• A rich week in macroeconomic data, led by key inflation reports, caused some increased volatility in markets but U.S. equities ended the week basically flat, as there was ultimately very little change in the assessment of economic conditions, inflation forecasts or future Federal Reserve (Fed) moves.

Core Inflation Creeps Toward Target Level

  • The August Consumer Price Index (CPI) reading was +0.6% on the headline, which was in line with expectations, but higher than the +0.2% increase seen in July. The year-over-year inflation rate rose to 3.7% from 3.2%. As energy (+5.6%) and particularly gasoline (+10.5%) were the primary contributors to this spike higher in headline inflation, markets paid more attention to core inflation (excluding food and energy), which rose 0.3%, higher than the +0.2% estimate and the +0.2% reading in July. Year-over-year core prices rose 4.3%, notably better than the 4.7% in July but still a reasonable distance from the Fed’s 2% target.
  • In assessing some of the subcomponents of the consumer inflation data, core services prices excluding housing were up 0.4%, as airfares spiked 4.9% after declining roughly 8% in each of the previous two months. But hotel prices were down 3.6% on the month as the post-COVID jump in travel demand appears to be leveling off. Another notable item in the report was the decline in used cars, down 1.2% on the month and 6.6% year over year, and furniture, down 1.2%, providing further evidence that goods price inflation has fallen to basically zero. Shelter price inflation dropped 0.1 point to +0.4%, as housing inflation slowly declines to target levels.
  • The August Producer Price Index (PPI) rose 0.7% on the headline, much higher than the 0.4% expected with an upward revision to July. Year over year, it is up only 1.6%, higher than the 1.2% at the end of July although well within the Fed’s target range. The miss of estimates was driven by a 10.5% increase in energy prices with core inflation at the producer level rising 0.2% month over month and 2.2% year over year, which was below the 2.4% registered in July. These hotter-than-expected CPI and headline PPI statistics are not expected to push the Fed to tighten during this week’s Federal Open Market Committee meeting, but they may perpetuate the “higher for longer” stance among Fed watchers and the members themselves. Federal funds futures’ probability of a November rate hike is down to 32% from 42% at the beginning of last week.

Evidence of Growing Consumer Reticence

  • August retail sales was another highly anticipated data point for an assessment of the health of the U.S. consumer this summer. Sales rose 0.6%, way above the +0.1% estimate, although higher gasoline prices were the primary driver of the beat. Looking at the control group, which takes out autos and gasoline, sales were up only 0.1%, below both the +0.2% estimate and the 0.7% increase in July, which was revised down from the +1.0% originally reported. Accounting for inflation seen during the month, real retail sales actually declined in a sign of growing consumer reticence as we approach the end of summer.
  • The September University of Michigan preliminary consumer sentiment survey confirmed this end of quarter hesitancy with a reading of 67.7, below the 69.0 estimate and the 69.5 posted in August, as the assessment of current conditions declined sharply to 69.8 from 75.7 in August. Expectations were slightly better month over month at 66.3 versus 65.5. The spike higher in gasoline prices was likely the biggest driver of deteriorating sentiment with little concern yet to be expressed about a potential government shutdown at the end of the month. On a more positive note, within the survey is the consumer expectation of the near-term and longer-term inflation rates, with the one-year expectation declining to 3.1% from 3.5% in August, the lowest level since March 2021. The five-year expectation also declined to 2.7% from 3.0% in August. The Fed will be encouraged by this progress as it has been concerned about the anchoring of expectations at higher-than-target levels.

Manufacturing Recession Should Be Shallow

  • In assessing business sentiment, there were some mixed signals, as manufacturing may be in the process of bottoming in what may turn out to be a rather short and shallow recession.
    • The August NFIB Small Business Optimism Index declined to 91.3 from 91.9 in July. It was the 20th consecutive month this index has been below its long-term average of 98. There were declines in expectations for better business conditions, sales optimism and capital expenditure plans, as small business owners continue to grapple with inflation and worker shortages in a tight labor market. Although somewhat encouragingly, there have yet to be signs of the anticipated credit crunch within the banking system as credit appears to be ample if needed.
    • The New York Fed’s September Empire State Manufacturing Survey came in at +1.9, much better than the -10.0 estimate and the -19.0 reported in August, as new orders and shipments improved and employment declined only slightly. The prices paid component was little changed. Markets will be more interested in the Philadelphia Fed’s manufacturing survey on Thursday, which is usually a better indicator of the state of manufacturing in the broader economy.
    • Moving away from surveys to actual data, August industrial production rose 0.4%, above the +0.1% estimate with a downward revision in July growth to 0.7% from the 1.0% originally reported. Manufacturing production was up 0.1%, in line with expectations and slower than the +0.3% in July. Slow growth persists, which is leading to the assessment that any recession in the manufacturing sector should be shallow.

ECB Still in Tightening Mode

  • As anticipated, the European Central Bank (ECB) raised its key rate 25 basis points to 4.00%. In its corresponding statement, the central bank said inflation continues to decline but is expected to remain too high for too long and rates will be set at sufficiently restrictive levels for as long as necessary. It will need to see continued progress on inflation to pause rate increases. Economists at the ECB lowered economic growth projections to 0.7% in 2023, 1.0% in 2024 and 1.5% in 2025.
  • In an offset to this rather harsh statement, ECB Chair Christine Lagarde in her press conference said rates have reached sufficiently high levels and indicators suggest a weak third quarter will ultimately be reported next month with services spending also beginning to weaken. She also expects inflation to fall in the coming months. With the decision to raise rates not unanimous and given the comments in the press conference, markets viewed the move as a “dovish hike” and perhaps the last one of the business cycle.

Trend Remains Positive in Equity Markets

  • September is living up to its billing as a volatile month for equity markets. Declines from the late July peak are 3% for the S&P 500 Index and 6% for the Nasdaq Composite Index. But weakness in seven U.S. based mega cap companies referred to as the “Magnificent Seven”—as reflected in the Nasdaq’s drawdown and typified by Nvidia’s 14% peak-to-trough decline—is making investors a little nervous. It’s important to look at the overall trend at times like this to determine if this is a momentary pullback or a pivot to a new trend. Economic strength is still evident, as highlighted above. Inflation is still moderating, even if not at the pace desired. The Fed may or may not raise rates one more time, but it appears close to, if not at, the finish line. From a macro perspective, earnings appear to have troughed. Until and unless these factors have changed, the trend is positive in equity markets. While we may face more wobbliness as September continues, downdrafts are likely to be looked back on as buying opportunities from the vantage point of year-end.

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