In my last market commentary, 'From Fear to FOMO', we suggested that investors would have a chance to “redefine this rally as a recovery” in September should the CPI inflation print its second consecutive decline. After all, this would help corroborate the notion that inflation had peaked. We also ended that blog with the caution that “downturns could be driven by renewed inflation concerns.” Evidently, last week on September 13th, those fears were renewed as the CPI number came in higher than expected at +0.1% versus the expected -0.1% decline. This report immediately shook markets, leading to a 3-5% drop across all the major American indexes. Unfortunately, it appears that inflation is falling more like a feather rather than a rock.

As a result, we feel investors need to reset the clock and wait for the two consecutive downward CPI prints that the economy has been unable to achieve thus far. At the minimum, failing to achieve this milestone has led investors to believe that the Fed needs to extend the period of tight monetary policy. This likely comes in the form of more rate hikes and leaving rates at a higher level for longer.

Market drops of 1000+ points in the Dow should be enough proof to say that the market was unhappy with the surprise inflation number. However, looking at other coincident indicators can help investors determine whether the market is in a mode of panic. For example, it may give investors a degree of solace that the VIX (a measure of market fear and panic) never spiked to the loftier levels seen in the spring, where it hit well above 30. Values greater than 30 are generally linked to large periods of uncertainty, risk, and investor fear. At the time of this writing, the VIX has actually settled around 26. Furthermore, amid the sell-off, investors saw oil prices acting quite stable, and prices even rose following the sell-off. Any foreshadowing of higher interest rates that could cause a deep recession would normally be met with falling oil prices as consumption and demand expectations wane. Finally, one may have also expected that in times of severe stress and fear, the demand for gold should increase due to its reputation as a safe haven asset. However, on that day of heavy selling, gold prices did not catch a bid and also succumbed to a fall in price. Although it is premature to call the heavy selling a short term event, the immediate response from the markets were not signaling an economic disaster.

A report like this brings up a variety of issues for investors to ponder. For one, diving deeper into the CPI number offers insight as to why the inflation print was a surprise. For example, “shelter costs,” defined as the cost of housing for both renters and homeowners, jumped 0.7% and are up 6.2% from last year. This measure makes up 1/3 of CPI. The spike in shelter costs may be a surprise to clients as many have shared and heard anecdotes of the housing market softening and the value of their homes falling. With that said, investors should understand that shelter costs lags the decline in home prices, and it will take time for falling rents and prices to make it into to CPI number. Moreover, if one had to reach for a silver lining, it would be that the inflation number surprise was not driven by the previous issues such as higher commodity prices, higher gasoline, and supply chain disruptions that accelerated the price increases of core goods. These categories continue to show price moderation.  Should the culprit of high inflation lean more towards shelter and housing than that is actually something the fed has influence and can manipulate lower. Whereas Fed interest rate increases are ineffective in solving commodity and supply chain issues, they are extremely effective in cooling housing. Hence, with the path of higher interest rates becoming more solidified, inflation as it relates to shelter should be contained. Hence, this ‘version’ of inflation should not return to those seemingly uncontrollable levels that were experienced in the spring. The key concern, however, is how long will it take for the cooling housing data to be reflected in the CPI number and can investors be patient? Moreover, in the determination of monetary policy, will the Fed accurately balance the progress that has been made in inflation with the cross currents that cause it to stay stubbornly elevated? And if not, will the Fed potentially perform a policy error and hike interest rates too far?

What is evident is that markets need more time to digest and reflect on the implications of lingering inflation. It is more than reasonable for investors to want to lean more defensive in their investment strategies. The inflation print was a clear miss, and excuses should not be made. In the world of investing, we find it rarely helps to label oneself as a bull or a bear. We tell our clients that it doesn’t help to force yourself to play for one team. All news, whether good or bad, will always get clouded and biased with the lenses that you put on. Hence, we encourage investors to be adaptable. Although the latest CPI print does not change our outlook for investors with an 18-24 month time horizon, it does cool our immediate expectations for growth. Speak to your advisor and review your asset mix and sector allocations and position the portfolio for an environment where interest rates are left higher for longer.