A close look at this week’s trending topic

US inflation falls, but still a long road ahead

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A drop in US consumer price inflation in July has supported risk assets. The S&P 500 recorded its fourth straight week of gains last week. But with the Federal Reserve still wanting to see compelling evidence that inflation is falling before adjusting its stance, we maintain a cautious approach, tilting our equity exposure toward value and defensive sectors.

The S&P 500 rallied 3.3% last week after US inflation data for July came in lower than expected. The index is now only down 10.8% from its all-time peak set in January, and is up nearly 17% from its June low.

Following a sharp drop in gasoline prices, US headline consumer prices were flat month-over-month in July, compared with consensus forecasts for a 0.2% increase after a 1.3% rise in June. Year-over-year, headline CPI rose by 8.5%, which was lower than consensus estimates of 8.7% and down from 9.1% in June.

The expected pace of further rate hikes by the Federal Reserve was scaled back in response. Futures markets are now pricing 5 basis points less in tightening by December. The yields on 2-year Treasuries dropped by 3bps and the 10-year rose by 6bps, resulting in a less inverted 2-year/10-year yield curve (currently –40bps). The Dollar Index (DXY) fell 0.7% on the week.

The details of the CPI report also point to moderating inflation. Food prices rose 1.1% month-over-month, partly offsetting the drop in gasoline. But stripping out volatile food and energy, core CPI rose by 0.3% month-overmonth, down from 0.7% in June, leaving the year-over-year rate unchanged at 5.9% in July. Core CPI had been expected to tick higher after declining for the last three months.

The inflation data is an encouraging move in the direction of our softlanding scenario. Around 30% of the items in the CPI basket showed monthly declines, more than in recent months, including car and truck rentals (–9.5%), airfares (–7.8%), and gasoline. Gas prices and airfares have fallen further so far in August, suggesting that the CPI could be around flat again next month. The US producer price index also fell by 0.5% in July, its first monthly decline since April 2020.

But we continue to recommend a relatively cautious approach.

The Fed is data dependent but will want to see more before pivoting policy. Investors priced in a less aggressive Fed hiking cycle into rates, but officials have pushed back against the idea of an early policy pivot. After the CPI release, Chicago Fed President Charles Evans said that inflation remains “unacceptably high” and that he still expects the Fed to increase rates for the rest of this year and into 2023.

Given the next Fed meeting is not until 21 September, investors should not overreact to a single data point. We need to remember that inflation remains far above the Fed’s target, and even the lower-than-expected 0.3% rise in core CPI was too rapid for policymakers to consider pausing the rate hiking cycle. Further, the CPI measure of rents is a lagging indicator that, in our view, still has some catching up to do. This is likely to keep the monthly core inflation numbers elevated for some time.

The Fed’s favored inflation measure is core PCE and chair Jerome Powell has said that the Fed is looking at quarter-on-quarter trends. So, if we get three months of 0.2% core PCE month-over-month, that would equate to a quarterly rate of 2.4% on an annualized basis, which would be consistent with the Fed’s average inflation target. In comparison, core PCE rose 0.6% month-over-month in June after a 0.3% rise in May.

We still expect the Fed to raise rates by at least 50bps at the September FOMC meeting and to continue hiking through year-end. Investor attention now turns to the Jackson Hole Economic Symposium from 25–27 August for any signs of a potential shift in the Fed’s thinking.

It’s uncertain whether the labor market can be balanced without a recession. The US labor market is currently characterized by historically high vacancy rates and historically low unemployment rates (3.5% in July). According to the Fed, bringing the vacancy rate down from 6.8% to 4.6% would be consistent with a less than one percentage point increase in unemployment. Recent labor market strength—nonfarm payrolls expanded by 528,000 in July—has bought the Fed time by pushing the start of a potential recession further into 2023 and widening the runway for a soft landing. But it remains uncertain whether this can be achieved in reality and what the second-order impacts of rising unemployment would be on consumer spending and risk assets.

How do we invest?

With continued ambiguity about the direction of the economy and Fed policy, we reiterate our view that this is not the time to make big directional calls on the market and to maintain a neutral tactical stance on equities.

Investors should look to build a robust portfolio that can perform well in various outcomes. We continue to prefer value stocks, including global energy and the UK market. Select hedge fund strategies can help insulate portfolios from volatility. Investors can also manage portfolio volatility with defensive equity exposure via global healthcare or quality income stocks; selective fixed income exposure including high grade bonds; and, in currencies, through the Swiss franc.

The US dollar fell across the board in an initial reaction to the CPI, and the Swiss franc was one of the beneficiaries. However, we still think the potential for USD strength versus the euro and British pound remains intact. Our forecast for a weaker euro and sterling is based on concerns over energy supply shortages and political uncertainty in the Eurozone and the UK, which will remain an issue in the coming months.

Questions for the week ahead

Will US economic data further allay slump fears?

Strong job growth and falling inflation have helped ease recession concerns in recent weeks. But sentiment can shift rapidly. As investors continue to assess the overall health of the US economy, July’s retail sales, industrial production, housing starts, and existing home sales data will offer further insights.

Can the tech rebound continue?

So far in August the MSCI ACWI growth index has gained 4%, while the equivalent value index is up 3%. We see headwinds for the more cyclical areas of tech and maintain our preference for value over growth.

Will Chinese equities turn the corner?

Chinese stocks have lagged global equities amid concerns about the country’s property sector. Credit growth has slowed by more than expected, and recent economic activity data also came in below expectations, prompting the People’s Bank of China to cut a key policy interest rate. With some signs of a stabilization in the property crisis, investors will be watching to see whether Chinese equities can find a bottom.

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