Markets React to Softer Inflation

Bottom Line at the Top Line

Markets reacted positively to this morning's Consumer Price Index (CPI) release. Softer inflation is good news for the Federal Reserve (Fed). Despite a good report this morning, the Fed will still likely communicate this afternoon their intentions to keep rates higher for longer in their updated Summary of Economic Projections. The updated dot plot will likely signal only two rate cuts this year, a change from the three cuts communicated back in March. 

Key Points

• Consumer prices were unchanged in May after rising 0.3% in April. 
• Bond yields dropped to their lowest levels this week (highlighted in the chart below) and stock futures rose after the release since it relieved some of the pressure the Fed had after the payroll report. 
•  The headline energy component fell 2% from a month ago, driven by a 3.6% decline in gas prices. 
• Airfare, new car prices, and clothing were among the categories that decreased in May. 
• Grocery prices were unchanged in May after falling in April, giving some reprieve to consumers, although price levels are still extremely high. 
• Restaurant prices continue to rise as consumers have an insatiable appetite for going out to eat. Looking ahead, this category may be an important leading indicator for consumer sentiment amid a slowing economy. 

Drivers of Inflation

Housing costs continue to be a challenge for consumers. Prices for shelter — which includes both rents and the imputed “owners equivalent rent” — rose 0.4% in May for the fourth consecutive month. However, industry data show rent prices are not increasing as fast as the official government data show. Industry data often include new leasing costs not initially captured by the Bureau of Labor Statistics, which explains why some of these industry measures show negative year-over-year rent costs since the middle of 2023.¹

Rising vacancies should eventually suppress shelter costs, which is one of the stickier components of inflation. 

Excluding food and energy, the annual rate of inflation decelerated to 3.4% in May from 3.6% the previous month.

Inflation Cools After a Rough Start to the Year

Source: LPL Research, Bureau of Labor Statistics, Bureau of Economic Analysis 06/12/24

Market Reactions

Thanks to Adam Turnquist, our Chief Technical Strategist, who created this second chart, we know some areas of the market often respond favorably to downside surprises in CPI. The bar chart highlights the average daily return of the S&P 500 and its sectors for all CPI release dates since the Fed started raising rates in March 2022. The returns are trifurcated between days when year-over-year (YoY) core CPI came in above, below, or in line with estimates.   

Market Performance on CPI Release Dates (March 2022 — YTD)

Source: LPL Research, Bloomberg 06/12/24
Disclosures: Past performance is no guarantee of future results. All indexes are unmanaged and can’t be invested in directly.

Not all sectors respond the same way to downside surprises. For obvious reasons, the real estate sector often outperforms on these days, along with the technology and consumer discretionary sectors. Overall, the S&P 500 has historically climbed 1.8% on days when core CPI came in softer than expected.   

Conclusion 

Battling inflation is not just for central bankers. Fiscal and regulatory policy also have inflationary implications, along with demographic shifts. As noted in previous weeks, our economy is less interest rate sensitive, adding a challenge for effective monetary policy. In sum, the structural shifts in the economy could make some of the stickier components of inflation stick around for a while, which is one reason we think the Fed will keep rates higher for longer. 

From an investment perspective, commodities could benefit from this period of sticky inflation, especially while we have supply and demand imbalances.