Last night’s US Consumer Price Index (CPI) figures were the perfect wake up call for markets following Jerome Powell’s Jackson hole speech; dramatically reinforcing the work ahead in taming inflation. Markets fell swiftly and sharply, the S&P500 down 4.3% and the NASDAQ down 5.5% as reality set in.
Three weeks ago in my weekly note, I outlined what Powell needed to say at that meeting for markets to take him seriously and understand the Federal Reserve’s commitment to reducing inflation. His speech was right on the money, and it was clear that the Fed was going to fight inflation as aggressively as required. Markets reacted as you’d expect initially and retreated, but only momentarily. It didn’t take long for the focus to turn to the CPI figures coming out last night.
The market, again overly optimistic, assumed inflation was going to fall hard. Ironically, when the sentiment becomes negative, commentators and strategists preach caution and the merits of staying data dependent. They insist it is prudent to wait to see what the data says before becoming concerned. The problem is that these same people (most of the market) forget that philosophy when they are expecting good news.
Consequently, the share market quickly talked itself into a scenario where the environment for inflation was rapidly falling. The implication being that interest rate rises would be short lived. Last night as I watched the US premarket open on Bloomberg TV, almost every market strategist who came on the show talked about how a ‘soft landing’ is a reality and that interest rates will be on hold after the next couple of CPI results.
At 10.30pm AEST the mood changed very quickly. The US CPI result was an upside surprise. The inflation figure was 8.3% instead of the 8.1% expected. Core inflation was up from 5.9% to 6.3%. Last night’s data is a game changer. It removes any hope of a dovish Fed that will halt or cut rates anytime soon, so markets need to recalibrate their expectations quickly. The CPI data confirmed that not only is an interest rate hike of 0.75% next week in the US locked in, but it puts a full 1% hike on the table, with more in the months ahead.
The narrative of transitory inflation that was slowly returning vanished. It means in the short-term, interest rates going much higher. Bond markets adjusted quickly as the 2-year US bond yields instantly went from 3.5% to 3.7%. Keep in mind a year ago they were 0.3% so we are talking about once in a generation maybe once in a lifetime moves. It’s quite incredible.
Share markets reacted as you’d expect and, in my opinion, this was the reality check markets needed. There was a merry-go-round of the share market rallying because firstly it didn’t believe Powell would be tough on inflation. Once it understood post Jackson Hole that he would be tough, it morphed into a market that didn’t believe inflation would be hard to get rid of. Last night everyone realised, perhaps for the first time, that both inflation will be hard to stop, and that Powell will do what is needed to stop it.
There is so much work to be done by the Fed before rates can pause and a lot more before they come down. After several false starts, the rally has finally stopped. We have persistent inflation that has become broadly embedded in the system. Mortgages, rents, wages, food, and energy bills are all going higher. Stagflation is quickly becoming the base case scenario. A situation globally where we face high inflation but no growth.
Keep in mind the backdrop to all of this is the worst prospects for the global economy since the GFC. To me, it seems obvious and unavoidable that Germany is headed into a deep recession and that it will take the rest of Europe with it. You have a nation at the start of an energy crisis in such a bad position that their manufacturing plants are closing because they can’t afford the energy bills. The German economy is on the brink. I expect the debate in the months ahead will end up being about whether the rest of the world economy is dragged down too.
From a share market perspective, I continue to expect this market to fall and retest the June lows. The key for investors to ride this out is to continue focusing on the long term and to hold only the highest quality companies. We continue to be overweight cash. For those holding cash, this will become a great buying opportunity in due course. We continue to be patient.
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