"Inflation is when you pay fifteen dollars for the ten dollar haircut you used to get for five dollars when you had hair." -Sam Ewing
The CPI report came in this morning and was in line monthly. However, the headline annual CPI rate came in at 2.9%, a welcome lighter-than-expected reading. This marks the fourth consecutive inflation report with a softer-than-expected element. Yesterday's Producer Price Index (PPI), a measure of wholesale inflation, also came in lighter than expected. The consistent beat of good inflation data has pretty profound consequences for markets.
The first print in the two handle for quite some time means that the Federal Reserve will likely cut at its upcoming September meeting. The odds for such a cut have now reached 100%, as implied by futures. There is about an even divide currently between expectations for a 50 bps and a 25 bps cut.
However, with the cover of four consecutive light inflation reports and labor reports missing to the upside, it seems clear that the Fed now will likely switch its focus to the other side of the mandate. For our purposes as investors, inflation is dead. You will still hear about inflation as a risk, but the focus will increasingly be on employment reports and other indicators of economic health.
The specifics of the CPI report are also pretty encouraging when you look beneath the surface. The leading categories that are keeping the number in the high twos are Services, Food Away From Home, and Energy Services, as you can see below. Importantly, many of these items are non-essential and can be foregone by consumers experiencing financial pressure. If you look at Food Away From Home compared to Food at Home, the difference is pretty stark, and it gives pennywise consumers options to pad their wallets by cooking at home.
This is not to say we don't need to worry about some economic slowing; we do. But now that the Fed has a cover to begin cuts, the market should begin to price things that give consumers immediate relief. One example would be mortgage debt, which has plummetted on the expectations of upcoming Fed cuts. This is a huge portion of the consumer wallet, and thus, relief here can help cushion economic slowing in other areas. So far, the pace of job growth has slowed, but it hasn't contracted.
The real question markets will begin to focus on tactically is whether or not the Fed will conduct a 25 bps cut or a 50 bps cut. As the economic data comes in, the probabilities will fluctuate. Right now, they still favor a 25 bps cut, but 50 bps will become a higher probability if the economy begins weakening. We should watch out for if the market begins to expect a 50 bps cut and one doesn't come. This could cause a temporary tantrum.
Most Americans are focused on the cost of basic items. Luckily, there has been some recent relief in food staples. Gasoline has cooperated recently. Of course, the potential for war between Israel and Iran could cause that to reverse. However, as I mentioned yesterday, I think there are several fundamental realities of the confrontation between Israel and Iran that could lead to a much more tame outcome than many expect. Given current expectations and strategic realities for both belligerents, it is unlikely that the Middle East will drive another major volatility event.
Still, I could be wrong about this. Furthermore, a Ukrainian incursion fairly deep into Russian sovereign territory has the potential to escalate that conflict. However, given both sides' tiredness and resource exhaustion, I think this is less likely. What is more likely is that I'm famously wrong about the Middle East risk and that Iran and Hezbollah decide they need to make a big show to restore deterrence.
War is inflationary. You can think of it as a trade barrier of sorts, but of course, the worst kind. In terms of the potential impact of a Middle East War between Israel and Iran, the fragmentation of the Middle Eastern economy and the exclusion of the largest oil producers from the conflict should limit its real-world impact, even if it does erupt. The place to watch is the Northern Border, as this is where Israel faces off against Hezbollah.
Despite both sides wanting to avoid an all-out war, the potential for escalation is likely the highest. Plus, Israel and Hezbollah may have to face each other in brutal ground combat to restore equilibrium on the Northern border after many thousands of people have been evacuated on both sides.
I would describe the current market situation as very positive. However, there is a significant risk that geopolitical deterioration could capture the market's attention between earnings seasons and cause a retest of recent lows. This is not the outcome I forecast as most likely, but it is possible. I still think it is likely that volatility trades lower and the market climbs a wall of worry.
The inflation risk is largely in the rearview mirror. You will still hear about it in a political season, but increasingly, the volatility that is priced into futures around election time seems like a good thing to short. I suspect the currents in favor of Kamala Harris will continue and lead to an overwhelming victory in November. A big victory should mean all else being equal and having less volatility.
