Inflation eases off. What does that mean for Fed action and recession risk?
Inflation, recession, and China are the key topics on this week's episode of Market Week in Review, hosted by Associate Director of USI Investment Analysts, Chris Kyle and featuring Investment Strategist Alex Cousley.
The relationship between CPI numbers and Fed projections
Kyle kicked off the conversation with a focus on the latest U.S. Consumer Price Index (CPI) headlines, noting that the CPI eased off its 40-year high. Kyle stated that the deceleration was certainly a boon to major indexes and asked Cousley to break down the latest data and its potential implications for the next steps of the U.S. Federal Reserve (the Fed).
Cousley observed: "Most of the downside surprise was really driven by more volatile items within the inflation basket. So gas, airfares—those kinds of things do move month-to-month." He noted that we saw a small tick down in the stickier parts of inflation: "Shelter and wages are still uncomfortably high, and so we don't foresee too much change in the Fed's direction for the rest of the year." Cousley explained that the Atlanta Fed wage tracker still showed wage growth at 7%, which is still far too elevated from where the Fed would like that number to be. He said: "We do think the Fed are going to have to keep raising rates to get that inflation back under control."
Stable Chinese inflation and less-stable China-Taiwan relations
Kyle shifted the conversation toward China, where China recently released its inflation numbers and where Nancy Pelosi, U.S. Speaker of the House of Representatives, recently visited Taiwan.
On the latest report on Chinese inflation, Cousley said, "Similar to the U.S., it came in below expectations." He explained that, in China, "The real push-pull is between oil prices—which came up and then flow through to fuel—and pork prices and food prices, that are still rising." Cousley explained that their 2.7% inflation is not a major concern for the Chinese government.
On the Taiwan issue, tensions are still quite elevated, and China is still running military exercises. Coulsey said: "From the U.S. side, we have the Taiwan Policy Act—which would be a more hawkish version of the Taiwan Relations Act—basically providing money for security systems for Taiwan and also giving them the distinction of being a major non-NATO ally, which would be deemed as kind of a step up in rhetoric from the Chinese side." He noted that it seems like we will continue to see elevated tensions and rhetoric but does not expect the situation to move beyond that in the near future.
China credit numbers
Cousley commented on the August 12 release of China bank loan numbers for July (which came in after this recording). According to data released by the People's Bank of China, Chinese banks extended 679 billion yuan (US$101 billion) in new yuan loans in July, less than a quarter of June's amount and falling significantly below expectations.
Recessionary risks and investor sentiment
Kyle noted that halfway through the quarter, conditions have been favorable for equity markets, especially in the U.S., while bond and credit markets are also mildly recovering. He asked, "What should we now be looking at in the coming months that may extend or reverse current sentiment?"
Cousley said: "We think that a lot of the equity rebound has been driven by positioning. So people were very negative on equity markets coming into July, which led to a relief rally."
In terms of recessionary risk, Cousley noted that, at Russell Investments, we are still concerned about a recession coming during the next 12 months. He noted that Russell Investments' recession probability number was recently at 35%. "We now think it's closer to 45% that we'll see some sort of recession in the next 12 months." Cousley pointed toward the inverted yield curve as the most-concerning indicator. (The yield curve is the difference between the 10-year U.S. government bond rate and the two-year U.S. government bond rate). Cousley said, "When that inverts, so the two-year goes above the 10-year, historically that's been a very good indicator of recessionary risk. Those numbers have eased a little bit this week, but it was recently close to the most inverted that we've seen throughout history, at close to 50 basis points." He concluded, saying, "This is really just tying to the idea that inflation is hot, the Fed is going to have to keep pushing, and that really kind of increases the risks that lead to a recession."
Cousley clarified that we are not projecting a deep recession, but rather a moderate, technical recession.