Looming inflation report could hold an unpleasant surprise for markets

Published Mon, Aug 7 20232:12 PM EDTUpdated Mon, Aug 7 20233:54 PM EDT

Wall Street's newfound faith in a soft landing faces a big test later this week with an economic report that could paint a deceptively benign inflation picture. The consumer price index, a widely followed gauge of goods and services costs across the U.S. economy, is expected to show a 0.2% increase in July, according to the Dow Jones consensus estimate. That would translate into a 12-month headline increase of 3.3%. However, the risk on that reading could be to the upside if a tracking measure the Cleveland Federal Reserve uses is accurate. The central bank district's Inflation Nowcast model points to a 0.4% rise that would equate to a 3.4% annual rate. While the 12-month figure would be a good deal below the 8.5% pace of a year ago , it's still well above the Fed's 2% annual target. "The financial markets would not welcome those numbers the way they did June's lower-than-expected CPI results," Ed Yardeni, president of Yardeni Research, wrote over the weekend. "Lots of commentators would opine that inflation no longer may be moderating but turning 'sticky.'" The discrepancy between the consensus about the future and fluctuating data is part of a larger debate on the Street over whether the economy can skirt a recession. On one side such heavyweights as Goldman Sachs, JPMorgan Chase and Bank of America now think the chances are that the U.S. will avoid a contraction . On the other side, experts at Morgan Stanley and Citigroup contend that the recent easing in inflationary pressures is hiding underlying factors that will pressure the Fed's policymaking response and could challenge investors who have been enjoying this year's red-hot stock market run. Three challenges to low inflation "While economic and corporate profit resilience have certainly surpassed our estimates, we worry about whether markets have become complacent, pricing out the potential that 2023's perfect planetary alignment could face obstacles," Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, said in a client note Monday. Shalett noted the firm is "unconvinced" by the Wall Street bull scenario, in which inflation glides down to the Fed's target, leading to interest rate cuts, no recession and a windfall for corporate profits. At the heart of Morgan Stanley's position is worry over three factors that could get in the way: a weakening consumer, a reversal of liquidity as the central bank continues to drain its balance sheet, and a vanishing fiscal boost as government-spending increases slow and student loan payments come due. "Tailwinds may turn into headwinds as consumer savings run down, fiscal spending decelerates and global liquidity shifts," Shalett wrote. To be sure, some of the signs of decelerating inflation pressures have a foundation. Primarily, high-frequency indicators are pointing to declines for rents and used vehicles, two key ingredients in the inflation surge that began in 2021. "Rent could be an important source of a positive (moderating) surprise in July's CPI," Yardeni wrote. 'Sticky' inflation persists But inflation has proven more persistent than most policymakers, particularly those at the Fed, would have thought. Chair Jerome Powell has repeatedly expressed a commitment to keep policy tight until there are more signs of easing. That's primarily because the prices for "sticky" goods and services have been, well, sticky. In fact, the Atlanta Fed's sticky CPI is still at 5.8% on a 12-month basis — though 2.9% at an annualized pace — after peaking at 6.7% earlier this year. Moreover, Thursday's core CPI reading is expected to show core inflation running at a 4.7% annual level, just a tad below the June reading. Also, the Cleveland Fed tracker sees CPI heating up even more in August, with headline projections now at a 0.6% and 3.9% respective levels for monthly and annual levels. One factor that could feed additional inflation pressures is rising compensation costs, according to Citigroup economist Andrew Hollenhorst. "Basic macroeconomic theory suggests that wage growth will remain strong or even accelerate so long as labor markets remain unsustainably tight," Hollenhorst said in a client note Monday. "That is happening in the data as average hourly earnings have advanced at a faster than 5% annualized rate in three out of the last four months." "It also seems consistent with recent organized labor actions that have succeeded in securing similarly large wage increases, in some cases for several years to come," he added. The rising wages "should be raising concerns about entrenched inflation, not alleviating them. This is exactly the mechanism through which an inflationary episode thought by some to be 'transitory' can become more persistent," Hollenhorst said. Markets expect the Fed will skip a rate hike at September's meeting and probably hold rates at current levels until the spring of 2024. However, UBS strategists are advising clients to step lightly in anticipating that the Fed can declare victory on inflation anytime soon, particularly as key data points like the July CPI reading and additional nonfarm payrolls reports loom. "Against this uncertain backdrop and with rate cuts still a distant prospect, in our view, we expect a challenging outlook for US stocks and advise investors to focus on parts of the market that have lagged," said Solita Marcelli, UBS Chief Investment Officer Americas.