Hotter Inflation Scorches Investor Sentiment

Markets

Friday saw a significant downturn in US markets as concerns over inflation and geopolitical tensions once again torched investor sentiment on Wall Street. The broader decline was exacerbated by a notable drop in major bank shares, further weighing on market performance.

US consumers expressed heightened inflation worries in Friday's Michigan Sentiment Survey poll release. Expectations for inflation over both short and longer horizons increased, with the crucial five-year point reaching 3% at the upper end of the range. This latest inflation overshoot is concerning, especially considering its impact on Federal Reserve policy decisions.

Similar occurrences in the past, such as the overshoot in five-year University of Michigan inflation expectations in June 2022, prompted the Fed to implement 75 basis points rate-hike increments. Make no mistake, this indicator plays a significant role in shaping Fed actions and monetary policy.

As investors increasingly interpret the landscape as signalling no cuts in 2024, markets are losing one of their key stabilizers; fortunately, the concept of rate hikes has yet to permeate the market lexicon.

Moreover, with consumer sentiment likely to weaken amidst the backdrop of a contentious election year, where persistent inflation may play a pivotal role in voters' decisions, stocks could soon lose another vital support: a robust US consumer base.

The recent string of concerning indicators prompts caution in both eastern and western markets. With China's consumer prices flirting with deflation and a dismal set of trade figures released by Beijing on Friday, including a nearly 8% drop in exports, it's wise to shelf bullish China and US calls for the time being.

Despite China Watchers’ attempts to attribute the March trade swoon to the holiday seasonal effects in January-February, the overall picture remains concerning. While exports showed a slight increase of around 1.5% for the whole quarter compared to the same period in 2023, this improvement is tempered by the fact that exports fell in Q4 compared to the final quarter of 2022.

Although volumes reached a new high, boosted by a remarkable 24% year-on-year surge in Chinese car exports during Q1, the contraction in export values alongside increased volumes suggests that China is resorting to price cuts to stimulate sales. This strategy, particularly evident in highly "competitive" sectors such as EVs and solar panels, is raising eyebrows in the US and Europe.

Furthermore, the weak import performance highlights Xi Jinping's challenges in addressing a persistent domestic demand slump. At the same time, China's ongoing overcapacity issues feed into bargain-basement export prices.

 

Week In Review

Equity markets faced headwinds this week, grappling with a challenging U.S. inflation report that tempered expectations for interest rate cuts. The S&P 500 declined by 1.6%. Additionally, the market sentiment was smacked by a mixed bag of early bank earnings reports, adding further pressure towards the end of the week.

The U.S. March CPI report painted a concerning picture, particularly with shorter-term inflation indicators signalling a worsening trend. Headline inflation accelerated to 3.5% year-over-year from the previous month's 3.2%, while core inflation remained stubbornly high at 3.8% year-over-year, surpassing expectations. Shorter-term metrics indicate a troubling trajectory, with 6-month core inflation now at 3.9% annualized and 3-month core inflation even higher at 4.5% annualized. The 3-month annualized 'supercore' inflation rate soared above 8%, highlighting significant inflationary pressures.

These inflationary signals dampened expectations for rate cuts, prompting a market reaction characterized by higher yields and lower stock prices. Consequently, Federal Reserve easing expectations have been pushed further out, with a full rate cut now only priced in by September and less than 50 basis points total for 2024.

Needless to say, this is not the stuff that stock market rallies are built on; hence, investors reacted with their feet and exited stage left.

 

FED Policy Throughput

The Fed's monetary policy has been akin to a space launch on hold since last July, waiting for concrete evidence that inflation is on a sustainable path back to target before initiating rate cuts. However, with the latest inflation indicators painting a concerning picture, there's a risk that the Fed's easing mission could be shelved altogether.

U.S. equity markets have been buoyed by the anticipation of resilient economic growth, subsiding inflation, and decreasing interest rates, all of which have contributed to inflated valuations and earnings. However, the unpleasant CPI report for March underscores that the spike in consumer inflation witnessed in January and February was not a temporary anomaly but rather a troublesome resurgence of cost pressures since the preceding fall.

Macroeconomists are once again embroiled in heated debates regarding the true level of the neutral fed funds rate. Is it still hovering around 2.6%, as the latest dot-plot indicates, or could it be substantially higher, possibly closer to 4.0% or 4.5%? If the neutral rate is indeed much higher than the FOMC currently perceives, it raises questions about the efficacy of current monetary policy measures in curbing inflation.

The inflation problem is becoming increasingly difficult to overlook, with worsening consumer inflation trends since the start of the year catching the attention of all market observers, including the Fed. The central question now is how patient a data-dependent Fed can afford to be before its credibility comes under fire, especially considering the scrutiny it faced in late 2021 when it downplayed the inflation spike as "transitory." Of particular concern is the climb in the “supercore” measure of CPI inflation, which excludes energy and housing. Over the last three months, this measure has been rising at an alarming 8.2% annualized pace, compared to a relatively stable 4.8% over the past twelve months.

Given that 2024 is a presidential election year, the Fed's actions, or lack thereof, and the fluctuations in consumer inflation month-to-month will be scrutinized and criticized for political gain.

If “hot” inflation isn’t enough to unsettle you, equity valuations at these levels look far more precarious amid increasing inflation and possibly no rate cuts in 2024.

The recent surge in Treasury yields is sounding the alarm on the Goldilocks illusion that the markets have been enjoying. With yields climbing back to levels not seen since the "higher for longer" era of September, before inflation took a downturn, the fixed-income markets are signalling a shift. This uptick has already pushed 30-year mortgage rates above 7.0%, posing a threat to home sales and housing affordability.

What's the impact on the growth outlook? So far this year, growth prospects have been tilted towards the upside, buoyed by a resilient consumer and labour market. However, the prospect of higher interest rates for an extended period is likely to exert downward pressure on consumer spending, business investment, housing, and labour markets.

 

Charts Of The Week

Over the last 2 days, over 900k TLT puts have been traded, which is the highest 2d volume ever. - Goldman Sachs

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The median monthly U.S. housing payment hit an all-time high of $2,747 during the four weeks ending April 7, up 11% from a year earlier. Housing payments are soaring because home prices and mortgage rates are high.

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In contrast to the US, China's March headline and core CPI were much weaker than expected. Core CPI fell back to 0.6% yoy from 1.2%! The US has stoked demand and inflation with fiscal stimulus, but China has fiscal issues, causing a Fitch downgrade.

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