by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment is divided into two main sections, starting with reactions from the market and the Fed to the latest CPI data. We include our thoughts on whether the Fed will pivot and why we are not convinced that inflation has plateaued. Next, we review international news focusing on stories that highlight rising geopolitical risks, namely, the latest developments in Ukraine, Taiwan, and Iran.

The Fed Speaks: Stocks rallied and the dollar weakened on Wednesday after the latest CPI report showed that inflation decelerated for the first time since February 2021.

• Regional Fed Presidents Neel Kashkari and Charles Evans cautioned investors not to assume that the latest CPI report will change the central bank’s policy path toward higher interest rates. Chicago Fed President Evans welcomed the news about the slowdown in price increases but added that the FOMC’s job is not finished. Minneapolis Fed President Kashkari further added that the Fed is far from declaring victory. The comments suggest that central bank officials view the market’s reaction as premature.
• Although both officials downplayed the possibility of a Fed pivot, neither changed his end-of-year target rate. For example, Evans maintained that the central bank should raise rates to around the median year-end projection in the Fed dot plots that was released in June. Meanwhile, Kashkari, who has the highest year-end fed funds target forecast, revealed that his end-of-year projection for the policy rate has not changed. Thus, it would seem Fed officials are not placing much weight on the July CPI report.
• It is too soon to tell whether inflation has indeed hit a turning point. Much of the decline in the CPI index was due to a drop in historically volatile energy prices. Meanwhile, relatively stable shelter prices, which comprise a third of the index, continue to rise well above their long-run averages. Thus, the market could be cruising toward a bruising if it gets too confident in a Fed pause or pivot. The next FOMC meeting will be September 20-21, 2022. At this time, central bank members will have the August CPI numbers, which will play a bigger role in whether the Fed decides to change course on its policy path.
  • Declining fuel prices suggest that the August report may show further decelerating inflation. This month, gasoline prices fell below $4/gallon for the first time since March.

Despite the market’s reaction over the last few days, an economic downturn will not necessarily force the Federal Reserve to end its tightening. The central bank’s mandate is to maintain price stability and prevent rising unemployment. It might want to encourage growth, but it is not under any obligation to do so. Thus, the Fed will likely be open to raising rates as long as the labor market remains strong and inflation remains high. An aggressive Fed determined to bring inflation back to its 2% target and markets brewing with confidence create a fertile environment for a Fed surprise. Thus, investors should be cautious to place too much emphasis on one report.

International Risks: Rising geopolitical tensions suggest that investing abroad may remain difficult.

• The Russia-Ukraine war shows no signs of abatement. Ukraine forces are set to launch a counter-offensive to retake regions lost to Russia. Ukrainian President Volodymyr Zelensky has built up troops around the city of Kherson in preparation for a battle, while also leaving troops to fight in contested areas of the Donbas region. The war will likely be extended if Ukraine successfully regains the lost territory or can force a strategic retreat. A protracted conflict in Ukraine will make investing in Europe challenging as firms struggle to receive much-needed energy supplies. Thus, the possibility of a recession in Europe is elevated.
  • The war will make it harder to reverse burdensome sanctions on Russia. The EU import ban on Russian coal will take effect on Thursday. Meanwhile, the International Energy Association (IEA) has projected that Russian oil output could fall by 20% by the start of next year due to the EU import ban. As a result, Russia’s lack of export capacity and production will likely keep commodity prices elevated going into next year.
• Tensions between the U.S. and China have boiled over for now, but the dispute over Taiwan could still lead to conflict. On Wednesday, China ended its military drills near Taiwan. Officials from Beijing vowed to regularly send patrols across the U.S.-drawn median line in the Taiwan Strait. Additionally, China withdrew its promise never to send troops to Taiwan in the event of a takeover. As this current crisis subsides, both sides will attempt to position themselves with more leverage in subsequent disputes over the island. Accordingly, the decoupling between the U.S. and China will likely accelerate over the next few months as firms come to terms with this new reality.
  • As an example of this decoupling, Apple (AAPL, $169.24) has looked to expand its manufacturing operations into Vietnam. Meanwhile, Foxconn (2354, NT$50.60), a major Apple supplier, is building its production capacity in India. In the short term, firms will try to divest away from China by building capacity in nearby areas in Asia due to their familiarity with many of the countries in the region. Over time, however, the lack of stability and political uncertainty in small Asian countries may force forms to shift operations near the U.S. or possibly into Europe. This shift will be costly and potentially inflationary in the short and medium terms as firms will have to price in additional risks to the supply chains.
• The Biden administration’s hope of securing a nuclear deal with Iran hit another roadblock. Former Secretary of State Mike Pompeo and former National Security Advisor John Bolton were targeted for assassination by affiliates of Iran’s Islamic Revolutionary Guard Corps. Iran has also provided military training for Russian troops fighting in Ukraine. The Biden administration would like to secure a deal with Iran to prevent conflict in the Middle East. In the past, Israel has mentioned that it will not stand idly by while Iran develops its nuclear capacity. Thus, the likelihood of a potential conflict between Iran and Israel is elevated.

The recent slate of international news reinforces our view that global equities remain risky. A more hostile world will likely exacerbate supply chain issues and potentially slow the production of commodities. This outcome should be beneficial to energy-related assets. Additionally, as countries build up their military capabilities, industries related to aerospace and defense should also benefit.

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