Over the last week, the S&P 500 (SPY) is down by 2.5%, although we are down by more than 5% from Monday’s close. Monday seems like a long time ago given that the S&P 500 was above…
4,100 and looked set to keep rising if the inflation number came in soft. There were also reasons to expect inflation to continue the trend from July showing a weaker number.
This was due to lower commodity prices and weakness in terms of leading indicators for inflation.
Some areas did show lower prices like gasoline and vehicles, but other areas continued to show rising prices like services and rents. And, these are notably the areas that correlate with ‘sticky’ inflation which is exactly what the Fed wants to avoid.
The hot inflation print was enough to wipe out all of the gains from the past week. Sometimes, the market can overreact, but I don’t think this is one of those times given that falling inflation is essential to any bull case as it brings with it relief on the rate front and a boost to margins.
On the other hand, inflation plateauing at these high levels means that the Fed is going to stay hawkish and pursue a restrictive level of monetary policy for longer.
In fact, the debate has shifted for the next FOMC meeting. Prior to the CPI report, the debate was about 50 basis points or 75 basis points. Now, it’s between 75 and 100 basis points.
Last week, I felt that the bullish and bearish forces were at equilibrium. This shifts the dynamic in the bears’ favor as it reduces the strength of the bullish tailwind of falling inflation and leads to a more hawkish Fed for longer.
If we parse the Fed’s words, then it could be said that 2 months of lower monthly inflation could lead to the Fed slowing down its hiking. The 0.6% monthly core CPI gain resets the clock.
The overall economy and earnings picture has been remarkably resilient. Earnings grew 6% in Q2 and are expected to grow about 5% in Q3. But, these figures were not calculated with the assumption of higher rates for longer.
Just one more note on this. These rate hikes end in 2 ways – either inflation breaks before the economy does or inflation breaks and the economy breaks.
The former scenario can’t be discounted as it’s exactly what’s happened this year, but I think the odds of the latter scenario have sharply risen.
Strategy
If we had gotten a ‘good’ inflation print, I think we could be re-testing the August highs of 4,300. A bad reading and our next major test will be the recent mid-June low at 3,600.
Given this, we are once again, shifting to a more defensive strategy and will be looking to use pockets of strength to reduce exposure.
On the long side, we will continue to identify fundamentally strong stocks for long-term ownership and short-term, low-risk setups. But, the larger focus will be on preserving our firepower when more offensive tactics will be rewarded.
Market Topics
Now let’s do a review of some important market topics…
Energy: We are seeing continued weakness in oil and energy prices. However, there are some attenuating circumstances.
For one, the US is a seller of oil as it is selling off a portion of its strategic petroleum reserve (SPR), and China’s economy continues to operate at full capacity, which is hurting oil demand.
So, this is a positive…
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