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Another Roller Coaster Week…

September 18, 2023

“The only investors who do not need to diversify are the ones who are right 100 % of the time.”

Sir John Templeton.

Another roller coaster week with high expectations dashed on the last day. Despite some big moves to the upside, the S&P 500 ended the week with a slight loss of .45%, the Dow Jones Industrial Average was off .07%, and the Nasdaq fell .95%. The good news: the FTSE 100 rose 2.11%, and the MSCI-EAFE was up slightly .03%. The 2-year treasury yield closed Friday at 5.054% continuing the inverted yield curve with the 10-year yield of 4.33%.

So, what happened? The United autoworkers decided to strike, trying a new technique of selective strike location, possible as a response to the rank-and-file practical reality of the inability, due to current middle class personal economic situations, to sustain a prolonged work stoppage.

The inflation number increased, confirming it stubbornness, and not cooperating with the Federal Reserve’s medicine to lower inflation to the 2% target. The consumer price index in August rose 3.7% year-over-year, up from July’s 3.2% pace. More than half of that inflation jump was driven by rising gas prices. “Energy price inflation has been the key driver of the post-pandemic inflation flareup, spilling over into transportation and commodities most directly, and pulling everything else up with it,” writes ZipRecruiter’s Chief Economist Julia Pollak.

Looking ahead: “While today’s worse-than-expected report can be attributed mostly to higher energy prices in August, it still shows that the Fed’s journey to bring inflation to its 2% target is not over and it will take more months of positive data to convince the Fed that it is,” said Eugenio Aleman, chief economist at Raymond James.

However, gas prices weren’t the only culprit. Transportation—including rental car prices and airfares—and motor vehicle insurance costs rose sharply in August. Housing costs also continued to climb, notching their 40th straight month of gains (albeit at a slightly slower pace).

As MarketWatch noted, that’s not great news on the surface, but August price trends fell largely in line with expectations. And there’s some room for optimism. Stripping out the more volatile gas and food prices, the picture becomes a bit better. Core CPI, as it’s known, actually decelerated slightly to growth of 4.3% year over year from July’s 4.7%. Moreover, prices excluding energy and food have only grown at a 2.4% rate in the past three months.

The current trajectory of core inflation makes it unlikely the Fed will increase rates at the Federal Open Market Committee meeting next week, writes BlackRock’s Gargi Chaudhuri. But he cautioned that medium-term inflation risks support the central bank keeping rates higher for longer.

The probability that Fed officials will skip an interest-rate hike next week increased to 97% this afternoon, according to the CME FedWatch Tool. That’s up from 92% on Tuesday. The odds of rate pauses extending into November and December were also up slightly on the CPI news.

More unsettling news… The University of Michigan consumer sentiment index turned negative and the whole sale producer prices rose.

Recent weakness in the U.S. stock market is likely to persist over the near-term, according to Wall Street’s most bullish strategist, who still thinks the S&P 500 is on a path to a record high this year.

John Stoltzfus, chief investment strategist at Oppenheimer Asset Management Inc., in late July projected the S&P 500 would rise above 4,900 by the end of 2023. That is the highest price target for the large-cap index among 20 Wall Street firms surveyed by MarketWatch in August.

It implies the S&P 500 would rise above its earlier closing record high of 4,796 reached on Jan. 3, 2022 by the end of the year. The path up, however, could get bumpy.

“Bullishness [in the stock market] is relatively high while the Fed remains shy of its inflation target,” said a team of Oppenheimer strategists led by Stoltzfus in a Sunday note. They also said, “we persist in suggesting that investors curb their enthusiasm [in the stock market] for a long rate pause or even a rate cut and instead right-size expectations.”

However, Stoltzfus doesn’t see current headwinds for stocks as something that would prevent the S&P 500 from achieving his team’s new peak target.

Meanwhile, a key Wall Street volatility index also pointed to “some choppiness” in the stock market in the near term to keep investors on their toes, said Stoltzfus. The CBOE Volatility Index VIX, at a level of 13.82 on Monday, hovered around its 12-month low and traded about 30% below its one-year average level of 19.9, and 37% below its two-year average of 21.88 (see chart below).

Expectations that the Federal Reserve is nearing an end to its current interest-rate hiking cycle, as well as optimism around artificial intelligence boosted the U.S. stock market in the first seven months of 2023. However, the rally came to a brief halt in August as investors worried the Fed could be forced to keep rates elevated as a batch of stronger-than-expected economic data and rising oil prices fueled concerns that still-sticky inflation would mean that borrowing costs will stay higher for longer.

On the flip side…

Erik Knutzen, chief investment officer of multi asset, worries that several factors could be a tipping point for the economy, from an economic slowdown in China to U.S. consumers finally becoming exhausted by higher rates.

Yet, Knutzen expects the high-yield, or junk bond, market to serve as the “canary in the coal mine” for broader market volatility, acting as “perhaps the most visible threat, and therefore one we think could be priced in sooner than later.”

The Bloomberg U.S. High Yield Bond Index has returned 6.4% through the end of August, producing one of the year’s highest gains in fixed income, helped along by a “resilient U.S. economy coupled with still-available financial liquidity,” according to the Wells Fargo Investment Institute.

But Knutzen worries that as the high-yield maturity wall draws closer, “the first policy rate cuts get priced further and further out, raising the threat of expensive refinancings.”

Top corporate executives appear hopeful that the Federal Reserve will cut rates sooner than later. Fed Chairman Jerome Powell said in Jackson Hole, Wyo., in August that the central bank is prepared to keep its policy rate restrictive for a while to get inflation down to its 2% target.

The economy is still uncertain, and no one can say what will happen to prices next — 18 months into the Fed’s inflation fight, that fear has been muted but not extinguished. Sure enough, it was front and center again today, as investors braced for the monthly consumer price index No Free Lunch. Stocks took in stride the news that headline inflation rose for the second consecutive month in August driven by higher prices at the pump.

As such, we remain convinced the economy is less than strong and the markets’ optimism warrant caution and therefore we will remain defensive.