Moving on From Inflation?

September’s Consumer Price Index (CPI) inflation report hit the wires Thursday, and something extraordinary happened: Headlines called it boring. The inflation rate staying at 3.7% y/y, matching August’s reading?^[i] Yawn. Core inflation (which excludes food and energy) easing a smidge from 4.3% to 4.1%?^[ii] Wake folks for something more interesting next time. Even the what does this mean for Fed policy? angles seemed half-hearted. Is the world finally moving on from last year’s inflation spike today, on the bull market’s first birthday? If so, the associated sentiment lift should help stocks.

Inflation’s improvement is hard for many to feel. As we discussed late last month, the inflation rate may be down, but prices aren’t. So it was always going to take some additional time before sour inflation sentiment from last year wore off. The psychological effects of inflation need extra time to clear.

Now it seems things are starting to sink in. Oddly, one news item frequently couched as a disappointment tied to the inflation report might help: The Social Security Cost of Living Adjustment (COLA) for next year will be just 3.2%, much lower than last year’s record-high 8.7%. On its face, this is a much smaller raise for beneficiaries. But it is smaller because the COLA is based on the average inflation rate of CPI-W (CPI for Urban Wage Earners and Clerical Workers) in July, August and September. So the COLA dropped -5.5 percentage points because the average inflation rate plunged over the last year. Not in a straight line, but when has anything pertaining to the economy (or markets) ever been wiggle-free?

Incidentally, this is why we suggest not getting hung up on the fact that CPI’s twin 3.7% y/y readings in August and September are up from 3.2% in July and the year-to-date low, June’s 3.0%.^[iii] Blips in both directions are normal, usually due to the base effect (fluctuations a year ago affecting the year-over-year calculation) or one-off movement in volatile categories. The latter is the case now, with gas prices’ summertime spike, but with oil down significantly since then, prices at the pump should ease.

From here, we don’t think slowing inflation itself is some massively bullish factor for stocks. It is too well-known for it to have any remaining surprise power over forward-looking stocks. Markets are too efficient for that. But we do see potential for investor sentiment to lift as society moves further beyond last year and the angst drops. It is one less thing to weigh on investors’ moods, one less source of angst, one less cloud fogging over better-than-appreciated fundamentals and therefore one less thing weighing on the willingness to take risk.

That is how falling uncertainty works as a market tailwind. It gradually chips away at investors’ general risk aversion, making them increasingly more willing to bid stocks higher. Easing inflation jitters are one source, but we see others that are likely to contribute over the period ahead: GDP continuing to grow despite rate hikes and “higher for longer” interest rates; getting a House speaker and moving past November’s government shutdown deadline; oil supply standing firm through regional conflict in the Middle East (and prices are down since the weekend’s outbreak); the presidential contest narrowing to two nominees and an eventual winner. These are just four examples. There are probably others. None are inherently bullish, in the sense that none directly propel corporate earnings. But they present opportunities for investors to get some emotional relief.

This is a key thing we suggest taking forward as this bull market celebrates its first birthday today—a milestone we have seen no one take notice of, probably due to the late-summer pullback. Sentiment and therefore volatility cut both ways. They cut downward in August and September, but the stage is set for the good kind. Turning points are impossible to pinpoint in advance, but with fundamentals strong and poised to keep beating dim expectations, the rally should resume in time (if it hasn’t already).