Markets wrestle with growth versus Inflation
The odds on a Fed rate cut in September reached almost 100% this week. Stocks climbed to new highs. Irrational exuberance permeated the markets. And then the Producer Price Index (PPI) for July was released.
To say the results were “hot” would be an understatement. Business inflation rose 0.9% over the prior month compared to Wall Street forecasts of 0.2%. On an annual basis, prices rose 3.3%, the most since February. If you strip out food and energy, core PPI hit a three-year high. So much for the government’s contention that tariffs are not inflationary.
Wall Street bulls had believed the administration’s no-inflation line for months. After all, there has been more than enough time (since April’s Liberation Day) for inflation to show up in the numbers. The opposite happened. Inflation has declined moderately over the last three months.
What investors failed to realize is that all of those threatened tariffs were postponed, reduced, or forgiven by Trump until recently. The 10% across-the-board tariffs, plus some of the tariffs on specific sectors such as aluminum and steel, are only now showing up in the PPI.
The truth is that American businesses have swallowed more than 64% of these tariff costs. The impact on profits won’t show up until the end of the third quarter. At some point soon, corporations will need to pass on any further tariffs to the consumer.
I suspect that investors will start to discount that in September. What’s worse is that those more recent higher tariffs on countries such as India, as well as those on Europe, Japan, and others, have yet to work their way through the system.
As I mentioned, the markets are convinced the Fed will lower interest rates next month. The combination of the surprise revisions of the non-farm payroll employment data, plus the mounting pressure by the Trump administration to lower rates, has led markets to believe lower rates are inevitable.
The Fed has two mandates: full employment and lower inflation. The markets assume that the weaker employment data over the last three months foreshadow a weaker economy. However, that may not be the case. Congress has just passed an enormous spending bill. That may not only support economic growth but also accelerate it.
That leaves the Fed in a quandary between guessing on the direction of future economic growth and the impact on inflation caused by tariffs. I expect inflation to increase through the end of the year. We may get a hint of what the Fed is thinking next week at the Jackson Hole economic policy symposium on August 21-23.
At any other time, we could expect one more job report before that meeting. Economists are expecting further downside revisions to the jobs numbers when and if it is released. Unfortunately, the president fired and has just hired a new head of the Bureau of Labor Statistics, Commissioner E.J. Antoni.
Trump fired the last commissioner because the employment data revisions did not suit his argument that the economy was doing fabulously. He need not worry about Anton; however, he is a Trump loyalist through and through and a long-time critic of the BLS. He has recently suggested that his department should suspend publishing monthly employment data because of its track record of frequent revisions. Given that background, some wonder how worthwhile the data will be even if it is released.
The hot inflation data caused stocks to fall, but the damage was contained and stocks rebounded. This is a reprise at best in the fight against inflation. I expect to see the PPI data show up in the CPI in a month or two. However, between now and then, markets will stay focused on an expected rate cut. I think the stock market has already discounted that cut so that the bulls will be dependent on the White House for further gains.
I have been waiting for a blow-off top in markets, which has yet to occur. If it does, my upside target on the S&P 500 Index is around 6,550-6,570. The most recent American Association of Individual Investors (AAII) poll shows bearish sentiment outweighing bullish sentiment by 16%. That is a positive indicator for the markets from a contrarian point of view.
Remember that markets are way beyond extended at this point. Speculation is rampant, but fund flows are still streaming into the equity markets. Stay invested but be cautious. Let things ride, but don’t add to positions.
Bill Schmick is a founding partner of Onota Partners, Inc., in the Berkshires. Bill’s forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners, Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at billiams1948@gmail.com. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal.