Why the September CPI data could be bullish for markets

Key Concepts

Consumer Price Index (CPI): A measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
Headline Inflation: The overall inflation rate, including all items in the CPI basket.
Core Inflation: Inflation that excludes volatile components like food and energy prices.
Federal Reserve (Fed): The central bank of the United States, responsible for monetary policy.
Interest Rate Cuts: Reductions in the target for the federal funds rate, which influences borrowing costs throughout the economy.
Quantitative Tightening (QT): The process by which the Federal Reserve reduces the size of its balance sheet.
Tariffs: Taxes imposed on imported goods, which can affect prices and inflation.
K-Shaped Economy: An economy where different sectors or groups of people experience vastly different outcomes, with some prospering while others struggle.
Financial Conditions: A broad measure of the ease with which businesses and consumers can access credit and financial markets.
Growth at a Reasonable Price (GARP): An investment strategy that seeks to buy growth stocks at a reasonable valuation.
Value Investing: An investment strategy that seeks to buy stocks that are trading below their intrinsic value.
Momentum Investing: An investment strategy that seeks to buy assets that have been performing well recently.

September CPI Report Analysis

The September Consumer Price Index (CPI) report showed a 0.3% increase month-over-month for the headline figure and a 0.2% increase for core inflation. Both figures were a tenth of a percent better than anticipated. Year-over-year, both core and headline inflation came in at 3%. This report is significant as it is likely the last high-quality government data point expected until early spring due to the government shutdown, leading to increased reliance on imputed or estimated data in subsequent reports.

Key Takeaways from the CPI Report:

Inflation Decelerating, Not Reaccelerating: The report suggests that inflation is not accelerating, pushing off immediate concerns about the impact of tariffs.
Housing, Shelter, and Food Slowdown: These components increased at a slower pace than previously estimated, contributing to the better-than-expected overall figures.
Services and Transportation Still Elevated: Despite the moderation, services are still advancing at a 3.6% year-over-year pace, and transportation remains at 1.7% year-over-year, even after a monthly decline.
Market Positive: The numbers are viewed as positive for the market, with futures indicating gains at the open.

Federal Reserve Policy Implications

The September CPI report is seen as providing significant cover for the Federal Reserve to proceed with interest rate cuts.

Expected Fed Actions:

October Rate Cut: The market has a nearly 100% probability priced in for a quarter-point rate cut at the upcoming October meeting.
December Rate Cut: The report also increases the likelihood of another rate cut in December.
Fed's Focus on Labor Market: With inflation appearing to be under control, the Fed is expected to shift its primary focus to the labor market.

Expert Perspectives on Fed Policy:

Joe Bruceuelis (RSM Chief Economist): Believes the report suggests a Fed cut is likely and that housing, shelter, and food increases are slowing. However, he cautions that inflation is still well above the Fed's 2% target and may take years to reach. He also highlights the concern that future data quality will be compromised by the government shutdown.
John Hillsenrath (StoneX Senior Advisor): Agrees that the numbers are good and will comfort the Fed, likely leading to a rate cut. He also anticipates a December cut. However, he expresses concern about inflation inertia and persistence, especially with the upcoming lack of quality data. He notes the Fed's willingness to let inflation run above target for a couple of years due to perceived transitory effects of tariffs.
George Borie (Allspring Global Investments Chief Investment Strategist for Fixed Income): Acknowledges the better-than-expected numbers but emphasizes that inflation is still well above the Fed's target. He believes it's premature to declare an "all clear" and that bond yields ticking down below 4% is a market reaction. He sees the report providing cover for the Fed to continue its "midcycle adjustment" to recalibrate policy.
Omar Aguilar (Schwab Asset Management CEO and CIO): States that one data point doesn't make a trend but views the report as positive for the Fed's decision-making, shifting their focus to the labor market. He notes that inflation is still not close to the 2% target and questions how long the Fed will continue easing. He also highlights the challenge of making investment decisions with limited quality data.

Data Quality Concerns Due to Government Shutdown

A significant concern raised by multiple experts is the diminished quality of economic data expected in the coming months due to the government shutdown.

Implications of the Shutdown:

Imputed Data: Government agencies will likely have to impute, or substitute, data they cannot collect, leading to less reliable figures.
Lag in Quality Data: This means that the September CPI report may be the last "hard data" that economists and investors can fully trust until early next spring.
Driving in Snow Analogy: John Hillsenrath uses the analogy of "driving in snow when you can't see out the windshield" to describe the Fed's challenge of making policy decisions without reliable data.

Inflationary Pressures and Tariffs

While the headline CPI numbers were encouraging, several experts pointed out persistent inflationary pressures and the potential impact of tariffs.

Specific Areas of Concern:

Meat and Poultry: Prices are up significantly year-over-year (over 14% for beef tenderloin), driven by demand, lack of inventory, and challenges for ranchers.
Natural Gas and Electricity: Natural gas is up 8% year-over-year, and electricity is up 5.1%.
Tariff Impact: While not fully reflected in overall inflation, tariffs are showing up in specific categories like audio equipment and furnishings. Brian Levitt suggests tariffs are more of a market problem impacting profitability than an economic problem for the Fed.
Services Inflation: Services, particularly shelter, are still a significant driver of inflation, although the shelter component moderated to 2% month-over-month.

Market Positioning and Investment Strategies

Experts offered insights into how investors should position themselves in the current market environment.

Fixed Income Strategies (George Borie):

Play the Yield Advantage: Bond yields are still relatively generous and above inflation rates, offering comfort to investors.
Diversify Duration: Position along the yield curve and stay tethered to the front end, which is expected to decline.
Corporate Credit and High Yield: These areas have performed well due to robust corporate profitability, but investors should be mindful of isolated defaults.
Key Message: "Income is your friend and diversify your duration."

Equity Market Considerations:

Risk-On Rally: The market is experiencing a "risk-on" rally, with large-cap tech leading.
Concentrated Market: The market remains heavily concentrated in a few large tech stocks, prompting advice to diversify.
Growth at a Reasonable Price (GARP): Omar Aguilar advocates for looking for growth at a reasonable price rather than growth at any price.
Value Investing Potential: There's a possibility that value stocks, which have underperformed growth for years, may see a resurgence, especially if the Fed signals a sequence of rate cuts. This could benefit value companies with more debt.
Small Cap Stocks: Differentiate between profitable (S&P 600) and unprofitable (Russell 2000) small-cap stocks.
Momentum Risk: Momentum strategies are risky and can reverse quickly.

Credit Market Concerns (John Hillsenrath):

Building Excesses: Financial conditions are easy, and excesses are building in the market.
Risk-Taking: The market is currently "in love with risk," leading to increased risk-taking.
Idiosyncratic Defaults: While some defaults are occurring, they are largely isolated to specific market segments.

Synthesis and Conclusion

The September CPI report provided a welcome, albeit potentially temporary, respite from inflation concerns, signaling a deceleration rather than reacceleration. This data point is widely expected to solidify the Federal Reserve's decision to implement a quarter-point interest rate cut at its upcoming October meeting, with a further cut in December also looking likely. However, the looming government shutdown casts a shadow over future economic data, creating a challenging environment for policymakers and investors alike.

While headline inflation moderated, persistent pressures remain in areas like services and certain food categories, with the long-term impact of tariffs still a subject of debate. Experts advise caution, emphasizing that inflation is still significantly above the Fed's 2% target and that the path back to that goal may be protracted.

In terms of investment strategy, the current "risk-on" environment favors income generation and diversification in fixed income. In equities, while growth stocks have dominated, there's a growing argument for considering value investments and diversifying away from the highly concentrated tech sector. The market's current enthusiasm for risk, coupled with the uncertainty of future data, suggests a need for careful navigation and a focus on fundamental value. The disconnect between the equity market's optimism and the real-world cost of living for many consumers highlights the ongoing challenges of a K-shaped economy.