September’s Consumer Price Index report hit the wires today, and once again, inflation data sent Fed watchers into a tizzy. While the headline rate slowed from 8.3% y/y to 8.2%, the “core” rate, which excludes food and energy, accelerated to 6.6%—a fresh multi-decade high.[i] Unsurprisingly, rate hike expectations jumped, with most market participants now seeing the fed-funds target range topping 4.5% by 2023’s end—and a growing minority now envisioning rates topping 5% by then.[ii] That is a big change from yesterday’s expectations, and it was initially enough of a jolt to send market sharply lower. The S&P 500 opened down around -1.6% from Wednesday’s close, and 10-year US Treasury yields jumped from 3.91% to a high of 4.22%.[iii] But as the day progressed, the moves reversed. The S&P 500 closed up 2.6% on the day and the 10-year yield flipped to finish at 3.94%.[iv] While we hesitate to read much into a wobbly day, we see a couple of interesting lessons to draw here, and we think they provide reason for optimism.
Why is always harder to know than what, but we doubt 10-year yields’ reversal stems much from Fed predictions, which remain high. Best as we can tell, the bigger development is the rampant chatter about the UK government plotting another U-turn on its recent “mini-budget” and will soon announce it doesn’t plan to cancel next year’s corporate tax hike after all. This seems to have radically shifted sentiment toward UK Gilts: British 10-year yields are down almost -33 basis points on the day as we write. Their decline has helped pull rates down globally, and if you look at an intraday chart of the US 10-year yield, you will see an initial decline that paralleled Europe, then a sharp spike as the inflation data came out, followed by a renewed decline—which in turn parallels stocks’ rise.
So, we would venture that the inflation report—and its impact on rate hike expectations—caused a fleeting sentiment jolt global factors soon overrode. This is unprovable, as most explanations for daily market movement are, but we think it is useful as a working hypothesis. Now, ordinarily we wouldn’t dwell on such things, but stock returns and bond yields have been very negatively correlated lately, which is rather unusual. Since 2000, the rolling 3-month correlation between weekly S&P 500 price returns and the weekly change in 10-year Treasury yields has been more negative than it is today on only four occasions.[v] To us, this is a strong indication that bond market freakouts are spilling over into stocks right now. So when rate hike expectations and UK Gilt volatility took Treasurys on a wild ride Thursday, stocks rode shotgun.
The bad news here is that sentiment-fueled swings in stock and bond markets alike are unpredictable. Even if we can identify reasonably probable causes for what just happened, we can’t use that to make judgments about what will happen immediately ahead. No one can. Sentiment is too finicky. However, we can set some baseline expectations for a more meaningful stretch of time. In the UK, which seems to be dominating global bond markets right now, we see a high likelihood that as internal divisions force the Conservative Party to keep watering down its fiscal plans, investors’ overreaction to what was only ever a series of tiny tax cuts probably fades. That points to tamer long rates.
In the US, we see a high likelihood that investors eventually realize their expectations for future long rates are overstated. To see this, consider another, liquid market-based indicator: breakeven inflation rates. These, based on nominal Treasury yields and Treasury Inflation-Protected Security yields, show markets’ expectations for average annual inflation. The 10-year breakeven inflation rate is presently 2.29%, implying investors expect inflation to average about 2.3% annually over the next decade.[vi] That is down from just over 3.0% in April.[vii] The 5-year rate, which is more sensitive to near-term expectations, has come down even more. It topped out at 3.59% in late March and is now down to 2.32%.[viii] That is a significant deceleration, and it is inconsistent with persistently rising 10-year Treasury yields. Maybe at some point even the Fed will notice and cool rate hikes, alleviating a weight on sentiment.
Why might markets be pricing in lower inflation despite September’s acceleration in core inflation? Especially considering core prices are widely considered to be stickier than headline given they aren’t skewed by volatile food and energy prices? Well, for starters, because commodity prices actually have a larger effect on core prices than you might think. Take a look at your surroundings, and you will see products containing industrial metals like iron ore. You will see electronics that include palladium and rare earth metals—and contain semiconductors made using neon gas. You will see gizmos with lithium-ion batteries. You will see all manner of plastics and synthetic rubbers, which use oil as a feedstock. You will see cleaning products and other chemicals made in facilities powered by natural gas. Heck, every manufactured product has a power bill.
All of these are avenues for commodity prices to feed into core CPI, and we think this year’s earlier commodity price spikes have done just that. It isn’t an instantaneous price input since companies will often hedge their raw materials and energy costs, hence the seemingly slow and delayed filtering-through. But sooner rather than later, commodity prices’ more recent declines should start filtering through, helping stabilize consumer goods prices. Easing supply chain bottlenecks and lower shipping costs should help, too. Meanwhile, home prices have started rolling over, which should stabilize both actual rent and owners’ equivalent rent. And on the monetary side, broad money supply measures throughout the developed world have slowed to pre-pandemic trends, which weren’t too inflationary.
The more inflation slows, the more investors’ expectations for long rates should ease and the more likely it is the Fed follows the market. Meanwhile, other, more stock market-specific forces should take hold, like the overwhelming likelihood that midterms increase gridlock, reducing the legislative risk aversion that has also loomed over stocks lately. Economic data should give more clarity on how the US is weathering Fed activity and Europe is faring amid its energy woes, helping ease uncertainty and enabling investors to move on and look further forward. Even if the numbers aren’t great, stocks’ year-to-date declines are consistent with markets pricing in a shallow recession, and getting confirmation of this would probably end the questioning and help investors look more to the future and an eventual recovery. This isn’t fanciful—stocks regularly start recovering before the economy does.
When markets are swinging wildly, we find that focusing on core, timeless tenets is quite helpful. Even if the day-to-day circumstances change, markets generally don’t. As Ben Graham so aptly described, they will still be voting machines in the short term, registering the world’s feelings. And in the long run they will still be weighing machines, registering likely corporate earnings over the next 3 – 30 months. Today’s robust profit margins, which aren’t getting nearly enough love right now, suggest earnings should be far more resilient than the world seems to expect. If margins today are flush despite all the challenges publicly traded companies have had to navigate over the past two and a half years, that speaks to businesses’ ability to absorb the punches and keep on truckin’. That resilience is what you own if you own stocks.
[i] Source: Bureau of Labor Statistics, as of 10/13/2022.
[ii] Source: CME Group, as of 10/13/2022.
[iii] Source: FactSet, as of 10/13/2022.
[v] Ibid. Rolling 3-month correlation between the weekly S&P 500 price returns and the change in 10-year bond yields, 12/31/1999 – 10/7/2022.
[vi] Source: FactSet, as of 10/13/2022. 10-year breakeven inflation rate on 10/12/2022.
[vii] Ibid. 10-year breakeven inflation rate on 4/21/2022.
[viii] Ibid. 5-year breakeven inflation rate on 3/25/2022 and 10/12/2022.
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