Inflation Concerns Drive Volatile Week

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

The Federal Reserve’s quest for a soft landing ran into turbulence last week as data out on Friday suggested inflation expectations have moved higher. The University of Michigan Survey of Consumer Sentiment showed that consumers expect prices to rise by 5.1 percent during the next year and 2.9 percent annually over the next five years. Both numbers represent an uptick from the prior month’s results and are likely being viewed as a concern by the Federal Reserve Board. The move upward coincided with higher than expected readings of core inflation in the latest Consumer Price Index report, which showed that month-over-month inflation, excluding volatile gas and food prices, rose 0.6 percent in September, identical to the increase seen for August, and year-over-year prices were up 6.6 percent — eclipsing a recent high of 6.4 percent in March of this year.

Digging deeper into the CPI data suggests that the economy is progressing much as we’ve described over the past several months. Namely, demand for goods peaked during the heart of the COVID pandemic, and since then, consumer spending has migrated to the services side of the economy. Consequently, inflation is following the same path, with price pressure for goods ebbing while the services side is seeing increased inflation. As a result, goods inflation was flat month over month in the latest CPI report and is up 6.7 percent year over year — well below the peak of 12.4 in February 2022. Conversely, prices on the services side of the economy are up 0.8 percent month over month and 6.7 percent higher year over year. When looking at the services reading, it is important to remember that shelter accounts for 33 percent of the total number. Given the 7- to 10-month lag time for moderating housing costs and rents to filter into the CPI reading, we believe that the services side of inflation is also ripe for significant softening in the coming months amid interest rates for 30-year mortgages that have topped 7 percent, affordability issues and slowing demand. These pressures have tempered rent and home price increases during the past several months. Evidence of moderating rents can be found in the latest data from Zillow Group Inc., which shows rents are up 10.9 percent year over year — well below the recent peak of 17.15 percent in February. This moderation will begin to filter into CPI data during the coming months and should put a cap on the impact of shelter inflation within services.

While reaction to the CPI reading was initially sour, equities reversed and moved markedly higher, perhaps because investors believe recent selling was overdone. Another possibility is that investors are growing more comfortable with the fact that the inflation measure is backward-looking and so has yet to capture the impact of slowing demand, easing supply chain challenges and rebuilt inventories that have been evident in many recent economic reports. However, news that consumer expectations of price hikes in the years ahead are inching higher led to selling pressures on Friday. The Fed has noted it monitors forward-looking expectations in its deliberations on future rate hikes. The fear is that if inflation expectations become unanchored and move higher, consumers will ramp up spending on goods in an effort to get ahead of future price increases.

While inflation expectations have risen, it is important to note that the move has yet to show up in consumer behavior. Retail sales on an inflation-adjusted basis in September were flat, according to the most recent report from the U.S. Commerce Department. Notably, spending increased in just six of the 13 categories measured compared with 10 of 13 seeing increased spending in August. Not surprisingly, categories that saw a decline in real spending were early beneficiaries in the surge of goods purchases during the pandemic, such as furniture, electronics and autos. With inventories now at or approaching pre-pandemic levels in many of these categories and demand receding, we expect inflationary pressures to continue to ease on the goods side of the equation.

Perhaps one of the reasons consumers haven’t been rushing to make purchases (despite their belief that prices will move higher) is their modest expectation for wage increases in the coming year, which has led them to adopt more conservative spending habits. According to the University of Michigan survey, respondents expect their household income to rise just 1.6 percent in the coming year. And despite a still-tight job market, consumers are beginning to feel less certain about long-term prospects for job security, with 19.2 percent believing they may be laid off in the coming five years, up from the 14.6 percent reading in March of this year. While the level is still relatively low, it has reached the highest level since June 2021 and may be an indicator that consumers are sensing the job market is cooling. The dampened outlook could translate to restrained discretionary spending in the months ahead.

While the promising picture painted by forward-looking data may be cold comfort for investors who are living through the weekly gyrations of the markets, it is important to focus on because it suggests a turning point in the inflation data and the trajectory of rate hikes that may be approaching. The markets have already priced in a significant amount of bad news. As a result, when backward-looking data — such as CPI and jobs numbers — begin to weaken, we believe there will be significant room to the upside given the widespread pessimism currently permeating the markets. Will the next several months be choppy? Yes, we believe so. But the discomfort may pale in comparison to the regret investors may feel should they move to the sidelines in hopes of timing the prefect entry point for the next bull run.

The week ahead

Monday: The Empire State Manufacturing Index released before the opening bell will provide a look at the health of manufacturing and general business conditions in the influential New York state region. Of particular interest will be data on hiring and costs for manufacturers in the region.

Tuesday: A week heavy on housing reports kicks off mid-morning with the Home Builders Index from the National Association of Home Builders. We’ve seen a recent uptick in builders providing concessions to buyers and will be watching for a continuation of the trend.  

Wednesday: The Federal Reserve will release data from its Beige Book. The book will provide recent anecdotal insights into the nation’s economy and could highlight ongoing improvements in labor and cost pressure for businesses.

Thursday: The latest numbers on existing home sales will be released mid-morning by the National Association of Realtors. The report, along with the new homes data released earlier in the week, should provide a clearer picture of whether the rapid cooling of the real estate market has gained momentum in light of mortgage rates moving higher and the economy cooling. We will also be looking for signs that the recent uptick in multifamily projects is continuing.

The Conference Board’s latest Leading Economic Index (LEI) survey will be a key release during the week. Recent reports have suggested the U.S. economy continues to inch toward a recession. We will be examining the data to determine whether the pace of softening has accelerated.

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