The Consumer Price Index (CPI) has become the most influential and critical variable in today's market. The CPI readings directly impact monetary policy put forth by Federal Reserve via interest rate hikes, bond buying, and liquidity measures.
Inflation continues to be persistent throughout the economy and the Federal Reserve must balance curtailing inflation without destroying the economy. The impact of inflation is now flowing through to companies and consumers alike. Inflation has reared its ugly head and is now negatively impacting companies' gross margins and dampening consumer demand due to soaring prices, specifically gasoline.
The confluence of rising interest rates, inflation, China Covid lockdowns and the war in Ukraine has resulted in months of selling. The relentless, indiscriminate selling has pushed the Dow Jones and S&P 500 deep into correction territory while pushing the Nasdaq deep into a bear market.
As such, the market appears to be factoring in a worst-case scenario that may result in a Federal Reserve induced recession as a function of over-tightening on monetary policy and/or its inability to combat inflation responsibly to engineer an economic "soft landing". The overall market is in a precarious position, and it'll likely take successive downward CPI readings before rates will stabilize and the markets can appreciate higher.
Inflation – 40-Year Highs
Inflation pushed higher in May as prices rose 8.6% from a year ago for the fastest increase in nearly 40 years. Excluding volatile food and energy prices, core CPI was up 6%.
Both CPI and core CPI exceeded estimates and came in hotter than expected. Surging costs for shelter, gasoline and food prices all contributed to the increase. The latest CPI numbers cast doubt that inflation may have peaked, adding to fears that the U.S. economy is nearing a recession.
The CPI report comes at a time when the Federal Reserve is in the early stages of a rate-hiking campaign to slow growth and bring down prices. May's report likely locks in multiple 50 basis point interest rate increases ahead. With 75 basis points of rate rises already put in place, markets widely expect the Fed to continue tightening through 2022 and likely into 2023.
Target and Walmart Harbinger
Target (TGT) and Walmart (WMT) warned that profits would take a hit from an inventory glut. Microsoft (MSFT) also issued a profit warning and said that revenue would be softer than expected due to unfavorable foreign exchange rates. Strategists say they expect to see more companies issuing profit warnings.
Inventories at some retailers have been building, as consumer demand shifted to different categories as Covid cases fell and consumers returned to social events and other activities. Higher costs also play a role, especially as consumers are pinched by record-high gasoline and rising food prices.
These profit warnings are two-fold:
1) margins will be squeezed by reduced demand and a stronger dollar
2) this may signal the peak of the inflation cycle via inventory glut and rising interest rates.
The former will take time to flow through quarterly earnings, while the latter may finally spur this bear market.
The Importance of CPI
The CPI is an important economic readout as this is a measure of price changes in a basket of consumer goods and services used to identify periods of inflation. Mild inflation can encourage economic growth and stimulate business investment and expansion.
High inflation reduces the buying power of the dollar and can reduce demand for goods and services. High inflation also drives interest rates higher while driving bond prices lower. By comparing the current cost of buying a basket of goods with the cost of buying the same basket a year ago indicates changes in the cost of living.
Thus, the CPI figure measures the rate of increase or decrease in a broad range of prices (i.e. food, housing, transportation, medical care, clothing, electricity, entertainment and services). As CPI numbers rage on and remain elevated, the Federal Reserve must act aggressively to tame inflation.
The CPI readings will become even more important moving forward and have directly impacted market movements and overall sentiment. These CPI reports are becoming more significant as the more robust CPI readings will translate into a stronger influence on the Federal Reserve's monetary policies and downstream interest rate hikes.
The Federal Reserve has reached an inflection point to where they were forced to curtail their stimulative easy monetary policies as inflation, unemployment and overall economy improved. Investors can expect increased volatility as these critically important CPI reports continue to be released through the remainder of 2022.
Conclusion
Inflation pushed higher in May as prices rose 8.6% from a year ago for the fastest increase in nearly 40 years. Both CPI and core CPI exceeded estimates and came in hotter than expected. The Consumer Price Index (CPI) has become the most influential and critical variable in today's market. The CPI readings directly impact monetary policy put forth by Federal Reserve via interest rate hikes, bond buying, and liquidity measures. The impact of inflation is now flowing through to companies and consumers, with Target and Walmart issuing profit warnings.
The confluence of rising interest rates, inflation, China Covid lockdowns and the war in Ukraine has resulted in months of selling. The relentless, indiscriminate selling has pushed the Dow Jones and S&P 500 deep into correction territory while pushing the Nasdaq deep into a bear market.
As such, the market appears to be factoring in a worst-case scenario that may result in a Federal Reserve induced recession as a function of over-tightening on monetary policy and/or its inability to combat inflation responsibly to engineer an economic "soft landing". The overall market is in a precarious position, and it'll likely take successive downward CPI readings before rates will stabilize and the markets can appreciate higher.
However, these profit warnings' silver lining may signal the inflation cycle's peak via an inventory glut and rising interest rates. If this signals that inflation has peaked, then rates may normalize, and the market can appreciate higher over the long term.
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