Since our last update, the market has continued to show volatility as sentiment shifts based on new economic data. Markets are particularly focused on signs of moderation in inflation, as this largely determines the path of interest rates and thus prices for a wide variety of assets. So far, the Federal Reserve has seen signs that their restrictive policy is having its desired effect, however not in the magnitude nor as quickly as they had hoped. As a result, markets have shifted from being optimistic that the rate hikes may soon come to an end to thinking rates may have to go higher and for longer than initially anticipated.
While the latest CPI print at 8.3% is below the June high of 9.1%, the pace of the decline has certainly been slower than markets had hoped. Falling oil prices have contributed to a sharp decline in gasoline prices, but prices in other areas like food, healthcare, and rents have remained higher. This is largely a function of the supply side nature of the current inflation, meaning that the extra time needed to bring products to market are still squeezing producers even as demand drops. The housing market is a good example, with the increase in mortgage rates causing a sharp drop in demand but with prices yet to move meaningfully lower due to lack of new supply. As builders catch up, prices may start to fall, but in the meantime, more would-be homebuyers are crowding the rental market and pushing up rents.
Similar dynamics are present in agriculture where, for example, the Ukraine war has constrained the global grain supply. While recent Ukrainian gains have stabilized farming and accelerated shipments out of the country, the output is still well below where it was before the war. Avian flu has caused similar drops in the supply of eggs and poultry, with other staples squeezed by worker shortages. Indonesia, a major exporter of cooking oil, reduced exports earlier this year to quell domestic protests, which has fed into a variety of product prices.
While we still see a wide range of outcomes, there are some reasons to believe inflation may trend downward, eventually giving the Fed the confirmation needed to slow rate hikes. For one, labor market tightness is finally showing signs of easing. The unemployment rate has ticked up as higher wages attract more people into the labor force, and the number of job openings continues to moderate as employers slow the pace of hiring. Having a more fluid labor market with gradual wage gains is a critical component of achieving price stability.
Elsewhere, newly signed rental agreements suggest a future softening in rents, with buyers in the housing market finally gaining some negotiating power, which could help bring prices down and free up rentals. Certain technical factors, such as the method for calculating health insurance, could also contribute to a moderation of the official figures in the coming months. Should these factors manifest, it would corroborate consumer surveys and market-based measures which are showing longer-term inflation expectations moderating. On the flipside, wildcards such as labor strikes and the continued persistent supply chain shortages could undermine these trends.
While this dynamic remains in the driver’s seat, earnings will soon come back into focus for the 3rd quarter. Critically for the market will be whether the slowing demand causes a hit to the bottom line, or whether companies can continue to beat expectations as they’ve been doing for the last year, albeit at a declining rate. There is a stark divide on Wall Street on this question, with some calling for a decline in margins to catalyze a further selloff, while others believe the still healthy consumer spending and passing on of costs will adequately protect nominal profits.
With stocks now significantly cheaper, markets are ripe for repricing should reality come in materially different than expectations. Stocks sold off into 2nd quarter earnings for example, only to rally strongly once results came in better than feared. That dynamic could repeat itself, or alternatively, companies may start to see the bite of lower demand, which in turn would likely drive the market lower but in the process create attractive buying opportunities.
You can be confident that we will continue to monitor these developments very closely. The volatility this year, while not ideal, has opened the door for us to acquire some assets which we believe will add value in portfolios over time, and we continue to remain ready on act on other high-quality assets should the opportunity present itself.