag. The 5.9% increase was down from May’s 6% number but was above consensus expectations for a 5.7% print and remains high relative to history. With each inflation print (whether its CPI, PPI, PCE, or another figure), it becomes clear that above-trend inflation is likely here to stay for at least the next two to three years.

Wednesday’s CPI reading led to a series of quotable quips from market commentators and expectations as the Fed’s next interest rate hike changed dramatically. CME Group’s Fed Watch Tool saw expectations for a 1% (rather than the 0.75% increase expected) rate hike at the July 27 FOMC meeting increase from less than 10% to more than 80% in a matter of hours. A 1% increase in the Fed’s target rate would be a rare occurrence; the last time the Fed increased rates by at least 1% in a single move was in 1980 when inflation had run above 6% for several years. Fed officials quickly downplayed the chances of a 1% increase next week, implying that they felt a 0.75% increase was a sufficient step in their path toward normalization. The Fed has placed increased emphasis on effectively communicating their next policy moves over the last several years and it appears that they currently place the importance of transparency and predictability above what some would argue are prudent policy decisions.

Another reason that Fed officials may be comfortable with going forward with a 0.75% increase is that their effort to downsize the $8.5 trillion Federal Reserve balance sheet ramps up in the coming months, with $95 billion in holdings expected to roll off each month. This means that over the next year or so, more than $1 trillion worth of U.S. Treasuries and mortgage-backed securities will be allowed to mature without being replaced. The Fed has suggested in the past that each $1 trillion reduction from the Fed’s balance sheet would be equivalent to an additional 0.20% rate increase. While this is a necessary (arguably overdue) step. it creates complications in fixed-income markets. The Fed uses bond buying to influence short-term interest rates and, without this tool in their arsenal, we could see heightened interest rate volatility – even more than we are seeing now. In fact, we saw the 10-year/2-year Treasury yield curve invert last week. This means that short-term Treasury rates, which should yield less because they are perceived to be less risky, are yielding more than their longer-term counterparts. Investors tend to assume that a recession will follow an inversion of these two key interest rates. This is the most inverted the yield curve has been since 2007.

In other economic news, the Producer Price Index (PPI), a leading counterpart to CPI, also came in higher than expected, showing a 11.3% increase year over year. Retail sales numbers were a rare bright spot last week rising 8.4% versus a year ago. While the reading was better than expected, underlying numbers were not particularly encouraging, and inflation numbers are still outpacing consumer spending. Elsewhere, Industrial Production and Capacity Utilization numbers declined relative to prior-year figures but are still showing growth – suggesting the U.S. economy hasn’t quite entered a recession. The third-quarter earnings season also kicked off with large banks reporting earnings last week that could probably be considered “adequate.” Earnings will ramp up over the next few weeks and should provide insight into how consumers and corporations feel about the economy. Earnings estimates have largely come down over the last several weeks as analysts worry about the effect inflation and rising interest rates might have on top- and bottom-line results. Similarly, the U.S. dollar has strengthened considerably over the last several months, which could act as a headwind for companies that have a global footprint. It has been nearly 20 years since the dollar was this strong relative to the euro.

The S&P 500 (SPX) finished just 0.91% lower last week despite all that we’ve discussed so far. The NASDAQ Composite lost 1.57% while the blue-chip Dow Jones Industrial Average shed just 0.16%. Last week’s performance was aided by a strong rally on Friday in which each major average rose at least 1.75% as Fed officials assured investors that a 1% rate hike was not an active consideration for the next FOMC meeting. Consumer Staples and Utilities companies were the top performers last week while shares of Communication Services and Energy companies lagged. The S&P 500 has settled into a trading range around 3800 over the last month and the question is whether the next major move will be higher or lower. The index is trading at the same level it was more than 17 months ago.

This week’s slate of economic data is relatively light as investors will spend most of the week worrying about the following week’s FOMC meeting. However, a variety of housing data is slated for release this week and collectively they could influence the Fed’s thinking heading into next week. Later in the week, we will see the typical jobless numbers as well as a reading of the Leading Economic Indicators.

Date Report Previous Consensus
Monday 7/18/2022 NAHB Home Builders’ Index 67 66
Tuesday 7/19/2022 Building Permits (SAAR, June) 1.70M 1.68M
Housing Starts (SAAR, June) 1.55M 1.59M
Wednesday 7/20/2022 Existing Home Sales (SAAR) 5.41M 5.38M
Thursday 7/21/2022 Initial Jobless Claims (July 16) 244,000 237,000
Continuing Jobless Claims (July 9) 1.33M
Leading Economic Indicators -0.4% -0.5%
Friday 7/22/2022 S&P Global U.S. Manufacturing PMI (July) 52.7 53.0
S&P Global U.S. Services PMI (July) 52.7 53.0


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