HIGHLIGHTS OF THE WEEK

  • The S&P500 has seen its biggest five-day loss since February this week. Much like then, higher bond yields have led to a repricing of stocks.
  • There are few signs the U.S. economy is cooling. September consumer price inflation data showed that inflation pressures remain quite contained.
  • On net, this argues for a continued gradual pace of rate hikes by the Fed. A severe tightening in financial conditionswould put this at risk, but there is little evidence of that yet.

 

 

Stocks Adjust to Higher Yields

The headline story this week has been the downturn in global equity markets. The S&P500 has fallen about 6% this past week, the biggest five-day loss since February. A bond market rout was the cause then, and it was behind the move in recent days too, as equities re-price to reflect the higher yield environment (Chart 1). This is not a bear market, which is a 20% drop for at least two months, or even a correction, which the market did experience back in February.

For its part, the U.S. economy continues to do well. Indeed, stocks have weakened in part because the economy is doing well. The Fed has clearly signaled they expect strong economic growth to continue, and expect to continue raising rates over the coming year. Bond markets are increasingly taking them at their word, and investors now require a higher yield to hold bonds. When analysts value equities, they discount the expected future cash flow or dividends, and with higher rates those discounted cash flows are looking less valuable, resulting in a repricing of stocks.

There are plenty of downside risks lurking around corners for the U.S. economy: negative impacts from increased tariffs; higher government deficits could lead to a further move up in Treasury yields; and the risk of a Fed policy error. But, at the moment it must be acknowledged that the U.S. economy is growing strongly, a healthy labor market is increasing the share of people with jobs, and wage gains are occurring. At the same time, inflation pressures remain very well behaved. That helps ensure the Fed can remain patient as it raises policy rates.

Further evidence was received this week that inflation pressures remained contained in September. The Consumer Price Index rose only 0.1% on the month both for the headline and core. Core inflation held steady at 2.2% year/year, within the range it has maintained since March. The story of core services inflation running around 3%, being offset by deflation in core goods remained unchanged (Chart 2). But, the cast of characters holding goods prices down on a month-to-month basis changed; in August it was apparel, in September, used cars. Still, the bottom line is that core goods have been firmly in deflationary territory for five years now. We had been expecting this to change, as the effects of past dollar appreciation wear off, but the more recent strength in the dollar will likely delay this. And, we haven’t seen much evidence yet of tariff impact at the consumer level.

Meanwhile, services inflation has picked up from its 2017 soft patch, but it hasn’t really broken new ground. We continue to expect a tight labor market, and increased wage pressures to lead core inflation higher over the next year. But, September’s inflation numbers provide reassurance that an undesirable sharper upturn is not occurring. We expect the Fed to continue raising rates a quarter point at every other meeting over the next year. It would take a much more severe tightening in financial conditions than recently observed to put this pace at risk.

 

Leslie Preston, Senior Economist | 416-983-7053

 

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