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Markets: Stocks Tumble in Response to Inflation Report

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Capital Markets Perspective brings you what to watch in the markets this week, published in partnership with Great-West Investments.

Buckle up, folks … We have encountered some turbulence.

The market added to Friday’s sell off on Monday with the S&P 500® Index entering bear market territory (down 20% from recent highs) for the first time since the COVID crash of 2020. The S&P 500 Index finished Monday’s trading session down 3.88%, amid freshly sparked inflation and economic growth concerns, and whether the Fed will take a more aggressive policy stance at upcoming meetings.

The highly anticipated United States Consumer Price Index (CPI) and the University of Michigan’s Consumer Sentiment Report were released on Friday and gave us a look through the eyes of the consumer, and how they are grappling with the erosion of purchasing power.

Both Headline and Core CPI – which excludes the more volatile food and energy components – came in above expectations and rattled the markets. Headline CPI was 8.6% YoY versus 8.2% expected, while Core CPI posted a 6% YoY increase versus 5% expected by the market, making it the highest level seen since the 1980s.[1] When decomposing this continued inflationary pressure, there are several standouts worth calling attention to.

But for starters, I think it is worth the friendly reminder that economic regime changes make forecasting particularly challenging, and that the market tends to overreact to missed estimates. This dynamic is especially important in today’s world of technology and data dependency where rapidly changing news is constantly being processed by the market, incorporated into complex econometric models and scrutinized by strategists or other talking heads on the street. Yet, despite how much time is dedicated to this cycle of data transcription, forecasts are still estimates at their core and have rarely been made with pinpoint accuracy. This past week was no exception to that theme, where we saw several notable indicators and the fresh 40-year high in CPI among others that were subject to forecasting error.

The broad-based increase in CPI experienced its largest contributions from shelter, gasoline and food components. On a year-over-year basis, we saw sharp increases of 10.1% for food and 34.6% for energy – the latter marking the largest increase for the component since 2005.1 While WTI Crude was steady around $120 per barrel during the week, the (CPI) energy index had under-the-hood contributions of a positive 48.7% for gasoline and a record-breaking 106.7% uptick in the fuel oil component that is the biggest increase since inception of the series in 1935.[1]

The airlines’ contribution to the headline figure was a notable increase from a year prior at a 12.6% YoY gain, not surprisingly driven by the reopening and the rise of the “revenge traveler” — those individuals that have not traveled since the depths of the pandemic and are eager to get out of their basement, whatever the cost. Word to the wise: If you have upcoming travel plans but have yet to book flights, you might want to get on that because transportation activities have exponentially increased in price as a function of this pent-up demand and rising oil prices. There are several contributing factors aside from rising oil prices that are leading to higher airfares: For starters, airlines are cautious to reinstate some of their previously idled jets out of fear that there might not be enough global demand for travel, and arguably even more important is the lack of qualified pilots to even fly these airbuses due to tight labor conditions.

Adding another brick to the markets’ wall of worry, shortly after Friday’s CPI report we got the preliminary reading of the University of Michigan Consumer Sentiment Index, which reported a record low of 50.2 and widely missed the median estimate of 58.1 by a Bloomberg survey of economists.[2]  This wasn’t just a low number, but was the lowest on record. Long-term inflation expectations reached their highest level since 2008 according to the survey data, as the five-year outlook came in at 3.3%, pointing to what the Fed would call increasingly “unanchored” inflation expectations on behalf of consumers. Overall, consumers are in a pretty sour mood lately, and this dynamic has the potential to stick around as much as the stickier components of our CPI reading – namely food and energy.

Cracks have begun to emerge in the housing market, with key releases on mortgage activity and home affordability – another area that consumers were particularly salty about as shown by their response to perceived buying conditions. According to data from Redfin, housing demand retreated 4% for the month of April.[3] This coincided with other bearish signals from the National Association of Realtors Home Affordability Index, which experienced a precipitous drop of 29% in March from the year prior and data from the Mortgage Bankers Association showing a 22-year low (down 6.5% YoY for the week ended June 3) in its MBA Market Composite Index – a measure of mortgage loan application volume.[4]

On a positive note, we received updates on the U.S. trade balance, which shrank by roughly 19% over the month of May – driven by an increase in exports that focused on industrial supplies and materials. The trade deficit was a meaningful impact to the lackluster GDP result in the first quarter, and is one positive development to see heading into the last few weeks of Q2. That said, there are other concerns that could put pressure on GDP growth such as those affecting retailers.

The large retailer Target Corporation surprised the market on Tuesday when it announced a profit warning – missing the mark on its purchasing orders, which has led to an oversupply of inventory and a need to cancel orders or implement additional markdowns to clear space on its shelves.[5] This buildup of inventory is yet another victim of the ongoing supply chain constraints that companies are wrestling with, but one could argue that these markdowns might help self-correct some of the inflationary pressures seen over the past year. Supply chain concerns have started to ease with help from China’s economy reopening, though it will take time to unclog ports and get back to pre-pandemic levels. Regardless, the stock sold off over 3% on Tuesday, bringing its consumer discretionary cohort down with it.

The U.S. is not the only one wrestling with how to combat this type of economic backdrop that we haven’t seen since the Volcker era, as the European Central Bank confirmed its path toward positive target interest rates by indicating on Thursday that it would be raising rates from negative territory for the first time in eight years come this July. The news wasn’t necessarily unexpected by the street as Europe has experienced the same inflationary pressures that many advanced economies are facing, yet the news seemed to reaffirm investor concerns causing European markets to tumble. The slowdown in global growth is something that is on everyone’s minds and was brought back to the forefront when the of Economic Cooperation and Development (OECD) revised down its global growth forecasts by 1.5 percentage points to 3% and warned that sharp interest-rate increases by central banks could slow growth further.[6]

June 13-18

Notable economic events (June 13–18)

Monday: no economic releases planned.

Tuesday: NFIB Small Business Optimism, PPI

Wednesday: FOMC Rate Decision, NAHB Housing Market Index, Empire Manufacturing, Retail Sales

Thursday: Philadelphia Fed business outlook, building permits, housing starts, initial jobless claims

Friday: Industrial production, capacity utilization, LEI

All eyes will be on the Fed this week, which will release its June rate decision and updated guidance on its quantitative tightening path forward on Wednesday. The market will be keenly focused on how it articulates its delicate approach to achieve what it has referred to as a “soft landing” back toward neutral. Based on the market’s reaction to inflation and consumer sentiment data in recent weeks, that landing might end up experiencing more turbulence than the Fed and investors would like, given the need for a faster and more aggressive stance. That said, the market has now fully priced in 50bps hikes in June, July and September meetings despite talks of a potential “pause” to reevaluate at the September meeting and not run the risk of overshooting its target by hiking us into recession. According to revised expectations by Barclays, a 75bp hike at one or more of the meetings isn’t out of the question,[7] though others view this as less likely given the methodical and well telegraphed approach by the Fed under the helm of Chair Jerome Powell.

Markets will once again be on watch for data pertaining to market sentiment, with the NFIB Small Business Optimism survey being released on Tuesday and more consumer-related insights Wednesday when we receive updated retail sales figures. Expectations for retail sales have been revised lower to a forecast of 0.2%, down from an initial expectation of 0.9% and is another example of how estimation error is omnipresent. Supply chain disruptions could once again work their way into the conversation, though this time in the form of oversupply versus the previous lack thereof.

We’ll get a better read into the housing market with a fairly heavy schedule of housing-related releases. This wave of information starts on Wednesday with the National Association of Home Builders’ housing market index, followed by starts and permits on Thursday. Expectations for the NAHB housing market index to continue to decline for the sixth consecutive month to 68. Housing starts in the U.S. declined 0.2% MoM to an annualized 1.724 million units in April of 2022, after a revised 2.8% drop in March, and are expected to decline further with consensus expectations for 1.7 million units in May. Similarly, building permits in May are anticipated to continue their decline to a forecasted 1.787 million units. In April, building permits in the United States dropped 3% from a month earlier to a seasonally adjusted annual rate of 1.823 million in April of 2022.[8] As we saw with the CPI release, housing remains a huge portion of economic activity and is interrelated to demand for inputs and labor, in addition to knock on effects associated with consumer sentiment.

And finally, on Friday we will receive information on manufacturing, industrial production and capacity utilization. Not surprisingly, production has slowed as evidenced by the recent decline in sentiment and demand for goods. The read on industrial production is expected to decline to a growth rate of 0.4%, which would break a four-month trend of MoM growth rates of +0.8% or better. But hey, your guess is as good as mine on whether this forecast is remotely accurate or if it succumbs to the biases and limitations with estimations.

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Personal Capital Advisors Corporation (“PCAC”) is a wholly owned subsidiary of Personal Capital Corporation (“PCC”), an Empower company. PCC and Empower Holdings, LLC are wholly owned subsidiaries of Great-West Lifeco Inc. Source for index data: Bloomberg.com; GWI calculations.

[1] U.S. Bureau of Labor Statistics

[2] Bloomberg

[3] Redfin

[4] Reuters

[5] Wall Street Journal

[6] Wall Street Journal

[7] Barclays research

[8] Trading Economic

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