Looking at: The Latest Inflation Numbers

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Demoted

Inflation data has been demoted to second-most important economic data, having been recently surpassed by jobs data.

We can not only hear this in the commentary around markets, but also in the market reactions of late. The one-day reactions in the S&P 500 have become more muted for inflation releases and more pronounced for labor market releases. Investors are now more focused on employment, and for good reason… it seems to be the key to predicting what the Federal Reserve might do with rates for the rest of the year.

But have we slayed the inflation dragon? What about all the fears of a resurgence in prices if the Fed cuts too soon, or if input costs rise again, or if shelter and car insurance just never ever ever come back down?

Expectations Feed Demand

Still those are valid concerns, and a resurgence is a possibility, especially in the case of a shock to energy prices or to commodities that affect raw materials prices. Those are typically caused by events outside our control that are unpredictable. It’s safe to say exogenous shocks are always a risk, and until or unless they become more obvious or imminent, there’s little value in trying to invest “around” them.

Outside of an exogenous shock, what else might cause inflation to heat back up? Growth surprising to the upside, which likely means demand has picked up and is again outstripping supply. A renewed economic overheating, so to speak. That’s the scenario the Fed believes they have more control over, and is the exact outcome they’re trying to avoid. Hence the long pause before beginning to cut rates.

In my opinion, the risk of that is the lowest it’s been in this entire cycle. There’s been a tone shift, and the most recent jobs report that came in weaker than expectations drove that home. I’ve long said consumers will continue spending as long as they feel confident in the employment picture, and I believe that confidence has been shaken.

One of the ways we can measure this is using the Conference Board survey of consumer confidence. We’ve stripped out a couple relevant components in the chart below, and can see a sharp decline in consumer expectations of real household income.

If consumers increasingly believe their real household income will be lower in the future than it is today, they’re not likely to increase their spending. Moreover, a rate cut isn’t likely to change their minds very easily. Which also means, I believe it’s time to start cutting.

Proof is in the Guidance

Q2 earnings season has been solid, posting a 12% year-over-year growth rate so far (91% of S&P 500 companies have reported), which is above the original expectation of 8.5%. But as we know, it’s just as much about how companies did last quarter as it is about what management expects in future quarters.

There’s been a general theme of guiding down, with a number of bellwether consumer companies in leisure and hospitality (e.g. Marriott, Hilton, Norwegian), restaurants (e.g. McDonalds, Starbucks), and others (e.g. Home Depot, LVMH, Visa) either already seeing a slowdown in customer demand or expecting some sort of pullback in consumer spending for Q3 and Q4.

To be clear, we needed a pullback in spending in order to cool inflation and keep it on a sustainable path toward the Fed’s target. We also needed a reduction in the risk that demand would heat back up if we cut too soon. I believe both are currently the case, and markets seem to as well. So despite the fact that this week’s big headline data was the consumer price index, we remain more focused on the labor market as the more important clue.

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