Weekly Market Update - October 19

Next rate increase locked in at 75 basis points

September inflation data came in higher than expected last week. The producer price index (PPI) released on Wednesday was at the upper end of the consensus range at 0.4%, up 0.5 percentage points month-over-month. (August PPI was -0.1%.) The year-over-year PPI dipped slightly to 8.5% from 8.7%.

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The consumer price index (CPI) followed the same pattern as PPI, suggesting that while inflation is not rising, it isn't dropping to more palatable levels. The year-over-year CPI number hardly budged between August and September, dipping ever-so-slightly from 8.3% to 8.2%.

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The market tanked on the CPI announcement at first, then rocketed back up. The Dow went on a wild swing over 1,400 points; when the smoke cleared, the Dow was up over 800 points and nearly 3% for the day. But by Friday, rising rate fears again gripped the markets and the 10-year Treasury rose above 4%. Both the S&P 500 and the Nasdaq ended down for the week, with the Dow squeaking out a gain.

The inflation numbers pretty much solidified another increase of 75 basis points (0.75%) by the Federal Reserve next month, which would bring the federal funds rate to 3.75%. The market has largely priced this rate increase into current levels, and the inflation numbers don’t appear to warrant a more aggressive move from the Fed. Is a 0.1 percentage point drop in CPI significant? Probably not, but inflation isn’t rising and may have peaked. Remember, the rates only began their liftoff in March, so the ripples we are seeing in the economy from the rate increases may be just beginning.

The concern is that the Fed will continue this path and keep looking for older, rearward-looking data for confirmation inflation is moving toward its intended 2% target and overcorrect. Instead, they should keep an ear to the ground and ease up once the downward movement in inflation has gained momentum. Looking back, the Fed’s first move should have been bold and decisive; they should have raised a full point and stopped their quantitative easing activities. Instead, they were timid and dragged their feet, raising the federal funds rate by only 25 basis points (0.25%) and keeping their bond buying going.

It's likely inflation won’t increase in a meaningful manner from here but will remain rangebound by the price of gas. When gas was $5 per gallon in June, we had 9.1% inflation; when gas prices dropped to $3.80 per gallon in August, we had 8.3% inflation. At the end of September, gas was at $3.75 per gallon and inflation dipped to 8.2%. Do you see a pattern here? High energy costs result in higher costs for producers and consumers, so that’s likely where we need to start. However, it is not simple scarcity driving these trends.

The government also needs to reevaluate spending money we do not have on things we do not need. Inflation will be with us for some time; will the Fed be eager or the government willing to take bold measures to tame inflation without destroying the economy and tanking the market? Lacking the fortitude to do so will likely make this economic malaise more prolonged and the economic pain to our society more pronounced.

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Looking Ahead:

• Third-quarter earnings have hit full stride this week. Over 350 companies will be reporting, including Bank of America, Bank of New York Mellon and United Airlines, Johnson & Johnson, Tesla and Netflix having already reported; P&G, American Airlines and Intel (Today); AT&T and American Express (Thursday); and Verizon (Friday). It will be interesting to see if earnings have deteriorated as a result of recent market conditions and the current interest rate environment.

• Fed speakers have given consistent and frequent messaging around interest rates the past two weeks. Any departure from the narrative or signal of dovishness could motivate markets to move higher.

• Thirty-year fixed mortgages are at the 7% mark. Look for mortgage applications, housing starts and permits to dry up in Wednesday’s report. Existing home sales, released on Thursday, could also continue to sputter.