Inflation, Rates and Market Movements

We have seen some more significant sharemarket moves this week and discuss below.

What happened?

US inflation rose again in May, increasing 8.6% from a year earlier and 1% from a month earlier. Shelter (rent), food, and gas were the largest contributors, but there was a fairly broad-based advance from most sub-components.

Core inflation, stripping out more volatile food and energy components, increased 6% from a year ago and 0.6% from the prior month.

Both came in above forecasts, and in contrast to recent talk that inflation may have peaked. This saw investors fret about faster and larger Fed rate rises than previously expected.

Why did it happen?

Record petrol prices, along with rising food and shelter costs, have been fueled by excess demand due to fiscal indulgence and monetary settings that were too loose for too long, along with supply shortages originally fueled by covid policies, Ukraine/Russia related supply issues including the effects of sanctions, and more recently Covid-zero policies in China.

What does it mean?

The higher inflation number implies that the US economy is running too hot and may have to be slowed with faster and larger rate rises than previously expected, which then raises the risk of a recession if the economy cools too fast.

The US Fed (Federal Reserve) has made it clear that it is highly likely to raise rates by 0.50% at each of its next two meetings to take the Fed funds rate to 2%, whilst the market is implying another 0.50% hike in September as well. There’s also been talk of 0.75% rate rises, which may be more unlikely.

Rising costs are dampening consumer confidence and sentiment as rate rises impact current and future demand whilst rate rises do little to help surging global commodity prices and structural changes in the way people spend and live post-covid.

In the last 5 days, bonds are down around 2.5%, global equities are down 5.2%, Australian equities are down 8.3%, whilst Australian listed property is down 11.5%.

This reaction appears to be overdone given the Fed had already made clear it would likely raise rates at the next two meetings by 0.50% and given the neutral Fed funds rate (i.e. the neutral setting between loose and tight settings) is likely to be between 2.0-2.5%. This path just gets them there faster, but it does increase the probability of a policy error, which is why the market has turned its attention to recession.

In the very short-term, this means added risk. But for those with a medium to longer term view, it means opportunity. For those fully invested, there’s no need to panic, as company fundamentals look sound. For those with money to invest, doing this progressively or ‘chipping away’ while prices are lower remains appropriate.