Stocks tumble on higher than expected consumer price data

In Wall Street, the only thing that’s hard to explain is next week. – Louis Rukeyser 

Heading into last week, expectations were high that the inflation data would be favorable and that prices had peaked and were beginning to decline. Those hopes were dashed on Tuesday, however, when the August core consumer price index (CPI) that excludes food and energy prices was much higher than expected as costs for food, shelter and medical care services increased and offset a sharp drop in gasoline prices. The monthly gain in the core CPI reading was double the forecasted increase and, as a result, the major stock averages suffered their worst day since June 2020. The technology-laden Nasdaq Composite Index plunged 5% and proceeded to lose 5.5% for the week while the S&P 500 Index tumbled nearly 5% by week’s end, effectively erasing the previous week’s gains and then some. The bad news only confirmed the inevitable belief that the Federal Reserve will raise the federal funds interest rate by 75 basis points (a basis point is one hundredth of one percent) when it convenes this week. The bond market also seems to agree with this scenario as the yield on the 10-year Treasury rose to 3.45% while the 2-year Treasury yield climbed to 3.85%, its highest level since October 2007.  Mortgage rates on 30-year loans also increased last week and now top 6%, making it difficult for prospective homebuyers to afford the purchase of a home. Unfortunately, the hotter than anticipated inflation data wasn’t the only bad news that investors received last week. On Friday, FedEx, the large transportation, e-commerce and package delivery company, preannounced that its earnings were much weaker than expected and the company withdrew its full-year guidance as global shipment volumes had significantly worsened. The CEO cited particular weakness in Asia and Europe for the company’s troubles.  The price of the stock plummeted and the rest of the market declined in sympathy on fears that other companies would also be affected by slowing economies around the world. The worry is that downward corporate earnings revisions for next year could increase as the Fed continues to tighten monetary policy to reduce inflation and economic growth stalls.

Last Week

The producer price index (PPI) in August fell slightly and was in line with estimates, rising 8.7% on a year-over-year basis, the lowest increase since August 2021. Import prices in August also fell but not as much as expected while August industrial production posted a modest decline. August retail sales were better than forecast due to a healthy increase in automobile sales and weekly jobless claims were favorable, declining by 5,000 to 213,000. The University of Michigan consumer sentiment index in September edged slightly higher as inflation expectations eased.

For the week, the Dow Jones Industrial Average fell 4.1% to close at 30,822 while the S&P 500 Index dropped 4.8% to close at 3,873. The Nasdaq Composite Index lost 5.5% to close at 11,448.

This Week

August housing starts are forecast to match the number in July while existing home sales are expected to be about 100,000 fewer than in the previous month. The Leading Economic Index for August is expected to increase slightly after falling for five straight months, a sign that the risk of a recession is rising.

The Federal Open Market Committee (FOMC) is widely expected to raise the federal funds rate by 75 basis points, especially after the most recent strong jobs report and the higher than expected consumer price index in August. The Bank of Japan (BOJ), on the other hand, is expected to leave its benchmark interest rate unchanged at negative 0.1%, where it has been since early 2016.

The most notable companies scheduled to report second quarter earnings are AutoZone, General Mills, Costco Wholesale, Darden Restaurants, Accenture, FedEx, KB Home and Lennar.

Portfolio Strategy

If there is a silver lining to the carnage in the stock and bond markets last week, it’s that short-term bond yields have risen to a level that offers investors a decent income stream compared to a year ago. At that time, a 2-year Treasury Note had a yield of just 0.21% and only 1% as recent as January. As of Friday, the same 2-year Treasury has a yield of approximately 3.9% and could eclipse 4% soon as the Federal Reserve continues its aggressive policies to stem the tide of rising inflation. It’s almost certain that the Fed will raise the federal funds rate by 0.75% this week and additional rate hikes are expected in November and December. The current range for the fed funds rate is between 2.25% and 2.50% and by the time the Fed completes its rate hiking cycle, the rate could peak at 4.5% or even slightly higher. The yield curve, or the difference between short-term bond yields and long-term bond yields, is currently inverted with the 2-year Treasury yield of about 3.9% higher than the 10-year Treasury yield of 3.45%. In other words, investors are not being rewarded for holding longer-term bonds as the yields are lower and the duration risk, or sensitivity to higher rates, is much higher. For this reason, investors would be wise to consider very short-term bond funds or exchange-traded funds (ETFs) for positive total returns as their yields are now high enough to weather any price pressures caused by higher interest rates. Two such ETFs are the JP Morgan Ultra-Short Income ETF (JPST) and the Vanguard Ultra-Short Bond ETF (VUSB). Both funds invest in U.S. government bonds, investment grade corporate bonds, mortgage-backed securities and commercial paper that provide current income with minimal interest rate sensitivity and have very little risk. JPST has a current yield of about 3% while VUSB yields 3.3% and both funds have an average maturity of approximately one year. These funds are only down about 1% this year compared to low double-digit losses for intermediate bonds and losses of 20% or more for long-term bonds.