It’s All About Inflation

Major stock market averages fell today (Dow -780 pts; SPX -2.7%) after an inflation report from the Bureau of Labor Statistics. Today’s decline essentially unwound the late May rally and puts back down near the correction lows. Consumer discretionary, technology and financial sectors are leading the rout, down over 3% in early trading. Even sectors like energy and materials, widely seen as good inflation hedges, are down more than 2%. The VIX fear index climbed back to 29, suggesting higher stock volatility over the next 30 days. Gold rose .5% but other commodities fell. WTI crude oil retreated back to $118.50/barrel. The bond market is also in selloff mode. Higher expected inflation means the Fed may have to raise interest rates all the more to rein it in. Traders priced-in another .5% Fed rate hike in September. The 10-year Treasury Note yield, a benchmark rate on which many lending rates are derived, climbed to 3.14%.

Those of us expecting to see signs of waning inflation got a shock this morning as the Consumer Price Index (CPI) rose 8.6% from year-ago levels. Economists were anticipating something closer to 8.3%. Core inflation—excluding food & energy—posted 6.0% vs. 5.9% expected. The report immediately hit asset markets. Any sign that the Fed will have to work harder to contain inflation increases the risk of a bumpy or hard landing for the economy. Looking into the CPI calculation, shelter, food & gasoline make up about half index and these are the areas where prices are on fire. Gas prices are up nearly 50% from a year ago and 4% in the last month. Groceries are up nearly 12% from a year ago.

Outside of these areas, however, we are seeing signs that inflation is slowing. Inventory gluts for big retailers like Amazon, Wal-Mart and Target are quickly feeding through the supply chain. According to FreightWaves, the volume of shipping containers bound for the US is down 36% since May 24th. That brings us back to pre-Covid levels. Not surprisingly, they say container rates from China to the US have fallen about 38% from just one month ago. We also know that some commodities are cooling off. Hot rolled coil steel has now fallen 21% since peaking in early April. Lumber prices have given back most of the post-Covid surge. And used car prices have been falling since January.

Today’s inflation report seems to take the easy soft-landing scenario off the table. Stock and bond markets will remain volatile in the near-term as investors constantly reassess the path of inflation vs. the path of Fed tightening. We believe the Fed has no intention of choking off economic growth and thereby causing a recession. But on the other hand they have a duty to restrain inflation.