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Weekly Update 9/16/2022: Inflation Wave

  • AT&T update
  • Adobe reports solid earnings and a new acquisition
  • J&J restarts buybacks
  • Bright retail sales data as rail strike averted

Consumer & Producer Prices

The theme of this week (and maybe this year) is inflation. We received two key data points this week which showed that prices are rising, and there is little hope that they substantially decline anytime soon. The markets didn’t like that with domestic stocks suffering their worst day in more than two years on Tuesday. And it wasn’t just stocks with investors dumping everything from crypto assets to bonds to oil and gold. It still may be too early to call a bottom in the markets but such widespread selling is often a contra-indicator that liquidations have been exhausted. Time will tell, and we will continue monitoring.

Consumer prices rose sharply in August from the prior month excluding food and energy prices according to the Labor Department. The overall index (CPI) which includes those volatile components rose 8.3% last month compared to the same month a year ago, down from 8.5% in July and 9.1% in June. Gasoline prices fell 10.6% on a month-over-month basis, the biggest monthly drop in over two years, and the price at the pump is now $3.71 per gallon according to travel-industry provider AAA, down from over $5 in June. However, gasoline per gallon is still up over 25% versus last year. Diesel gasoline, characterized as “other motor fuels,” is up 53% in the past year though it, too, declined month over month. Higher diesel prices mean higher shipping prices because trucks run on that fuel which is likely to translate into higher prices being passed along to consumers in the retail field. Natural gas futures prices have risen over 133% year-to-date. This energy source is the largest source of electricity generation in the country, and the colder winter season is only a few months away suggesting heating homes is going to be sticker shock to many households this year. Food prices continued to climb as well. They were up 0.8% in August which translates into an 11.4% increase from a year ago, the most since 1979.

But what concerned the markets the most was the so-called core CPI. It jumped 0.6% from July for an on-the-year gain of 6.3% compared to Wall Street’s consensus of 6.1% and up from the 5.9% annual pace set in the month prior. That involves anything tracked by the Bureau of Labor Statistics that is not considered in the basket of food and energy items. So that would include household furnishings and supplies, recreation services, apparel and medical care services among others. The biggest item is shelter otherwise known as owners’ equivalent rent of primary residence. It is essentially how much homeowners would have to pay if they were renting their homes—the idea is to separate out shelter, the service provided by a house, from whatever value the house might have as an investment. Thus, the price of homes which is tracked by other data such as new and existing home sales do not play a role in this CPI component. However, they are somewhat linked. Since the pandemic, prices for homes have skyrocketed as mortgage interest rates dropped to induce buyers and families fled cities for non-urban wide-open spaces. As time passed and life has returned to a “new normal” that has involved a resurgence of people looking for homes but many being priced out of the market and forced to pay higher rents from landlords now firmly in control of pricing power. Overall shelter costs in the latest core CPI rose 0.7% from July and 6.2% from a year ago, both the most since the early 1990s. With mortgage rates now much higher than at the start of the year, the trend towards higher annual rents is likely to continue as leases expire and new ones are signed and as mortgage loan rates top 6% according to Freddie Mac.

Producer prices decreased 0.1% from a month earlier but were 8.7% higher than a year ago according to data released by the Labor Department on Wednesday. Excluding food and energy, the core PPI rose a larger-than-forecast 0.4% last month and was up 7.3% from a year earlier. Supply chains are improving but producers are still contending with increasing wage pressures. Stripping out trade services from the core figure, the index rose 5.6% from August of last year. So whether it is consumer or wholesale prices, the level of inflation is incongruent with the Fed’s preferred target of “around 2%.” In order to be in compliance with the Congressional mandate from Congress, the Fed has had to be very aggressive in raising rates to combat the waves of price increases.

Retail Sales

One economic bright spot this week came from data from the Commerce Department. Retail sales unexpectedly rose 0.3% last month after a downwardly revised 0.4% drop in July. Excluding gasoline, retail sales were up 0.8%. Eight of 13 categories grew in August led by sales at auto dealers. This suggests that the consumer remains relatively healthy even with inflation reaching multi-decade highs. Spending has shifted from goods to services as the fear of the pandemic fades. Nevertheless, authorities are on the lookout for any resurgence in hospitalizations due to Covid-19 as the weather cools and people spend more time indoors potentially helping spread the still potent virus more easily. A solid back-to-school period this summer is a bright spot for many retailers which will face an uncertain holiday period given the economy’s challenges.

The nation’s retail sector also benefitted from a near miss. The country’s largest freight railroads and union leaders reached a tentative labor agreement just hours before a nationwide strike would have crippled many sectors of the U.S. economy. The federal government stepped in to help broker a deal to prevent snarling supply chains and adding to already high inflationary pressures. Union members have been working without a contract since 2019, and labor leaders felt it was time they drew a line in the sand. Unions were looking for raises of 31% over five years which was nearly double the 17% offered by railroads. The compromise, which is retroactive to 2019, resulted in a 24% pay increase over five years (including a 14.1% bump upon ratification) and looser attendance rules. Amtrak, Norfolk Southern and Union Pacific had suspended long-distance train service ahead of the Friday deadline for a possible strike. Thousands of nurses in Minnesota returned to work on Thursday after a three-day strike of their own hoping to push forward stalled contract negotiations with various healthcare systems. These are but two examples of how employees are empowered by the slack in the labor force to demand change. It is also an example of what the Fed does not want to see—the beginning of a wage-price spiral whereby rising wages increase disposable income raising the demand for goods and services and causes prices to rise and induces a demand for higher wages…rinse and repeat. So far, that is not happening based upon today’s preliminary University of Michigan consumer survey. While 1-year inflation is expected to reach 4.6%, the 5-10 year inflation level is anticipated to be 2.8%, slightly below August’s reading of 2.9%. As long as that relationship holds and inflation is expected to decline, the Fed can claim some sort of victory.

Expectations

Next Wednesday, Fed Chairman Jerome Powell will hold a press conference where he will explain the result of the vote of the Federal Open Market Committee (FOMC). Before this week’s inflation data, the markets were leaning towards a 75 basis point (0.75%) hike in its benchmark federal funds rate. Now, there is talk of the biggest hike in decades to 100 basis points. According to the futures markets, the three quarter’s hike is definitely priced in but there’s a not so insignificant chance of a full percentage point. That is unlikely to happen unless something dramatic unfolds between this weekend and next Wednesday in some data point like new home starts or existing home sales flying through the roof (pun intended!). The attention at next week’s FOMC meeting will be on expectations for what comes next. Stubbornly and perhaps a bit asinine, the markets are still pricing in rate cuts from the Fed starting in the first half of next year. Fed governors have consistently emphasized that rates not only are not at their peak but, once there, are likely to stay there for some time. That is not meant to mean years, but probably more than just a meeting or two. If, as expected, they raise rates through December, is it likely over the course of the next two or three meetings they do an about face and start cutting? Anything is possible. But it just seems improbable at this point unless the economy is on the verge of collapse, and they feel they must act. Tuesday’s reaction in the markets was resetting expectations to reality. Time will tell if more resetting needs to take place starting next Wednesday when the latest Fed “dot plot” is released and Powell speaks before the cameras.

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