Prices Cool. Sentiment Warms.

US Consumer Price Index (CPI) inflation slowed again in June, and a strange thing happened: People actually noticed. Headlines heralded the deceleration to 3.0% y/y, in line with the long-term average inflation rate.^[i] Pundits also cheered core CPI’s slowing from 5.3% y/y to 4.8% and—refreshingly—explained correctly that this figure is skewed higher by shelter costs, which hit CPI at a lag and, in the case of owner’s equivalent rent, are mostly imaginary.^[ii] Excluding food, energy and shelter, the inflation rate is all the way down to 2.7% y/y.^[iii] What should investors make of this nascent sentiment turnabout? Let us explore.

The CPI report came out at 6:30 AM PDT, and in its wake, the S&P 500 went vertical, opening about 1% higher from Tuesday’s close.^[iv] It has since eased back a bit and sits up 0.75% in price terms, as we write mid-morning. So it would not surprise us if there were a bit of a positive feedback loop here and the market’s reaction influenced the tone of today’s inflation coverage. Whatever the reason, though, sentiment toward inflation does seem to have warmed, which suggests to us the improvement is getting priced in. It might still bring households welcome relief as prices slow further, but the effect is probably baked into stocks (or close to it). Markets are efficient and have long since seen the underlying improvement everyone is getting hip to now.

We seem to be at a similar point with rate hikes. After the Fed paused last month, market-based indicators penciled in two more quarter-point hikes by yearend. That remained the popular expectation following June’s CPI report, with most coverage saying inflation still wasn’t low enough for the Fed’s taste, which would probably prompt a bit more tightening ahead. Time will tell if they are correct—Fed moves are always unpredictable, and they might decide to give more weight to the continued improvement in leading inflation indicators we covered last week. The fall in money supply, for instance, is gaining more notice.

Then again, central bankers are all about saving face, and this crew has tied itself in knots on that front. When inflation started picking up in 2021, the Fed (and other central banks) deemed it transitory. Most of the world wrongly interpreted this as “ultra-fleeting” and, when inflation continued accelerating to near-double-digit highs through last summer, central bankers caught a lot of flak for being wrong. So they changed their view and described inflation as “persistent,” a word they still use. Having dug in on this front, they may decide it is a bad look to stop hiking just yet. This, despite the fact the definition of “transitory” is simply “not permanent.” And Exhibit 1 shows the spike was very much temporary.

Exhibit 1: High Inflation Looks Transitory After All

Source: FactSet, as of 7/12/2023.

Regardless, the thought of a couple more Fed rate hikes doesn’t seem to be bothering the world too much. Here, too, sentiment has changed a lot. With most economic indicators holding up ok through the Fed’s tightening campaign, few seem to think another hike or two is going to move the needle in a bad way now. The chatter has shifted from will the Fed cause a recession? to how much more does the Fed need to slow the economy to keep inflation in check? At least subconsciously, people seem to finally be fathoming that rate hikes aren’t auto-bearish or recessionary, even if they are probably crediting the Fed with more direct economic influence than it has. After all, if the Fed were all-powerful, banks’ funding costs would be right in line with the fed-funds target range rather than a few percentage points lower. The current national average savings deposit rate is just 0.4%, and average CD rates are below 2.0%.^[v]

If markets are indeed moving on from inflation and Fed fears, that is good news—it means one or two fewer things weighing on sentiment. There are still plenty of other bricks left in the wall of worry, but having a couple less fears in the mix can help people get a bit more positive and eager to bid up stocks. This is how bull markets unfold: Investors gradually shed false fears, and their slowly warming spirits help lift stocks. This is the phenomenon that underpins Sir John Templeton’s famous description: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” We still think this bull market is in that relatively dour first half, but deep pessimism seems behind us. Which seems natural, nine months to the day from stocks’ low. The gradual thaw evident in inflation reactions seems right on schedule.