Markets brace for hot consumer inflation report in the week ahead

Investors are paying close attention to any reading on inflation these days, and the consumer price index will be the big one to watch in the coming week.

The latest snapshot of the economy comes just a week before the Federal Reserve’s important September meeting. At that meeting, the Fed is expected to discuss more details about its plan to taper down its bond buying program, or quantitative easing.

Market professionals say a hotter inflation reading could speed up the Fed’s plans to slow the $120 billion a month in bond purchases. The paring back of its asset purchase program would be the Fed’s first major step away from the easy policy it put in place to combat the pandemic.

The consumer price index is expected Tuesday, and there is retail sales data is released Thursday. They are expected to show consumer prices jumped at a 5.3% annual pace in August, according to the consensus estimate from FactSet, while the consumer continued to pull back from the high spending levels of earlier in the year.

Hot CPI

“If the CPI is hotter than expected, it could make the difference between a September announcement for tapering or waiting to November,” Bleakley Advisory Group chief investment officer Peter Boockvar said.

Economists expect CPI to rise at a 0.4% pace month over month. The report comes after August’s producer price index — which was released Friday — showed a jump of 8.3% year over year, due in part to supply chain constraints.

The Fed’s formal announcement about tapering its bond-buying program, also called QE, is widely expected in November or December. Many of those who had expected a September announcement pushed back their time frame to later in the year after August’s employment report showed just 235,000 jobs added, about 500,000 less than expected.

“Certainly the trend has been for the inflation number to come in above expectations. I think if that happens again, it will feed the narrative that high inflation is going to stick. Obviously, it’s an issue for the bond market if it’s viewed at all as accelerating the timing of the QE tapering, and or accelerating the timing of the first rate hike,” CIBC Private Wealth U.S. chief investment officer David Donabedian said. That would be a negative for stocks.

“If markets have an inflation mutiny here and there’s volatility as a result, they could move it up to September,” Donabedian said of the Fed’s taper announcement. “But I think there’s kind of a one in four likelihood in my view.”

Stagflation?

That combination of higher inflation and slower spending, particularly after August’s weaker jobs report, has spurred talk about the threat of stagflation. Those worries have also increased as economists ratchet back growth forecasts for the third quarter to a still high level just above 5%, from above 6%.

“I’m more about the ‘flation’ side of it than the ‘stag.’ I think the economy is going to perform fine right through next year,” Donabedian said. He said the slowdown in consumer spending after stimulus checks had boosted retail sales earlier in the year is not surprising and may be just a “short-term warning.”

“We had this explosive growth in retail sales early in the year as a direct result of stimulus payments and vaccines coming and a burst of consumer optimism. It’s really settled down now,” he said. “There was an enormous amount of liquidity and saving and they spent what they spent out of that extra amount of savings and you’re going through a bit of a retracement here, which is why you’re seeing economists mark down their third quarter estimates. Consumer fundamentals are pretty good.”

Barclays chief U.S. economist Michael Gapen said he expects the CPI report to show that inflation is peaking, just as the Fed has said. But he says the slowing trend is not just an issue for consumer spending. It is also showing up in business spending and housing.

“With where labor markets are, August was a bit of an egg. But growth in employment has been solid on average, very robust over the course of the year,” he said. “Even though employment disappointed in August, hours and and earnings were still pretty good. There’s income there for consumers to spend. We’re looking at this as a short-term hiccup.”

Gapen said third-quarter economic growth may be somewhat slower than expected. However, he said some of the lost growth could show up in the fourth quarter.

“It has some characteristics of stagflation, but true stagflation is rising unemployment and rising inflation. We don’t have that,” he said. “These are bottlenecks that are kind of constraining the pace of the recovery and lead to higher inflation. Demand isn’t the problem right now. Supply is. The unemployment rate is still coming down and employment is improving. It has the whiff but I wouldn’t call it stagflation.”

Donabedian expects higher prices and shortages to continue into next year, as supply chains keep getting disrupted. Some companies, including PPG and General Electric, have already commented on how they see issues with supplies stretching into 2022. Donabedian expects to see more warnings ahead of the third-quarter earnings season.

Stocks were lower this week, with the S&P 500 losing 1.7%. The closely watched 10-year Treasury yield has held above 1.3% and was at 1.33% on Friday.

A number of strategists expect to see the stock market pullback during the typically choppy September and October period. Some say the Fed’s September meeting could be a catalyst, especially if the central bank sounds particularly hawkish.

“We’re up over 30% in 2019, over 18% last year and over 21% in the first months of this year,” Donabedian said. “These are unsustainable rates or return. …Our takeaway is it’s going to get tougher from here. Valuations are somewhat extended and this whole incredibly supportive policy framework is going to get a little less friendly.”

Now watch Congress

Donabedian said it will be important to watch discussions in Congress as it begins to put details around the infrastructure spending and what type of tax increases will be proposed to pay for it.

“They’re going to start to fill in the blanks on where the money is going to be spent and what taxes and tax rates are going to be written into the legislation,” he said. “It’s the overall corporate tax rate, it’s the tax on foreign earned income, capital gains rates and dividend tax rate. These are big investor related issues.”

He said the market has been ignoring the tax issue. “Those sort of issues went quiet over the summer but it’s back full bore over the next two weeks. It will get a lot of attention.”

The tax decisions could have big implications for corporate earnings, which have been a big driver of the stock market’s gains. “One very direct way that could go wrong is if you get a large set of tax increases that go into effect in 2022. That’s a direct hair cut,” he said.