Last week's inflation report in the US (August CPI) was a ‘shocker’ , as core components of price inflation remain 'sticky' and are not slowing as fast as hoped. That is perhaps not so surprising considering the overall strength of the US consumer, and limited softening in business indicators.
Looking ahead though, indicators tend neutral to negative despite continued the continued strength in employment and spending. The median of consensus forecasts per Bloomberg is 50% chance of a recession in the next year.
Bears point to concerns including further downward revisions to company earnings (EPS), mid-term elections, elevated valuations, Fed tightening, declining C-suite confidence, and the labor backdrop. Bulls say that the S&P tends to bottom while EPS are still falling, valuations are still well below past peaks, paying down debt is providing an EPS cushion, supply chains are improving, and high frequency economic indicators are improving.
Consumer Spending continues to be robust
This is supported by wage inflation and Covid-era savings. But inflation does seem to be impacting what we are spending on. Restaurant spending seems relatively flat with pre-Covid levels, while grocery & rent inflation is eating into budgets. Travel and gas had a strong summer as we all got in our post covid 'revenge' travel. Disney parks have seen per capita spending +40% vs pre-Covid, while Livenation ticket sales are up +50%.
At what stage does overall demand become impacted by raising rates?
Businesses doing fine
The U.S. Economy does appear to be slowing but no recession at this stage. Overall business sentiment is stable to slightly down, mixed across business segments. For example, Trucking is slowing sharply (somewhat fits with FedEx results last week) which could indicate weaker retail. But Autos, Airlines, and temp & perm Employment agencies all remain strong. On the demand side, there is perhaps more caution for those selling to longer cycle businesses, than to consumers.
The risk to businesses seems more on the cost side of EPS right now, but if prices have to rise further when does that impact demand?
Inflation remains at record highs
Last week’s Inflation report (CPI) suggests “sticky” inflation ... i.e. it's not going away as fast as hoped. Shelter, autos and food remain elevated, but energy and imports are improving. While the US seems to be somewhat insulated from war in Europe and covid lock downs in China, continued weakness in these markets will impact international earnings and supply chains.
The biggest issue around inflation is that future expectations can drive a self fulfilling prophecy. It seems that those expectations have reduced recently, but they may increase again if prices continue to go up.
Market looking for clarity on when interest rates will peak
The Fed is raising interest rates to prevent the self-fulfilling prophecy of inflation expectations. But, how high do they need to go to change behavior? Expectations of the peak rate expected have risen dramatically this year, and are moving from 3.5% to 4.5%.
As Mortgage Rates Top 6%, new home buyers confront a dramatically different cost of ownership than anyone has seen for many years. So far, it seems there has been limited impact. About half of all the income in the US is earned by households making more than $100,000 per year. Most of these households own their own homes, and either have no mortgage or have refinanced into a 30-year fixed-rate mortgage at an extremely low rate. This means that the largest expense for these households is not rising even as the Fed is hiking, but their wages are (median wage growth in the US is ~6.5%, per the Atlanta Fed). For many of these households, which represent a large share of national income, financial conditions aren’t tightening, they’re easing. This may help to explain why core inflation is so ‘sticky’ right now.
Things look different at the low end of the income distribution, where households are more likely to face high rent inflation and be more impacted by higher food and energy costs. This seems to present a real dilemma, one that in the market’s eyes increases the likelihood that the Fed will have to do more. It is too early to pivot.
Will slaying inflation require recession? And how hard a landing?
Comments