All too easy – vigilance is the key

If you look at equity markets in particular, you’d think everything smelled of roses. For the 47th time this calendar year US indices have made record all-time highs and 46 times at record closing highs. Earning season is underway and so far, it is doing what it always does, which is beating the Street 75 percent of the time.

Banking, Tech and industrials are the standouts. And even when you look at the 493 non magnificent 7 stocks on the S&P 500 the gap between the seven and the rest is finally starting to close up. 

So all is well at least that’s how it appears.

However over the next 20 days the risks that are facing global markets cannot be understated. First and foremost is the US presidential election. As we point out in our US 2024 election specials, the margin between Trump and Harris has never been closer. In fact, most probability markets now have Trump ahead. Predictit for example, Trump leads by three points and on RealClearPolitics it’s even larger sitting at 10.8 points.

Most of the key states or swing states are statistical dead heat but on average Trump is now ahead by 0.2 at 47.7 to 47.5. Whichever way you look at it, whoever wins on Election Day, it will lead to disputes and the other side is unlikely to accept the result. The political upheaval will filter through into markets, and we need to be ready for that.

What has also been lost in geopolitics and the incredible run in equities is movements in the bond market and the risks around US inflation. And it is this that we need to take a closer look at.

Trends and Key Drivers in US Inflation

Blink and you will have missed it, the back end of the USU curve is back above 4%. This is down to several risk factors, The US presidential election being one, employment being another, and then the big one inflation rearing its head in September.

There was an unexpectedly strong rise in CPI inflation for September. So is there some going on here or is it just a false flag?

First things first – Core PCE inflation continues to trend at a consistent pace of approximately 2 per cent on an annualised basis. This suggests that inflationary pressures, while present in some sectors, remain largely in check but risks remain. 

So what are the keys here?

Key Factors on the Inflation Outlook:

1. Core CPI Outperformance and PCE Expectations:

September’s core CPI surprised with a 0.31per cent month-on-month (MoM) increase, surpassing consensus forecast of 0.25 per cent. While this unexpected rise is noteworthy, the details of the PPI (Producer Price Index) data suggest a more moderate increase in core PCE inflation, estimated at 0.21per cent MoM for the same period. 

The issues in the inflation figures however remain in components such as shelter and insurance, which had been driving much of the previous increases, with weather events and housing price volatility expect inflation fluctuations here to persist in the near term.

The upward surprises in the headline CPI data were concentrated in volatile categories like apparel and airfares. Airfares, for instance, rose by approximately 3 per cent MoM on a seasonally adjusted basis. 

2. Wage Growth and Labor Market Dynamics:

The Atlanta Fed’s wage tracker indicated that wages picked up in September, with the unsmoothed year-on-year (YoY) measure reaching 4.9 per cent, up from 4.7 per cent in August. Additionally, the 3-month smoothed measure and the overall weighted average both rose to 4.7 per cent, compared to 4.6 per cent in the previous month. Whichever measure you want to use, real wages in the US are growing at about 2.5 per cent. While this wage growth exceeds the rate typically consistent with a 2 percent inflation target (in the absence of significant productivity gains), it remains only modestly stronger and isn’t a concern, yet. 

It’s worth noting that wage growth may take longer to cool off, particularly given seasonal patterns in early 2024 and the effects of recent labour strikes in sectors like port operations and aircraft manufacturing, both of which have underscored the potential for more persistent wage inflation. 

Interestingly, the Atlanta Fed wage data revealed a sharp deceleration in wage growth for job switchers compared to job stayers. Normally, job switchers see higher wage increases, but over the past few months, the growth rates for both groups have converged. This shift may signal weaker demand for labour and could be a key indicator of wage trends in the coming months. 

However, wages for current employees may lag behind, requiring time to adjust downward, much like how rental prices for new leases often move ahead of existing rents in shelter inflation. 

This dynamic suggests that wage pressures might remain elevated for a time, particularly if companies raise wages for existing employees to catch up with the now-slowing wage increases for new hires. The ongoing wage growth for current employees could also keep hiring demand subdued, as firms may focus on managing costs rather than expanding their workforce only time will tell here.

3. Potential Impact of Hurricanes Helene and Milton:

The inflationary impact from Hurricanes Helene and Milton are yet to be factored into most forecasts and thus it is important to acknowledge the potential for volatility in certain inflation components. 

Historically, hurricanes have primarily affected gas prices by disrupting supply chains. However, there has been only minimal upward pressure on retail gas prices so far. Demand led cost in infrastructure and construction supplies also tend to increase post hurricanes as the clean-up and rebuild takes precedence.

Another major CPI component that has historically shown sensitivity to hurricane-related disruptions is “lodging away from home.” For example, in the aftermath of Hurricane Katrina in 2005, lodging prices initially dropped before rebounding the following month. It remains unclear whether the recent hurricanes will affect hotel or recreational service prices in Florida, which were among the areas impacted. 

September CPI already showed weaker-than-expected data for lodging, and with discretionary spending on services potentially declining, this component could face further downside risks. However, if there is an unusually sharp drop in lodging prices for October, any hurricane-related distortions might result in a bounce-back in November CPI.

This is why we think the market needs to remain cautious on core PCE inflation. Will it stay modestly higher than the Fed’s 2% target over the near term? It’s clearly possible. Then there is the ongoing volatility in certain sectors and potential risks from external shocks like hurricanes mean inflation forecasts could still see adjustments.

All in all we remain vigilant that despite the enthusiasm and bullishness in indices risks are building and traders need to be vigilant.