Making sense of US inflation and the ASX 200 bloodbath

A scorching US inflation report triggered a severe selloff for global equity markets, with the S&P 500 down -4.3% and Nasdaq Composite sliding -5.2%.

The S&P/ASX 200 fares slightly better, down -2.6% in early trade.

The consumer price index rose 0.1% month-on-month in August and up 8.3% year-on-year from 8.5% in July.

Core inflation, which is the Fed's preferred measure of inflation, accelerated 0.6% month-on-month and up 6.3% year-on-year from 5.9% in July. This reading was well-above consensus expectations of 6.1%.

The market was rather complacent in the lead up to the CPI print, flaunting a four day winning streak on hopes that inflation had peaked.

Energy prices fall but so what

Falling gasoline and oil prices has arguably been the main factor driving the view that the worst of rising inflation was behind us.

To some extent, this view was correct, with the energy component of August CPI down -5% month-on-month, the largest contraction since April 2020.

Source: Bloomberg

The problem was we seemed to have forgotten about everything that didn't involve fuel.

"Increases in the shelter, food, and medical care indexes were the largest of many contributors to the broad-based monthly all items increase," noted the US Bureau of Labour Statistics.

Shelter is the single biggest component of CPI (approximately 33% of the Index) and accelerated to 6.2% year-on-year, surpassing the previous high in August 1990.

Food was another problematic component, with the index accelerating to 11.4% over the last year, the largest 12-month increase since May 1979.

Shelter and food tend to be rather 'sticky' components of inflation. They don't exactly rise and fall quickly like fuel prices.

Inflation surprise awakens even more aggressive Fed

Prior to the inflation print, markets held the view that the Fed will hike rates by 75 bps in September, 50 bps in November and 25 bps in December.

"The Fed will likely have to be even more aggressive with raising rates and that is bad news for risky assets," said Oanda senior market analyst, Ed Moya.

Now, there's a chance that the Fed whips out the 100 bps in September. CME's Fedwatch tool says there is a 33% probability for the triple digit hike, up from 0%.

Source: CME Group

This is the kind of left field stuff that throws the market into an existential crisis. The uncertainty inspires volatility, as it tries to price in the new path.

What now?

Year-to-date, 7 out of 9 US inflation prints have been hotter-than-expected. and the S&P 500 fell every single time, with an average decline of -1.7%.

Only January was in-line with expectations and August was cooler-than-expected (referring to inflation for the prior month).

The occurrence of hot inflation reports isn't exactly new, but more recently, the market seems to be increasingly banking on a peak inflation and a Fed pivot.

"Look to the 1994 cycle to understand the current one: Valuations are unlikely to rally until the Fed is done tightening and the 2-year yield starts falling," said Jurrien Timmer, Director of Global Macro at Fidelity.

Source: Fidelity

The market is now pricing for the Fed to hike rates to 4.25% to 4.50% by the first quarter of next year. But rate cuts are still expected in the second-half of 2023.

Source: Compound Capital, Charlie Bilello