Falling inflation fuels rising stock prices

The last week’s market highlights:

Each week, we present our featured topics in the context of the major themes from Nuveen’s most recent global investment outlookOpens in a new window:

• U.S. economy: Recession has become a 50/50 proposition by the end of next year.
• Global economy: High commodity prices threaten emerging markets and energy importers.
• Policy watch: Central banks are tightening but now risk going too fast, too far.
• Fixed income: Corporate credit and municipal bonds offer some recession protection and compelling value.
• Equities: Too soon to call a market bottom with recession risks looming, but U.S. growth stocks have cheapened a lot.
• Asset allocation: Plenty of opportunities for investors with a tolerance for volatility.

Quote of the week:

"History is a guide to navigation in perilous times. History is who we are and why we are the way we are."  –  David McCullough

Welcome to an economy that has defied all norms

In nearly every major developed economy, unemployment is low, inflation is high, and growth is stagnating, if not contracting — an unusual combination, to be sure. In the U.S., add “consumers are miserable” to that mix, as August’s University of Michigan Consumer Sentiment Index hovered near an all-time low. The sour mood can be chalked up in part to (1) rising home prices and mortgage costs, which have pushed many prospective homebuyers to the sidelines, leading to increased demand for rentals and higher rents, and/or (2) a 3%+ drop in disposable income (after inflation) over the past year.⁴

Despite this decline in income, consumer spending continues to outpace inflation. Sure, people are buying a little less “stuff” (i.e., goods), opting instead for services such as dining out and taking vacations. To stay ahead of rising costs, consumers have been saving less and relying on credit cards more, two signs they feel optimistic about their job security and finances.

Indeed, according to the New York Fed’s Quarterly Report on Household Debt and CreditOpens in a new window, outstanding consumer credit jumped by a historically large degree in June. But over the past few years, the growth in revolving credit (e.g., credit card debt) has yet to catch up to its pre-COVID trend. And it’s not that far above its peak in 2008, when nominal U.S. GDP was only about 60% of today’s level.⁵ The U.S. was essentially a cash economy throughout 2020 and most of 2021, as households used stimulus checks and “forced” savings (by staying at home) to reduce their liabilities. They’ve only just begun to “charge it” again.

Although predicting the economy’s performance has been especially challenging of late, our faith in the strength of U.S. consumers, in particular, remains well-founded, albeit not without a caveat. On one hand, consumer spending has supported corporate earnings (and, indirectly, employment). On the other hand, consumers’ unrelenting appetite for goods and services has propped up demand to the point that it’s prevented prices from dropping, contributing to persistently hot inflation.

Eventually, the odd mix of low unemployment/high inflation/sluggish growth will play out. We envision two potential resolutions:

• In the first scenario, continued high inflation and negative real income growth will eventually halt real spending and drive the U.S. into a “genuine” recession — i.e., officially declared as such by the National Bureau of Economic Research and not based on the colloquial definition of two consecutive quarters of negative GDP growth.
• The second, far more positive alternative, is that inflation will decline significantly without a major rise in unemployment, and a return to positive real income growth will keep the economy afloat.

On a global scale, taming inflation is the first order of business for central banks. Countries with hotter inflation rates and lower disposable incomes per capita will suffer more, while nations better able to lower inflation and whose consumers are well-supported will likely perform better over the balance of 2022.

So what did we learn about inflation this week?

U.S. inflation cooled off in July…sort of

Positive inflation news has been rare since early 2021, but July’s 0% headline increase in the Consumer Price Index (CPI) should give us all cheer. Over the past 12 months, the CPI rose 8.5%, lower than June’s 9.1% reading (which was the largest year-over-year increase in more than 40 years).⁶

A softer report had been expected after a steep downturn (-4.6%) in overall energy prices.⁷ Within the energy category, falling fuel prices contributed to a 7.8% plunge in airfares, which have declined the past two months after soaring 59% from January through May.⁸ Energy costs will almost certainly help depress August’s headline CPI, giving some welcome relief from sticker shock at the pump. Last week, the national average price for gasoline dipped to $4.01/gallon, its lowest level since March.⁹

But the good news on inflation went beyond the energy sector. Core CPI, which strips out fuel and energy costs, rose by a less-than-expected 0.3%, thanks to the drop in air fares, as well as lower prices for used cars and trucks, and apparel.¹⁰

While certainly a dose of good news, July’s CPI release also highlighted some areas of concern, which is why we’re not more ebullient. Core services inflation — the largest and “stickiest” (most tenacious) component of CPI inflation — is still far too elevated. In particular, rent inflation remained high even as it decelerated from 0.8% in June to 0.7% in July. (When the CPI isn’t running rampant, rent inflation is usually around 0.3%.)¹¹

What does the Federal Reserve think about this CPI print? A number of Fed officials pushed back against hopes of a dovish pivot, emphasizing the central bank’s need to focus on moving inflation far closer to its 2% target. Investors were more optimistic about a change of heart at the Fed. Following July’s stellar employment data, markets had priced in a 75 basis points (bps) hike for the Fed’s next meeting in September. But in the wake of this cooler inflation report, the odds of such a move became a toss-up.

As we see it, if Chair Jerome Powell and his colleagues aren’t happy with the market’s response, they have only themselves to blame. That’s because back in the spring, they made headline CPI the centerpiece of their inflation-fighting mission. And in so doing, the Fed incorporated gasoline prices into its formula for determining interest-rate policy. That led markets to price in more hawkish scenarios as gas prices spiked. But with gas prices falling for the better part of two months, investors — rightly or wrongly — are assuming the Fed will moderate its aggressive tightening path.

In our view, last month’s jobs report, combined with the concerning rise in rent inflation, probably keeps a third straight 75 bps hike in play in September. Until then, the Fed will continue to examine incoming data. This includes another employment release and a CPI report, among other key gauges of the economy. In the meantime, let’s respond with a “huzzah” to a (headline) inflation-free month. Keep in mind, though, that we probably haven’t seen the last of sharply rising prices. That means further hawkish risks to Fed policy and heightened volatility in the stock and bond markets.