U.S. stock market futures are down, and the dollar is up to parity with the euro as the market responds to strong inflation data by pricing in a one in three chance of a 1% rate hike later in July.
Investors should sit still – the cost of an economic downturn may already be priced into much of the stock market.
Headline June CPI has come in at 9.1% year-on-year, well above the expectations of 8.8% and the highest increase since 1981. This mostly reflects strong energy and food price rises in June.
Unsurprisingly, energy and food inflation also dominate the year-on-year inflation, with the energy component up 41% and food up 10%. This is a frustration for the Fed. Higher interest rates work well for curbing demand for discretionary goods but are a blunt tool regarding energy and food.
Meanwhile, CPI excluding food and energy also rose to 5.9% year-on-year, led by used vehicle and transportation prices in June.
A Long Way to Go:
With a current target range of 1.5% to 1.75%, it is worth noting how low Fed interest rates still are, even after last month’s 75bp hike. Not just compared to inflation but compared to the 3.75% that Fed policy members think rates will peak at by the end of 2023 (as suggested by the Fed’s June plot chart).
A 75bp rate hike this month later is now a real possibility -if not, potentially, a full 1%. The Fed will want to demonstrate it has the will to squash inflation, even at the risk of recession.
A widening today of the inverted 2yr/10yr Treasury yield spread suggests the fixed income market is expecting a recession.
What’s the Plan?
The goal of the Fed is to ensure that a tight labour market, combined with strong headline CPI inflation, does not lead to ‘inflation busting’ pay increases, which will then stoke a wages-prices spiral, as we saw in the 1970s.
Its method of attack is to reduce demand in the economy by raising interest rates, hoping that the labour market will weaken (i.e., unemployment will rise), as consumers and businesses spend less. This will help keep wage growth low and should result in falling core inflation.
As for energy and food inflation………..the Fed hopes that eventually, these will roll over on a year-on-year basis, such is the nature of supply-side shocks. For the same reason, goods price inflation stemming from the lockdowns in China will reverse at some point as the lockdowns end.
In the meantime, the Fed will be mindful that high prices tend to attract new entrants into industries and lead to increases in the production of those producers who have capacity. These will help lower global prices over the coming years, even if there is no return to pre-war levels of energy and food exports from Russia and Ukraine.
Assuming slack in the labour market does lead to reduced wage growth, we may well see substantially lower CPI inflation in a year’s time, though at the cost of weak domestic growth, if not a potential recession.
Investors may wish to sit still while the inflation squeeze on real incomes works its way through the U.S and global economy.
Certainly, on the stock market, defensive sectors and financials look set to perform relatively well against cyclicals and tech. But many of the most interest-rate exposed sectors have already seen large share price falls and may have already priced in much of the bad news. And stock markets are said to move six months to a year ahead of real economic data: the worst of the downturn might already be priced in.
Maintaining a balanced portfolio should remain an investment priority, with a mix of bonds, equities and alternatives to maximise long-term returns relative to portfolio volatility.
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