• Stubborn inflation was the primary theme last week, as it could potentially keep the Federal Reserve (Fed) at these relatively tight federal funds rate levels for longer than the markets are currently anticipating and increase the risk that rates are currently too high in an already slowing economy. Equity markets held up reasonably well given the data, but the S&P 500 Index experienced its first decline in five weeks. Bond markets also experienced weakness as evidenced by a shift higher in most of the yield curve.

Hotter-Than-Expected Inflation Data Stirs Up Concerns

  • The January headline Consumer Price Index (CPI) reading improved on a year-over-year basis to 3.1% from 3.4% at the end of December, but it was above the mean estimate of 2.9%. Core (excluding food and energy) CPI was more disappointing in its lack of progress, as the year-over-year increase was 3.9%, flat with December and above the 3.7% estimate. The largest contributors to this upside miss were owners’ equivalent rent (+0.6% month over month), hospital services (1.6%), car insurance (1.4%), restaurants (+0.5%) and airfares (+1.4%). Sectors of the economy that allowed the headline number to improve slightly in its year-over-year progression were used cars (-3.4% month over month), energy (-0.9%) and new cars, which showed no change during the month.
  • Equity markets had largely recovered from this surprise in consumer price inflation until the near-term stickiness of inflation was confirmed by the January Producer Price Index (PPI), which also came in above estimates at both the headline and core levels. Goods prices continued on a deflationary path, declining 0.2% during the month, but services prices rose 0.6%, led by hospital outpatient care (+2.2%) and securities brokers and dealers (+0.7%). Other mildly concerning inflation data points published last week were an increase in the prices-paid component of both the New York Fed’s Empire State and Philadelphia Fed’s manufacturing surveys, a continued low level of weekly jobless claims, which could keep upward pressure on wage inflation, and a slight increase in one-year inflation expectations embedded in the February preliminary University of Michigan consumer sentiment survey.
  • While the inflation data decreased the probability of a Fed rate cut in March to below 10%, some weaker January consumer and manufacturing data could revive concern among Fed members that policy may be too tight given a naturally slowing economy. After a rather strong fourth quarter, consumer spending got off to a slow start in 2024 with January retail sales down 0.8%, when they were expected to decline only 0.1%, and with December sales revised down by 0.2 points to +0.4%. Abnormally cold weather in parts of the country may have been a larger contributing factor in declines in sectors such as building materials and supplies, health and personal care, and miscellaneous retailers. A post-holiday hangover may have been evident in the 0.9% decline in online sales. Although initial jobless claims remain at low levels, there continues to be high-profile layoff announcements daily, and continuing claims have picked up in another indication that job and wage growth should finally begin to slow.
  • The University of Michigan consumer sentiment survey is historically sensitive to price levels, especially energy prices, and the continued low levels of gasoline prices appear to be boosting confidence as this month’s survey came in at 79.6, an improvement from the 79.0 seen in January, but slightly below the 80.0 estimate. The assessment of current conditions fell slightly although expectations picked up over the first half of the month.

Slowdown in Business Spending Continues

  • Business spending also remains stagnant with January industrial production down 0.1%, below the estimate of a 0.3% increase. Manufacturing production was down 0.5% for the month, as mining production fell 2.5% likely in reaction to lower energy prices. Goods production was generally lower during the month, although there were small pockets of strength in the automobile, defense and electrical equipment sectors. In a somewhat encouraging indication that any slowdown or recession in the manufacturing sector will be rather shallow and short, the New York and Philadelphia Fed surveys both improved month over month and beat estimates, with Philadelphia moving into slight expansion while New York remains in contraction. New orders improved notably in both surveys, although employment is beginning to weaken.
  • Small business owners continue to struggle with the effects of cost inflation on their margins, as evidenced by a decline in the January NFIB Small Business Optimism Index to 89.9 from 91.9 in December, when it was expected to improve to 92.3. Small business owners cited the pressure of continued high labor costs and remain hesitant about adding new workers and spending more on capital projects.

Long-term Demand Intact in the Housing Sector

  • The housing sector saw some mixed data, as January housing starts declined 14.8%, albeit from a sharply higher revised December level. Weather was blamed for the regional weakness in the Northeast and Midwest, driving the decline that was dominated by a 36% decrease in multifamily starts. More forward-looking building permits also declined for the month, but only by 1.5%. This decrease was also dominated by a decline in the multifamily space, which is likely reflective of an overbuild of rental apartments. The longer-term dynamic of single-home demand appears to remain intact as indicated by another month of rising confidence among housebuilders with the February NAHB/Wells Fargo Housing Market Index rising four points to 48, better than the 46.5 estimate. The assessment of current conditions, sales expectations and buyer traffic all improved notably month over month.

Investor Enthusiasm Drives Equity Market Rally Despite Lackluster Earnings Guidance

  • With 80% of S&P 500 companies having reported thus far, 79% of those who have reported are beating earnings estimates, slightly above the five-year average. The aggregate results for the fourth quarter of 2023 are coming in 2.3% better than expectations at the beginning of the quarter. While that is good news, estimates for full-year 2024 have barely budged in recent weeks, highlighting both tepid corporate guidance and analysts’ skepticism. Still, equity market performance last week—mostly flat but with a broadening of the rally to small cap stocks—was impressive given the meaningfully hotter-than-expected CPI and PPI. The rally is indicating investor enthusiasm that the economy will continue to grow, that inflation is abating, and that the Fed will eventually lower interest rates later this year. Seeing analysts’ estimates for corporate earnings beginning to increase would be an excellent confirmation of that thesis. So far, it has yet to occur, but we continue to watch.

Please read important disclosures here.