Better Than Expected Inflation Data Sends Markets Higher

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Better than expected inflation data out last week unleashed a wave of optimism on Wall Street, and the major indices moved sharply higher, with the S&P reaching a level not seen since April 2022. The inflation data breathed new life into expectations that the Fed is nearing the end of its rate hiking cycle. While the consensus view remains that the Fed will raise rates again next week, futures markets suggest investors believe that the next hike will be the last of the year.

The latest Consumer Price Index (CPI) release showed price pressure continuing to fall, with headline inflation growing 0.2 percent in June. The report was up slightly from May’s rate of a scant 0.1 percent but below consensus expectations of 0.3 percent. On a year-over-year basis, prices rose 3 percent, well below the prior reading of 4 percent and the lowest level since March 2021. Shelter continued to be an outlier in the uptick in the monthly inflation reading, coming in at an increase of 0.4 percent and accounting for 70 percent of the month-over-month increase in the headline number. On a year-over-year basis the category was up 7.8 percent in June, a decrease of 0.2 percent from the prior reading. As a reminder, shelter has a large and lagging effect on inflation readings in services (it accounts for 34 percent of the total CPI measure and has around a 12-month lag).

As we’ve noted in previous commentaries, given the lagging nature of the shelter reading, we believe that stripping out this backward-looking measure provides a clearer real-time picture of inflation. Doing so highlights the significant progress made in bringing inflationary pressures down. Since the surge in CPI readings that took place in May and June of 2022, prices excluding the shelter number are up just 0.7 percent year over year on a non-seasonally adjusted basis. Put simply, when excluding the lagging shelter reading, all-in inflation is running at a level below the Fed’s stated target. It’s important to note that home prices peaked in the U.S. in June 2022, and given the lag of housing feeding into CPI, we expect the shelter component will continue to moderate in the coming months and will result in further easing of the inflation measure. Core CPI, which excludes volatile food and gas prices, rose 0.2 percent in June, down from May’s reading of 0.4 percent and the smallest increase since August 2021. On a year-over-year basis, the core reading came in at 4.8 percent, down 0.5 percent from the level of 5.3 percent recorded in May. The latest year-over-year figure marks the slowest 12-month increase since October 2021. Once again, if shelter is taken out of the equation, core CPI comes in at 2.7 percent year over year, the lowest level since March 2021.

Dissecting the data further reveals that food and shelter combined have been significant drivers of high year-over-year readings. When those two categories are removed, all-in inflation is actually down 0.6 percent, below the Fed’s long-term target of 2 percent. It’s worth noting that the latest report showed food prices have continued to ease and were up just 0.1 percent month over month.

While investors welcomed the latest data, we are not yet convinced it will be enough to convince the Fed to abandon its historic rate-hiking cycle. Despite all signs pointing to inflation well on its way to returning to historical norms, the Fed continues to worry about elevated wage pressures. It continues to view wage growth as the last domino needed to fall to prevent a return to the stagflation years of 1966–1982. Until annualized wage increases consistently register below 4 percent, we believe the Fed will be unwilling to take rate hikes off the table. Fortunately, with inflation falling as it has, the Fed may be willing to slow the pace of potential future rate hikes, allowing the full effects of its previous rate increases to take hold.

Wall Street Wrap

While the latest CPI reading garnered most of the attention last week, other reports painted a similarly encouraging picture about inflation trends.

Input costs lower than expected: Producer input final demand prices were up just 0.1 percent in June, according to the latest Producer Price Index (PPI) from the Bureau of Labor Statistics. On a year-over-year basis, headline PPI is up 0.1 percent. Core PPI, which strips out volatile food and energy, declined 0.2 percent in June compared to a 0.1 percent increase in May and was up 2.6 percent on a year-over-year basis. This was the lowest 12-month reading since January 2021. The PPI measures price increases for finished goods leaving the factory; it is generally a forward-looking measure of where prices for consumers are headed. As the costs producers face for finished goods continue to ease, we expect to see further price relief for consumers at the retail level.

Small businesses' prices rise at slowest pace in more than two years: The latest data from the National Federation of Independent Business (NFIB) shows that just 29 percent of respondents reported raising prices during the most recent survey period, which was the lowest percentage since March 2021. The latest figure marked a decline of 3 percentage points from May’s reading.

Overall, optimism among small business owners inched higher to 91, up 1.6 points from May. However, the reading marks the 18^th consecutive month of readings below the 49-year average of 98. Expectations for the coming months improved somewhat but still remain decidedly negative with just 40 percent of respondents anticipating better business conditions during the next six months. Additional details from the survey point to a potential easing of the labor and wage picture. The latest survey shows that 15 percent of small businesses plan to hire new staff, down from May’s reading of 19 percent and well off the pace of 26 percent recorded in May 2022. For further context, the measure hit a record level of 32 percent looking to add staff in August 2021. The compensation index also fell to 36, in line with pre-COVID norms. The latest reading continues a downward trend since the recent high of 50 in January 2022. NFIB Chief Economist Bill Dunkelberg noted in a release of the latest survey results that the potential for an economic contraction continued to weigh on small business owners. “Halfway through the year, small business owners remain very pessimistic about future business conditions and their sales prospects,” according to Dunkelberg.

Jobless claims fall: Weekly jobless claims fell to 237,000 from last week’s upwardly revised 249,000 new claims. The four-week rolling average of new jobless came in at 246,750, down 6,750 from the previous week. Continuing claims (those people remaining on unemployment benefits) remain elevated at 1.729 million, up 11,000 from the prior reading.

Consumer sentiment bolts higher: Consumer sentiment jumped in July to 72.6, up from June’s reading of 64.4, according to the latest consumer sentiment survey released by the University of Michigan. Expectations for economic conditions six months forward also rose, with the latest reading registering at 69.4, up from June’s level of 61.5.  

The survey also showed that inflation expectations also remained anchored, with respondents expecting prices to rise 3.4 percent in the coming year, an increase of 0.1 percent from June’s reading. However, that figure is well below the 4.2 percent level recorded in May. Long-term inflation expectations remained stable at 3.1 percent, inside the range of 2.9 to 3.1 percent recorded during the past 24 months. 

A word on earnings: Several large banks reported earnings last week. Some common themes that we’ve seen in earnings reports include solid consumer spending figures, with some of the spending being paid using credit and debit cards. The uptick in card usage suggests that excess liquidity from stimulus programs started in response to COVID may be drying up. On the credit side, banks are seeing rising delinquencies on the consumer side as well as in commercial and industrial loan portfolios—specifically within office real estate. At this point, banks are characterizing the uptick as a return to norms experienced prior to the pandemic. However, should the economy tip into recession, we expect what is currently a trend of a return to normal could evolve into an elevated level of delinquencies.

The week ahead

Monday: The Empire State Manufacturing Index released before the opening bell will offer a look at the health of manufacturing and general business conditions in the influential New York state region.

Tuesday: A week heavy on housing reports kicks off mid-morning with the Home Builders Index from the National Association of Home Builders.

The U.S. Census Bureau will release the latest numbers on retail sales before the opening bell. The data should yield insights into whether consumers are curbing their spending habits in anticipation of a potential recession.

We’ll get a look at the manufacturing side of the economy with the release of the latest industrial production figures from the Federal Reserve. Consumer spending has been a source of strength in the economy, while manufacturing has been weak. We’ll be watching to see if this report, along with the retail sales data, will show a continuing trend with industrial production flat.

Wednesday: We will get March housing starts and building permits from the U.S. Census Bureau. This data, along with the Homebuilders Index released on Tuesday, will provide insights on whether consumers can expect greater housing inventory in the months ahead.

Thursday: We’ll get a look at existing home sales mid-morning by the National Association of Realtors. This report, along with the new homes data released earlier in the week, should give a clearer picture of whether the rapid cooling of the real estate market has stabilized.

Initial and continuing jobless claims will be announced before the market opens. Initial filings and continuing claims rose last week, and we will be watching for signs that the employment picture is weakening.

The Conference Board’s latest Leading Economic Index survey will be a key release during the week. Recent reports have suggested the U.S. economy may be on the cusp of a recession. We will be scrutinizing the data for any indications of a change in the pace of the slowdown.

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