Globally, stocks gave back recent gains as a disappointing U.S. inflation report served as a wake-up call that central banks are likely to tighten further. The MSCI All Country World Index tumbled 4.1% while the S&P 500 slumped 4.8% and the Dow Jones slipped 4.1%. The tech-heavy NASDAQ dropped 5.5% as interest rates ratcheted higher with the 10-year U.S. Treasury yield climbing 14 basis points to 3.45%.
The August consumer price index (CPI) report showed headline inflation falling from 8.5% to 8.3% as energy prices eased. However, higher prices for shelter, food, and used cars pushed core inflation up – from 5.9% to 6.3%. As a result, financial markets quickly priced in another 75-basis-point rate hike from the Federal Reserve at its September meeting and a terminal fed funds rate north of 4.0%.
It is clear now that hopes of a “Fed pause” in September were premature. While inflation appears to be headed in the right direction, the Federal Reserve seems to believe that further rate hikes are needed. It remains an open question of whether a fed funds rate of 4.0% to 4.5% will be restrictive enough to bring down inflation to the Fed’s 2.0% target, but we do think the Fed may eventually go into a holding pattern at some point in 2023 as it waits to see the delayed impact of its recent monetary policy tightening.
Shawn Snyder
Head of Investment Strategy,
Citi Personal Wealth Management
Last Week's Closeof the main usa stock market indices
S&P 5003,873
(-4.8%index change down 4.8 percent from last week)
DJIAdow jones industrial average30,822
(-4.1%index change down 4.1 percent from last week)
NASDAQ11,448
(-5.5%index change down 5.5 percent from last week)
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).
Figure 1. Daily Change in the Dow Jones Industrial Average Since September 5, 2022
This bar graph shows the daily change in the Dow Jones Industrial average since September 5, 2022.
Sources: Haver Analytics and Citi Global Wealth Investments as of September 16, 2022.
Figure 2. National Home Prices vs. CPI: Shelter Prices (Year-on-Year Percent Change)
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.
Sources: Haver Analytics and Citi Global Wealth Investments as of August 2022.
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).
Figure 3. Atlanta Fed’s Measures of Flexible and Sticky Inflation (Year-on-Year Percent Change)
This line chart shows the year-on-year percent change of Atlanta Feds's Measures of Flexible and Sticky Inflation from 1970 to 2020.
Sources: Bloomberg and Citi Global Wealth Investments as of August 31, 2022. Note: The Atlanta Fed sorts the components of the CPI into either flexible or sticky (slow to change) categories based on the frequency of their price adjustment.
Figure 4. Case Shiller Home Price Index (Lagged One-Year) vs. 30-Year Fixed Mortgage Rate
This line chart shows the lagged one-year, Case Shiller Home Price Index vs the 30-Year Fixed Mortgage Rate.
Sources: Bloomberg and Citi U.S. Wealth Management as of September 19, 2022.
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.
Figure 5. Leading U.S. Economic Indicators vs. Periods of Recession
This line chart shows the leading U.S. Economic Indicators vs Periods of Recession from 1986 to 2021.
Sources: Haver Analytics and Citi Global Wealth Investments as of July 2022. Note: Shaded regions denote recession.
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.
Market Indicators
Figure 6: U.S. Stock Market Returns and Select Assets
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
❮ Swipe left for more
This table shows returns for various USA equity markets and select assets, in weekly,
year-to-date and 12 month changes.
Figure 7: International Stock Market Returns
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%
❮ Swipe left for more
This table shows the US Stock Market Returns and Select Assets and International Stock
Market Returns.
Sources: Bloomberg and Citi U.S. Wealth Management as of September 16, 2022. Note 1 (Equities): Global = MSCI All Country World Index (USD); Europe = MSCI Europe (USD); Japan = MSCI Japan (USD); Emerging Markets = MSCI Emerging Markets (USD). The equity index returns shown here are based in U.S. dollars. Returns for a non-U.S.-based investor can differ significantly depending on the effects of foreign currency exchange. Note 2 (Instrument): Gold = U.S. dollars per Troy ounce; Oil = West Texas Intermediate crude at Cushing, OK. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance is not indicative of future returns. Real results may vary.
The
Week Ahead
Figure 8: U.S. The Week Ahead
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
1609kthousand
1674kthousand
9/20
8:30
Housing Starts
AugAugust
1450kthousand
1446kthousand
9/21
10:00
Existing Home Sales
AugAugust
4.70mmillion
4.81mmillion
9/21
14:00
FOMCfederal 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.
Sources: Bloomberg and Citi Global Wealth Investment as of September 16, 2022. All forecasts are expressions of opinion and are subject to change without notice and are not intended to be a guarantee of future. Note: “A” means actual reported figure.
Shawn Snyder
Head of Investment Strategy,
Citi Personal Wealth Management