A word on US Inflation, the Fed’s next move, and the current melt-up

The U.S. headline inflation rate fell to 4.0% in May, which was a bit more than has been projected and which marks the lowest point since March 2021. Meanwhile, U.S. core inflation saw a less-than-anticipated decrease to 5.3% in May. Core inflation has now exceeded 5% for 16 months straight.

A meaningful decline

Shown below is an update of our US Inflation Monitor, following the May Consumer Price Index (CPI) report.

Key Highlights:

  • All six of the 3-month annualized CPI inflation metrics in the Monitor – with the Personal Consumption Expenditures Price Index set for release on the last day of June – declined in May.
  • Excluding Core inflation, the 3-month annualized CPI measures dropped considerably. The average of these six metrics fell to 3.4% from 4.3% the preceding month.
  • Federal Reserve Chairman Powell’s preferred inflation measure in this cycle, Core Services ex Shelter, dropped to 2.9%, marking the first sub-3% level in 19 months.
  • Year-on-year CPI statistics also showed a decrease across the board.
  • Remarkably, the average of the one-month annualized CPI measures stood at 3.0%, still considerably above the Fed’s 2% target. An elevated Core CPI, majorly influenced by high shelter inflation, was again a significant contributor to this.

Our assessment of the latest US CPI reports is constructive, signaling that inflationary pressures are reducing rather quickly. Considering the weak ISM Services at 50.3 and the ISM Manufacturing already under 50, there’s enough leeway for the Federal Reserve to skip the next rate hike.

On the other hand, we also believe that Powell will try to persuade markets that the Fed is inclined towards another rate hike unless there’s a clear deterioration in macroeconomic data and/or inflation expectations.

An effective method to do this is by raising the dots in the incoming dot plot, which is set to be released at the forthcoming FOMC meeting, alongside the most recent staff projections for inflation and GDP growth. The current median dot for 2023 is at 5.125%, which is where we are now (average 5.0% lower bound and 5.25% upper bound.) But should FOMC members also lift the 2024 median dot, this will likely hurt equities. Currently, the Fed Futures price a Fed Target Rate of 3.84% for December 2024.

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Market dynamics

While the most recent inflation data in the US provided further support to the ongoing stock market rally, developments in the bond market indicate that investor sentiment in equities is increasingly driven by animal spirits. Although the 2-year US Treasury yield initially declined by nearly 10 basis points, it ultimately rebounded, finishing 10 basis points higher. These movements failed to significantly impact the equity market. At this point, they couldn’t care less.

But we do! There is no compelling reason to believe that the strong correlation between bond yields and equity market Valuation – as shown in the chart below – has been disrupted.

First, because the 2-year yield is once again approaching the 5% mark, which previously triggered bank runs at several regional banks.

Second, the earnings (E) component of the price-to-earnings (P/E) ratio is at risk. Our latest Monthly Investor Guide reveals that our bellwether earnings-per-share indicator points to a decline of more than 10% in global earnings. This decline occurs at a time when P/E ratios are already elevated, suggesting limited potential for the price in the P/E ratio.

The melt-up

Having said that, we acknowledge the current market dynamics, which should be characterized as a ‘melt-up.’ This means that if the Federal Reserve communicates a message that is interpreted by investors as an imminent end to the tightening cycle, with a likely recession still a few quarters away, both global and US stock markets may continue to push toward new highs.