The S&P 500 had its worst day since March 2020, but don't lose sight of the bigger picture, said Larry Adam, chief investment officer at Raymond James.
The financial markets have had a laser focus on inflation as it has such a huge impact on the prospects of Federal Reserve (Fed) tightening, interest rates and valuation metrics on the equity market. The markets have been constantly recalibrating expectations: easing inflation with the potential ending of the Fed’s tightening cycle versus persistent inflation driving further rate hikes. Today’s 4.3% decline is over the apparent disappointment that the latter scenario is likely. Just as the three-year inflation expectations in the New York Fed’s Survey of Consumer Expectations fell to nearly a two-year low, the August inflation report came in hotter-than-expected and the fears of an aggressive for longer Fed were once again revived as the S&P 500 posted its worst day since March 2020. While market movements such as these are uncomfortable, there are some dynamics to consider.
The shortcomings of CPI calculation
The Consumer Price Index (CPI) captures more than its fair share of media attention, perhaps because it is heavily utilized as a benchmark for public policy and oftentimes is the first inflation reading released each month. Regardless, the methodology behind its calculation is flawed and many economists and market commentators (including ourselves and the Fed) do not believe it is a superior measure of inflation. In fact, in 2013, Federal Reserve Bank of St. Louis President James Bullard wrote about the many reasons why the Fed changed its preferred measure of inflation to the Personal Consumption Expenditures (PCE). In summary, the Consumer Price Index does not account for the substitution of goods (e.g., trading down), has less comprehensive coverage, and does not readily account for shifts in consumer behavior. As a result of these biases, CPI tends to overstate inflation. For example, over the time period of Bullard’s study (January1995 to May 2013), CPI was more than 7% higher than PCE.
One print doesn't make a pattern
This is a phrase expressed by the Fed and we’ve repeated it as we’ve discussed the potential policy path over the past several weeks and months. Today, we will use it again as we explain why this singular CPI reading is not indicative of inflation’s path moving forward – which we believe is still in a downward trajectory. Why? There are a number of real-time indicators that suggest inflationary pressures are easing. The average price of a gallon of gasoline has fallen for over 90 days – the longest streak since 2015. Oceanic freight rates posted their largest weekly decline on record (-14%) and are now down~70% from their recent peak. Elevated inventories have led to an above-average proportion of apparel and footwear on markdown. The Manheim Used Vehicle Value Index has declined for six out of the last seven months. There are even more indicators that we could highlight (e.g., impact of the stronger dollar, falling supply chain bottle necks), but we believe the breadth of evidence supports our view that the pace of inflation will ease in the months ahead.