In the midst of record-breaking heat, markets are breathing a collective sigh of relief as inflation finally shows widespread cooling. On the back of June’s inflation data, several markets moved at once: The dollar weakened, interest rates fell, and equity market valuations marched relentlessly higher. Given this backdrop, it’s worth refreshing our core views in balance with the optimism that is driving traditional markets higher.
CPI, a sigh of relief: While the disinflationary process has been in place since mid-2022, up to this point it had been choppy and uneven. But the June CPI report showed that disinflation is now widespread, and provided particular relief to those who were focused on some of the stickier measures buried on the services side. Headline consumer prices rose 0.2% m/m in June, less than the 0.3% expected, pulling inflation down to 3.0% y/y for the first time since early 2021. Inflation is now falling as some base effects fade. Energy in particular is now down -17% y/y. In June, the owners’ equivalent rent component, which is 25% of the overall index, rose only 0.4%, the lowest monthly gain since January 2022. Markets had been anticipating this softening of rent inflation, but to see it confirmed was clearly appreciated.
CPI: Faster and broader disinflation
Source: Bureau of Labor Statistics, as of July 17, 2023.
Inflation is clearly receding. The important discussion is now about inflation dynamics going forward. Will it settle neatly back into the 2% box—a process that will still take another several quarters simply because of pesky base effects? Or will consumer price inflation linger closer to 3% as a tight labor market puts upward pressure on wages and the marginal cost associated with deglobalization keeps goods prices elevated above pre-COVID levels? Those who have followed my research know I am in the latter camp. Let me be even more nuanced. The 20 years preceding COVID were notable for low—and low volatility!—inflation. Outside of energy price volatility, core CPI held 1-sigma range of 1.6%-2.4% with an average of 2%. This was specifically enabled by increased globalization and the tsunami of low-costs goods imports from Asia.
Here’s the nuance. If we have even a mild recession in 2024, as I expect, contracting demand may well cause inflation to overshoot to the downside. However, the global shock of the pandemic combined with deglobalization is likely to cause higher volatility in the business cycle, and higher volatility in inflation. We’ve written at length about this in our summary piece Modeling the End of the Great Moderation. Yes, this is a story that I expect will play out in years, rather than months or quarters. But the foundation of my view is that markets are too complacent about mean-reverting to a steady 2% inflation heartbeat when in fact history is full of counter examples when inflation was significantly more volatile to the upside and downside. But I digress—lets return to the latest CPI print.
Inflation news seen as green light go: On the back of the CPI data, the prior bond sell-off that had taken the 10-year Treasury north of 4% quickly reversed, returning the bellwether yield to the 3.75%-3.85% range it held for most of June. Lower U.S. yields across the curve hit the dollar hard, and the U.S. Dollar Index (DXY) plunged below the 101 threshold that had survived multiple tests in 2023. The -3.3% decline in just one week was broad-based across the major developed European and Japanese currencies, and reflects the fact that other central banks are now likely to be relatively more hawkish than the Fed for the remainder of 2023. The weaker dollar in turn buoys U.S. multi-national large caps, and last week saw a 3.3% rally in the Nasdaq. High yield spreads have narrowed to 425 bps (ICE BofA High Yield Bond Index).
Tightening gets real. There is another side to falling inflation that will weigh on the economy and, increasingly, on traditional equity markets. The nominal pace of tightening is winding down. The market now expects one more 25 bps rate hike at the July 26 FOMC meeting, and de minimis odds of a rate hike thereafter. My two cents: it may yet be too early to put a fork in this Fed rate hike cycle, but that’s not the focus today. As inflation falls, monetary tightening will continue even if the Fed goes on an extended pause. Last week, real interest rates—nominal interest rates adjusted for inflation—hit the highest since 2009. This real tightening is likely to continue as the Fed continues to push back against rate cut expectations and—for all intents and purposes—manage longer-term interest rates through hawkish rhetoric. This real policy tightening is the classic channel for Fed policy to impact the economy. Households are somewhat insulated from this rate hike cycle rate hikes because most mortgage debt is long-term and fixed rate. But credit card debt and new auto debt are all seeing interest expense rise sharply. All else equal, this is a headwind to household spending.
Real yields highest since 2009
Source: Bloomberg Finance, L.P., as of July 17, 2023.
Earnings season action: Earnings season is heating up, and guidance will be a key focus. Despite solid GDP growth, earnings have been falling year-over-year, and the consensus is that the second quarter will be the trough with about -8% y/y decline. Expectations are that earnings growth will be about flat year-over-year in Q3, and steadily trend higher thereafter. Yet topline revenue and margins connect directly to nominal growth and inflation. We have long warned that as inflation declines, nominal growth will slow. Think of it this way—the next two quarters may complete the fastest deceleration in inflation in decades. For equities, this means the sharpest slowdown in nominal growth. Margins are likely to remain under pressure as lower inflation leads to slower nominal GDP and sales growth while some cost burdens—especially wages—remain elevated.
Conclusion: Traditional markets are vulnerable from here into the second half of the year. The economy is sailing along, but headwinds are gathering at a time when markets have minimized the risk of recession. The upside of falling inflation is the Fed likely stops raising the Fed funds rate. The downside is that topline growth will slow, and margins will come under pressure. This creates a challenging backdrop for earnings growth to accelerate in the second half of the year, as is expected. Fixed income has been a grind year to date, up only 2.5% at time off writing, barely any recovery from the -13% decline from last year. Further gains in fixed income will be unlikely without rekindling expectations of a Fed rate cut, which we view as highly unlikely – remember an aggressive series of rate cuts would be the result of a bad economic outcome. As the Fed moves to the sidelines, the economy is in the driver’s seat, and the second half of the year will likely see momentum fade and valuations come under pressure.