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Market Commentary: More Seasonal Choppiness

Stocks continue to trade in a choppy range after the best seven-month start to a year since 1997. August and September tend to see seasonal weakness, and this is playing out once again as expected. Bullish investors may view this as encouraging, as they would prefer to see stocks catch their breath before an eventual move higher, which we still expect over the coming months.

  • Stocks continue to consolidate, which is perfectly normal for this time of year.
  • Some signs indicate stocks will break out to new highs once the consolidation is complete.
  • Energy prices pushed headline inflation higher in August.
  • However, core inflation shows an encouraging downtrend.
  • Disinflation continues in the used vehicle and housing categories.
  • Slowing core inflation, along with an easing labor market, likely means the Fed will pause rate hikes at its September meeting.

What are some clues that better times could be coming soon? Sentiment is quite pessimistic, which could be a sign that the influx of bulls during the summer is slowing. This is encouraging, as the market needs to shake them out. Also, consumer discretionary stocks are outperforming consumer staples. This is another clue the overall market will likely go higher — it’s a positive sign when the aggressive areas of the market lead the defensive ones. Lastly, high yield is outperforming Treasuries, another sign aggressive areas are doing better than defensive. If a monster was under the bed, we’d expect to see high yield doing much worse, but that hasn’t been the case.

Energy Prices are No Longer Slowing Inflation. But What’s Next?

Inflation, as measured by the Consumer Price Index (CPI), rose 0.6% in August, bringing its year-over-year pace to 3.7%. As the chart below shows, the primary driver of disinflation over the past year, from a peak of 9% in June 2022 to 3% in June 2023, was falling energy prices. But that reversed in August, with gas prices rising 10.6%.

The drag on inflation from energy prices is declining, and in many ways this is not surprising. The jump in gas prices is certainly not welcome, but pump prices have shown signs of stabilizing recently.

For inflation to continue to fall, categories outside energy need to ease. Encouragingly, signs indicate this downward trend is still in place. Headline inflation was up at an annualized pace of 4% over the past three months, but core inflation, which excludes food and energy, is running at 2.4%. That’s the slowest pace since March 2021.

A closer look at the data shows disinflation continues in the used vehicle and housing categories. Used vehicle prices dropped for the third straight month, falling 1.2%, and this downtrend should continue based on what private data is showing. On the other hand, new vehicle prices increased 0.3%, the fastest pace since March. Inventories must rise to prevent further increases, and most signs point to that happening. Note there is an outside risk that the autoworker strikes could hamper inventory build-up.

Housing makes up 40% of core inflation, and the August numbers showed the official data is catching up to private rental data, albeit slowly. Housing inflation ran at an annualized pace of 8-10% between June 2022 and February 2023. That slowed to a 5.5-7% annual pace between March and July, and it fell further in August, to 5%. This is still high and is keeping core inflation elevated. However, housing data is likely to continue its downtrend in the months ahead, putting further downward pressure on core inflation. Market-based rental indices from Apartment List show rents are now down 1% over the past year.

The Federal Reserve is likely to look past the jump in energy prices for now and the core inflation downtrend. The labor market is also easing, with job openings falling, quit rates normalizing, and wage growth easing. The unemployment rate is up to 3.8%. This all signals the Fed will likely pause on rate hikes at its meeting this week. That will be a welcome break.

At the same time, we do not expect Fed members to even hint that they’re thinking about cutting rates any time soon, especially since the economy continues to show strength, as evidenced by relatively strong retail sales and industrial production data last week. Retail sales have now increased at an annualized pace of 5% over the past three months, while manufacturing activity is also showing an uptick despite negative sentiment. Fed members will want to preserve some optionality in case stronger economic growth results in more inflationary pressure and they have to raise rates again. We don’t think it will come to that, mostly because we believe core inflation will continue to ease even in the face of a relatively strong economy.