Tough Love

This week’s CPI report served up tough love for both bulls and hopeful doves. The rally that took us back above 4,000 on the S&P 500 was put to a painful end on Tuesday, when the S&P fell 4.3% and the Nasdaq tumbled 5.2% on the heels of hotter-than-expected inflation. The problem is that it wasn’t just hotter on one metric — it was hotter on the headline number, the core number, and when measured month-over-month and year-over-year.

The real star of the “tough love” show was the month-over-month (m/m) change. According to estimates, this month was expected to be the first where CPI would post a negative m/m reading since May 2020. Instead, we got a positive 0.1%.

It’s Not Me, It’s You

It’s not energy, it’s services. The optimism about a cooler inflation report was driven by the fact that energy and gas prices have fallen substantially in the last three months. WTI Crude Oil is down 28% over that period and the average cost of gas in the U.S. is down over 26%. The chart above depicts the energy (yellow) component pulling the overall reading down.

But an increase in services inflation won the fight this time. In particular, the problem spot that is finally emerging in the data is housing, which falls under services in this methodology. We’ve known for some time that housing affordability is low and that home prices and rent levels have skyrocketed. We also know that they haven’t started to come down in a meaningful way, and that it takes longer for housing market indicators to make their way into these headline numbers. And here we are.

Everybody Hurts

For those of you who are younger than I am, “Everybody Hurts” is a 90s song by a band called R.E.M., and it’s not short on sad lyrics.

On Tuesday, we saw the worst one-day drop in the S&P since June 2020. I can’t help but think it was a pivotal day, whether it was the realization that sticky inflation will require more pain to fix, or simply the beginning of another valuation flush that could take us down to prior lows. There’s also the possibility it will look like an overreaction in a couple months.

In any event, I think we’ll talk about that day for a while, but it’s important to put it in perspective. A 4.3% daily drop was large by any standards, but still not nearly as large as what we saw in the depths of Covid when uncertainty was at its peak and the market literally wasn’t functioning as it should.

I don’t want to minimize it though. September and October can be tough months for markets and this year feels like no exception. Given that we have a Fed meeting looming in the next week, and it will be one where they publish a new dot plot and summary of economic projections, there could be more one-day flushes to come. These pesky high inflation prints could be foreshadowing a more hawkish dot plot, and higher projections for inflation, unemployment, and the Fed Funds Rate.

The persistently hawkish stance and messaging by the Fed leads me to believe that markets may see a few more daily stabs downward that proves to be a final big flush. This may sound odd, but if that happens swiftly, meaning within the next couple months, that actually becomes the bull case in my view. It could be a quick and painful drop, resulting in a renewed move higher later in the year that’s more durable, as inflation falls more notably. Of course, no one knows exactly what will happen or when, but on days when everybody hurts, I tend to believe that the end of pain comes closer into view.

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