CPI Report Shakes the Fed Tightrope
Clients of the Firm,
Markets declined significantly today with the S&P 500 dropping -4.32% closing at 3,932 or -17.90% below the all-time high set in January 2022.
The CPI report was released this morning showing continuing high inflation of 8.3% versus the prior month’s 8.5% read. Energy and food continue to be some of the most inflated classes of expenses, despite recent declines in gasoline and crude oil prices. Importantly, the core inflation rate rose to 6.3%, worsening from the prior month. Much of the market was positioned for a lower inflation number. Correspondingly, stock market prices fell sharply and short-term bond yields spiked to reflect the expectation that the Fed will continue its aggressive rate hiking regime to attempt to bring inflation down. Expectations have solidified around an 0.75% rate increase or higher next week with further rates increases in the offing for November and December.
Our view continues to be that inflation pressures are due to a combination of factors including wages due to employment levels in the U.S., supply chain disruptions and the war in Ukraine impacting energy and food prices. As a result, the Fed will likely continue to put pressure on the economy to reduce economic demand through higher rates. Consistent with their mandate for maximum employment and price stability, the Fed will likely end that pressure when inflation stabilizes, or employment destabilizes. Ideal policy implementation would somehow land squarely between these two extremes, but the task of hitting that mark is very tenuous.
Indeed, the risk of a policy mistake on either side of the equation could lead to persistent or even runaway inflation or a recession triggered by higher rates and lower employment levels. The worst outcome would be stagflation, a stagnant economy with high inflation. Today, market interpretations of these potential outcomes are articulated through lower stock and bond prices and higher yields. As we have discussed before, modern markets quickly move to terminal pricing for such potential outcomes. In this case, short-term interest rates moved aggressively higher and closer to what the perceived neutral rate of Fed Funds will be. As we have also seen throughout this year, market expectations and corresponding earnings multiples are currently closely tied to the level of interest rates. Therefore, stock prices declined to reflect these rate expectations.
The volatility of the markets around rate expectations will likely persist until the Fed pauses its tightening cycle. We should not expect the markets to be placid around these types of economic number releases as participants try to price in expected outcomes based on the data as it emerges.
Staying on strategy is important in volatile markets. Robert Waterman, a former senior partner of McKinsey & Company said, “A strategy is necessary because the future is unpredictable.” The path of the economy from here is uncertain and thus our current investment thinking is focused on attempting to benefit from price dislocations and higher income while avoiding excessive valuation pockets where they exist. Tactically, this means being patient with purchases and staying in shorter duration fixed income to reduce price volatility while collecting yield. This strategy combined with our value investing and GARP equity investments should help us navigate the path ahead.
Thank you for your continued confidence in our firm to manage your funds.
Sincerely,
Peter C. Wernau
CEO, Wernau Asset Management
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