The end of the tightening cycle is nigh
The decline in the US inflation rate to more than a two-year low, marks a major step towards the end of the Fed’s historic monetary tightening cycle1. We believe key deflationary forces are in play – (1) weaker commodity prices (2) improvement in global supply chains (3) moderation in demand (4) lower inflation expectations. Therefore, the June decline in inflation is just the start of a series of decreases.
Softer than expected inflation report
As highlighted in the chart below, the details for June were also better than expected with key measures of underlying inflation coming in below forecasts. The inflation report suggests that some of the stickier components of inflation such as used cars and airline fares are also moderating.
It’s important to note that most of the rise in the June CPI can be attributed to housing, however because of the way it is calculated it tends to lag current conditions. The S&P Case Shiller Home Price Index which tends to lead CPI shelter by roughly a year, is already flat which highlights US inflation is likely headed lower. Inflation for labour intensive services such as restaurants, recreation and personal care remained higher in June reflecting the pass -through of higher wages and robust services demand2. Potential further softening in the labour market could bring these categories back to target consistent levels. Softening in the labour market was evident in June’s employment report (nonfarm payrolls rose by 209k versus consensus 230k) which was weaker than expected for the first time in 15 months3.
US Producer Prices confirmed a similar deflationary theme. The US Producer Price Index (PPI) inflation for June was softer than expected with headline and core PPI advancing 0.1% over the prior month4. Business surveys are also pointing to weakening pricing power, such as the Institute of Supply Management (ISM) services index which ties in with a lower inflation backdrop.
US inflation can’t prevent the July rate hike
While expectations for the July rate hike of 25Bps remain firmly in place, the market has scaled back expectations for a second hike – with 21bps / 3bps / 3bps of hikes priced for the July / September / November FOMC meetings5. The disinflation trend increases our belief that the Fed is close to, or will be, at the end of the current rate hike cycle.
Earnings take centre stage for the next leg of the rally
The key question now remains whether the market continues to trade off expectations of an easing narrative. Central bank policy has been the biggest drag for equities last year. The timing of the easing narrative comes at the heels of a volatile Q2 2023 earnings season. The S&P 500 Index earnings in the Q2 2023 are expected to decline 6.8% y/y, worse than the decline of 3.9% in the Q1 20233. This would be the largest earnings decline since the pandemic-fuelled 31.6% y/y decline in the Q2 2020. Earnings will be the key deciding factor for an extension in the current rally.
Investors will be keen to hear from management whether they are looking to adopt a leaner cost structure and ways they are looking to remove excess capacity. Investors will be looking for guidance on productivity and efficiency gains rather than the financial engineering we have witnessed over the past decade.
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.
Softer than expected inflation report
As highlighted in the chart below, the details for June were also better than expected with key measures of underlying inflation coming in below forecasts. The inflation report suggests that some of the stickier components of inflation such as used cars and airline fares are also moderating.
It’s important to note that most of the rise in the June CPI can be attributed to housing, however because of the way it is calculated it tends to lag current conditions. The S&P Case Shiller Home Price Index which tends to lead CPI shelter by roughly a year, is already flat which highlights US inflation is likely headed lower. Inflation for labour intensive services such as restaurants, recreation and personal care remained higher in June reflecting the pass -through of higher wages and robust services demand2. Potential further softening in the labour market could bring these categories back to target consistent levels. Softening in the labour market was evident in June’s employment report (nonfarm payrolls rose by 209k versus consensus 230k) which was weaker than expected for the first time in 15 months3.
US Producer Prices confirmed a similar deflationary theme. The US Producer Price Index (PPI) inflation for June was softer than expected with headline and core PPI advancing 0.1% over the prior month4. Business surveys are also pointing to weakening pricing power, such as the Institute of Supply Management (ISM) services index which ties in with a lower inflation backdrop.
US inflation can’t prevent the July rate hike
While expectations for the July rate hike of 25Bps remain firmly in place, the market has scaled back expectations for a second hike – with 21bps / 3bps / 3bps of hikes priced for the July / September / November FOMC meetings5. The disinflation trend increases our belief that the Fed is close to, or will be, at the end of the current rate hike cycle.
Earnings take centre stage for the next leg of the rally
The key question now remains whether the market continues to trade off expectations of an easing narrative. Central bank policy has been the biggest drag for equities last year. The timing of the easing narrative comes at the heels of a volatile Q2 2023 earnings season. The S&P 500 Index earnings in the Q2 2023 are expected to decline 6.8% y/y, worse than the decline of 3.9% in the Q1 20233. This would be the largest earnings decline since the pandemic-fuelled 31.6% y/y decline in the Q2 2020. Earnings will be the key deciding factor for an extension in the current rally.
Investors will be keen to hear from management whether they are looking to adopt a leaner cost structure and ways they are looking to remove excess capacity. Investors will be looking for guidance on productivity and efficiency gains rather than the financial engineering we have witnessed over the past decade.
This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.