Gill Capital Partners Mid-September 2022 Update
It’s been a busy week in the world of economics, investing, and markets. We received another report on inflation earlier this week and markets did not like what they saw. This latest inflation report has rippled through interest rate and equity markets like an unwelcome house guest that just extended their stay. Below are updates on inflation, the Federal Reserve, and how the market is interpreting all of this.
Inflation Update
Earlier this week we received the monthly Consumer Price Index (CPI) report for the month of August. This data, while trending lower, was higher than what the market had anticipated. The report showed that consumer price increases declined from 8.5% to 8.3% on a year-over-year basis and rose 0.1% on a monthly basis. The “headline” data is moving in the right direction, but the progress is slower than the markets had hoped. The “core” inflation data, which excludes volatile food and energy prices, seemed to catch the markets off guard. Core prices rose 0.6% in August on a monthly basis and 6.3% on a year-over-year basis. The chart below provides great insight into the year-over-year headline CPI trend across the major components. As you can see, energy prices, along with new and used vehicle prices, have been trending lower and contributing to lower inflation. These inputs, however, are being largely offset by sticky inflationary pressure in food and housing prices.
Our view – This wasn’t the news that markets were hoping for following a better-than-expected report last month. Yes, prices continue to trend lower at the headline level, but the unwelcome acceleration in prices for food and shelter were discouraging. While there are some encouraging aspects to this report, particularly a significant drop in energy inflation, the seemingly relentless pressure from food and housing prices stole the show. We are holding out optimism that inflation will continue to trend lower, and likely significantly so, in the coming months, as we see significant drops from post-COVID price peaks in inflationary inputs including:
Lumber prices down roughly 60%
Copper prices down roughly 35%
Oil price down roughly 35%
Iron ore down roughly 60%
Corn prices down 17%
Wheat prices down 39%
Freight rates down 79%
So why does inflation remain so sticky? And why aren’t food costs coming down with core commodity prices? We believe they will… eventually. It takes time for input prices on commodities such as corn and wheat to work their way through the supply chain and find their way into a finished good such as a box of cereal. Changes in oil prices are felt nearly instantly as prices at the pump change almost in real time, but they take some time to filter through to savings in shipping and distribution costs. These monthly inflation reports are volatile, but what is more important is the trend. This month’s report was not the report that markets were hoping for, but the trend is moving in the right direction. Just as the reopening from COVID has taken much longer than the shutdown, so too will the unwinding of supply chain disruptions, shipping delays, and employment issues.
Federal Reserve, Interest Rates & Bonds
The Federal Reserve meets next week and, following the inflation report from earlier this week, they are now expected to increase interest rates by 75 basis points. More important than the actual rates (which are a foregone conclusion), however, will be a fresh round of projections and commentary from Fed Chair Jerome Powell. Following next week’s meeting, the Fed meets twice more this year, in November and December. The market is currently pricing a Fed Funds Rate between 4%-4.25% by the end of the year, up significantly since the last inflation report. Interest rates on bonds and mortgages have risen dramatically on the back of these renewed assumptions as interest rate markets have rapidly priced in a higher future interest rate environment. Remember, markets move well ahead of the Fed. As shown in the chart below, bond yields (green line) have already priced where they think the Fed is going, which is higher than the Fed’s last forecast.
Our view – Interest rates have moved materially higher over the past month. In fact, the yield on the 10-year U.S. Treasury is up nearly an entire percentage point, from 2.64% to 3.45%. That is a big move, and almost back to its peak from June. As mentioned above, the bond market is now pricing in a more aggressive Fed. However, in the face of a slowing economy and deflationary pressures in the pipeline, we feel there is a reasonable chance that the Fed will not be as aggressive as what markets have priced in. This could lead to a dramatic swing lower in interest rates on any soft reading for the economy or inflation in the coming months. With bond yields now at multi-year highs and a slowing economic picture, we are more excited about buying bonds than we have been in some time. Investors can now lock in reasonable returns on very safe bonds. You could almost say that we are giddy about bonds at the moment, so please excuse our excitement.
Enjoy your weekend. As a wise man once said, “Every house guest will bring you happiness. Some when they arrive, and some when they are leaving.” We hope this inflation house guest is soon to be departing…
As always, please let us know if you have any questions or concerns, or if we can provide assistance with any other financial planning matters including education, taxes, insurance or estate needs.