A Wake-Up Call

The Dow Jones dropped 1,276 points last Tuesday when the August consumer prices index (CPI) release disappointed investors. While a 1,000-point drop is always a wake-up call, the percentage decline was just 3.9%. Alarming, but a far cry from Black Monday (October 19, 1987) when the blue-chip index fell by 508 points – a whopping 22.6% one-day decline. We also found it interesting that very few people seemed to be aware of the 1,234 points gained in the previous four trading days as investors bet on a more significant decline in the pace of inflation (see figure 1). Our aim is not to make light of the recent CPI release, but to remind investors that it is good to keep things in perspective.

Let’s start with the inflation report. Headline inflation has come down two months in a row now – falling from 9.1% in June to 8.3% in August as energy prices eased. Core inflation, which excludes food and energy, moved in the other direction with core CPI rising from 5.9% to 6.3%. Importantly, core inflation is still below the 6.5% level seen in March, but shelter prices continue to firm (see figure 2) with last year’s gains in home prices still filtering through to the CPI’s measure of owner’s equivalent rent (total shelter prices account for nearly 1/3 of the CPI index).

This bar graph shows the daily change in the Dow Jones Industrial average since September 5, 2022.

This line chart shows the year-on-year percent change of National Home Prices vs the Consumer Price Index of Shelter Prices from 2000 to 2020.

If we look at the Atlanta Fed’s flexible CPI component and sticky CPI component, we continue to see a diverging trend as well. Flexible CPI, which includes energy and more volatile price categories, has dropped from 16.3% in July to 14.5% in August while sticky prices, like housing and healthcare, have risen from 5.7% in July to 6.1% in August (see figure 3). However, we believe it is important to recognize that sticky prices tend to lag flexible prices. As figure 3 shows, in the early 1970s, sticky prices started to roll over materially about a year after flexible prices did. This suggests that core inflation may take longer to show an easing, but the sharp jump in mortgage rates suggests that shelter prices will eventually fall as the housing market unwinds some of the gains witnessed in 2021 (see figure 4).

This line chart shows the year-on-year percent change of Atlanta Feds's Measures of Flexible and Sticky Inflation from 1970 to 2020.

This line chart shows the lagged one-year, Case Shiller Home Price Index vs the 30-Year Fixed Mortgage Rate.

What Does This Mean for the Fed?

It likely means a Fed pause or reduction in the pace of rate hikes is off the table and another 75-basis-point rate hike at the upcoming September FOMC meeting should be expected. According to financial markets, there is about a 16% chance of a 100 basis-point rate hike. The market has also ratcheted up its expectation for the terminal fed funds rate, which is the rate at which the Fed would presumably stop raising rates, from about 3.75% to somewhere between 4.00% to 4.50%.

While some market watchers suggest the terminal rate could exceed 5.00%, we think that is aggressive – especially given that leading US economic indicators already suggest the economy is facing a potential recession in 2023 (see figure 5). We think it is more likely the Fed will raise rates a bit further and then go on hold to see what happens – like us, policymakers are aware that the impact of monetary policy often doesn’t hit the economy until about 9-12 months later. We would not be surprised to see the Fed trimming the size of its rate hikes to 50 basis points later this year, but that would require the Fed to affirm that it views a 4.00%-4.50% terminal rate as restrictive and not just neutral.

Right now, the Fed’s price stability mandate has a solid greenlight with unemployment well below the 5%-6% rate typically associated with maximum employment. However, that policy prescription may become less clear if unemployment starts to rise. While Fed Chair Powell has acknowledged that there might be some economic pain ahead, we think there is a reasonable chance that a cautionary yellow light from the labor market in the quarters ahead could cause a shift in the tone. For additional insights, please see our CIO Strategy Bulletin | Identifying Winners and Losers If The Fed Drives a Recession.

This line chart shows the leading U.S. Economic Indicators vs Periods of Recession from 1986 to 2021.

What Should U.S. Investors Watch in the Week Ahead?

The economic calendar includes a slew of housing data including existing homes sales and housing starts. The consensus expects existing home sales to slow an additional 2.3%. The Conference Board will also release its August reading of the leading economic indicator index (see in the chart above). While the index comes after the Fed’s meeting and does not garner much attention, we think it’s worth watching as a continued decline could mean that the U.S. economy is nearing an onset of recession. If that proves to be the case, the market bottom may end up being in 2023 and not in June 2022. For a more detailed discussion, please see our CIO Strategy Bulletin | Market Uncertainty: What We Have Not Yet Seen.

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Index	Weekly Chgchange in percent	YTDyear to date change in percent	12 Months12 month change in percent	Div. Yielddivision yield in percent
Dow Jones	-4.1%	-15.2%	-11.3%	2.2%
S&P 500	-4.8%	-18.7%	-13.4%	1.7%
NASDAQ	-5.5%	-26.8%	-24.6%	0.9%
Instrument	Weekly Chgchange	YTDyear to date	12 Months12 month change	Level
10-Year Treasury Yield (%)	13.9 bps	193.9 bps	211 bps	3.45%
Gold ($/Oz.)	-2.4%	-8.4%	-4.5%	$1,675.1
Oil ($/bbl)	-1.9%	10.5%	17.2%	$85.11

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This table shows returns for various USA equity markets and select assets, in weekly, year-to-date and 12 month changes.

Index	Weekly Chgchange in percent	YTDyear to date in percent	12 Months12 month change in percent	Div. Yielddivision yield in percent
Global	-4.1%	-20.8%	-18.7%	2.3%
Europe	-2.9%	-25.2%	-24.0%	3.5%
Japan	-1.9%	-22.4%	-29.0%	2.5%
Emerging Markets	-2.6%	-21.5%	-23.9%	3.4%

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This table shows the US Stock Market Returns and Select Assets and International Stock Market Returns.

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Date	Time	Event	Period	Consensus	Prior
9/19	10:00	NAHBnational association of home builders Housing Market Index	SepSeptember	47.0	49.0
9/20	8:30	Building Permits	AugAugust	1609k thousand	1674k thousand
9/20	8:30	Housing Starts	AugAugust	1450k thousand	1446k thousand
9/21	10:00	Existing Home Sales	AugAugust	4.70m million	4.81m million
9/21	14:00	FOMC federal open market committee Rate Decision (Upper Bound)	9/21/2022	3.25%	2.50%
9/22	10:00	Leading Index	AugAugust	-0.1%	-0.4%

This table lists a number of key economic events, analysis reports and forecasts from influential institutions.

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