Daily Comment (October 14, 2022)

by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning. Today’s Comment begins with our thoughts on yesterday’s CPI report. Next, we discuss significant policy shifts in some of the most influential countries. Finally, we discuss how Russia’s nuclear threat has encouraged other countries to become more pugnacious.

The Market Reacts: A possible short-covering rally lifted equity prices on Thursday as investors digested the latest Consumer Price Index (CPI) report.

  • The horrible September inflation report raised the likelihood of another jumbo hike from the Fed in its next meeting in November. Although headline CPI decelerated from 8.3% to 8.2% last month, core CPI jumped from 6.1% to 6.3%. Much of the disappointment in the CPI report came from accelerating rent, transportation, and airline prices. The stronger-than-expected inflation report means that the Fed will raise its benchmark interest rate by at least 75 bps and possibly 100 bps next month.
  • Initially, the market viewed the report negatively, but sentiment began to change once investors dismissed the chance of a soft landing. All 11 of the S&P 500 sectors rose while bond prices fell due to concerns that the Fed will have to lift rates higher. Several theories exist for the equity rally, including short-covering, inflation peak expectations, and a possible Fed pivot. Whatever the reason for optimism, we do not expect it to last much longer as the economy continues to show signs of slowing. Although it’s easy to assume that the Fed could rein in its tightening if the country falls into recession, there are Fed officials who are for additional hikes even during a downturn. In short, we are not convinced that the stock market has hit its bottom quite yet.
  • It isn’t all bad when you look at the monthly data. Core goods prices were unchanged from the previous month thanks to a sharp drop in used autos and apparel prices. Meanwhile, food and energy prices are showing consistent signs of deceleration. Hence, much of the rise in the year-over-year change in inflation was due to base changes as opposed to renewed inflationary pressures. In fact, we suspect that the October CPI report could surprise to the downside. If we are correct, it will likely encourage Fed officials to signal a pause in 2023.

Big Changes: Major countries are beginning to make sudden shifts in their economic and foreign policy agenda to cope with the challenging environment.

  • In a shock, U.K. Prime Minister Liz Truss sacked Chancellor Kwasi Kwarteng on Friday. The move comes after Truss was forced to make an embarrassing U-turn on major parts of her flagship tax plan. The new budget will eliminate the £18 billion corporate tax cut. Following the news of the budgetary changes on Thursday, U.K. government bonds and the British pound rallied. Although Truss’s policy reversal will relieve the financial stress caused by her tax plan, there is no guarantee that the market turmoil will end after the BOE ends the bond purchasing program today. Additionally, there is still concern that Truss’s leadership may be in jeopardy.
  • China will host its 20th National Party Congress on Sunday. The convention will formally instate Xi Jinping as President for the third consecutive time and will outline the country’s plan for the next five years. Although the remarks have not been released, we expect Xi will emphasize that the country should shift its focus away from constant growth and toward self-dependency. The Chinese economy is facing one of the rockiest economic periods in recent history. It has struggled to contain a faltering real estate market, persistent COVID outbreaks, and isolation from the U.S. An inward-focus economy will benefit domestic industries, particularly in tech, and the country looks to aid their development through stimulus.
  • The European Central Bank officials intend to unwind the bank’s balance sheet in 2023. As opposed to selling the bonds, members of the Governing Council prefer to let the bonds mature. If the bank follows through on this plan, it could lead to more financial stress in European Bond markets, especially as the central bank raises its policy rate.

Missiles, Missiles, Missiles: Speculations of a Russian nuclear strike in Ukraine have forced other countries to flex their might.

  • The chance of a nuclear Armageddon is rising. EU foreign policy chief Josep Borrell warned Moscow that NATO countries would “annihilate” Russian forces if Putin decides to use nuclear weapons in Ukraine. Both Russian and NATO forces have planned nuclear drills. The escalation in rhetoric has led to concerns that there is a possibility of miscalculation. In order to mitigate that risk, French President Macron clarified that his country would not respond in kind in the event of a nuclear attack on Ukraine. Financial markets are the least of your concerns in the event of nuclear war; however, in the build-up, commodities will benefit from the rising uncertainty.
  • Not wanting to be left out, North Korea reminded the world that it also has weapons. Earlier today,  it launched two ballistic missiles and sent fighter jets close to the border of its southern neighbor. South Korea responded to the provocative acts by scrambling its jets and slapping unilateral sanctions on Pyongyang. The escalation of tension on the Korean peninsula has flown under the radar due to the war in Ukraine. A fight between North and South Korea could lead to an intercontinental war in Asia as Japan, the U.S., and China all have vested interests in the outcome of the conflict. As a result, we think investors should be cautious when looking at international equities as geopolitical risks are still quite elevated.
  • The U.S. now believes it is battling nuclear threats in both Europe and Asia. The Biden administration’s new National Security Strategy stated that Russia was an imminent concern, and that China was a long-term threat. The focus on these two countries comes amidst heightened tensions over Ukraine and Taiwan. The document states that the U.S. will not allow these countries to achieve their foreign policy objective by use of force. This posturing by the U.S. signals that it is prepared to invest more in its defense to take on its foreign challengers. The resulting increase in military spending should favor more aerospace and defense industries.

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