September’s Consumer Price Index rose 3.7% from a year earlier, above the 3.6% economists expected and up from 3.4% in August. The gasoline component rose 9.1% for the month and accounted for more than half of the monthly increase. Core inflation, which excludes food and energy, rose 0.3% for a second straight month, bringing the annual rate to 2.6% against a 2.5% forecast. Shelter, the largest part of the index, rose 0.4%, its fastest monthly gain in five months. Before the CPI release, futures markets priced the odds of a Fed rate hike at 22% for the October 27-28 meeting. By midmorning yesterday, the odds had climbed back up to nearly 50%, and the 10-year Treasury yield rose about 8 basis points, to 5.3% (CNBC).

Pave’s optimizer registered inflation pressure in several areas, favoring the companies that sell fuel over those that rely on discretionary spending. Rate-sensitive names continued to rank poorly, and the optimizer looked toward the Land of the Rising Sun for steadier footing.

Paid at the pump

Higher gas prices are moving money from households to the companies that make the fuel, and Pave's scores have reflected the shift at hand. Petroleum refiners ranked in the top quintile of U.S. stocks on average, the highest-ranked group in the energy sector. Oil itself has slipped from the top decile of Pave's fund rankings in early September to near the middle. As refiners continue to earn on the gap between what they pay for crude and what they’re charging for fuel, the optimizer is favoring those businesses over the commodity itself.

Companies that rely on discretionary spending moved the other way. Among U.S. large and mid-sized companies, car dealers fell from the top quarter of Pave’s fund rankings to the bottom half, with auto parts makers, restaurants, and food producers sliding as well. It is becoming clear that consumers are feeling the burden of higher prices. When more of each paycheck goes to rent and gas, a new car, a meal out, and name-brand groceries are some of the first purchases to get swapped for cheaper options.

While gas prices can fall back relatively quickly, stickier prices for expenses like rent rarely do. Even if inflation slows from here, the consequences of today’s higher prices may linger for longer than households hoped, as budgets are drained to absorb increased shelter and fuel costs. 

The reach of higher rates

Pave's optimizer treated higher inflation as a rates problem and did not reach for the usual inflation hedges. TIPS and gold sat in the bottom third of Pave’s fund rankings, and broad commodity funds sat near the middle. If the optimizer expected inflation to keep accelerating, those hedges would typically rank higher. Instead, the scores suggest that persistently high interest rates remain the greater risk, particularly for companies that depend on inexpensive financing.

The pressure landed on rate-sensitive stocks, as utilities ranked lowest of any U.S. sector, and real estate investment trusts slid about 10 percentile points over six weeks to the 38th percentile. Homebuilders, the stocks most tied to housing demand, also sat near the bottom of the universe even as shelter costs rose 3.2% over the year. Looking toward fixed income, high rates have pushed both long-duration Treasuries and corporate credit to the bottom decile of Pave's fund rankings.

Banks are another area where pressure may be emerging. Earnings from the largest U.S. banks this week painted a picture of a still-healthy U.S. economy with strong capital markets activity. The results were generally good, yet not strong enough to justify the built-up expectations. Banks generally aren't seeing major credit stress, but several institutions increased provisions for potential loan losses, signaling caution about future credit conditions rather than concern about current conditions (Forbes). Pave’s scores on large U.S. financials align with these concerns, with scores falling from the 75th percentile to the 58th over six weeks, and U.S. commercial banks falling from the 75th to the 62nd over the same period.

Standouts from abroad

Outside the U.S., Europe is weakening while Japan holds up across Pave’s universe. European weakness is seemingly being driven by slowing growth, sticky input costs, and a weaker currency. The dollar fund climbed to the top quarter of Pave’s fund rankings over the last six weeks, while the euro fund fell to the bottom decile. European stocks weakened alongside the currency, with German and Spanish stocks each falling about 10 percentile points. 

Japanese stocks, on the other hand, ranked among the top three countries in Pave’s data this week, with strength detected across every sector and company size. Japan’s breadth contrasts with the U.S., where strength continues to narrow as the share of large caps scoring positive fell from 78% to 56% over the last six weeks. Mega caps, where concentration is most prominent, managed to hold near 80%. For investors watching U.S. strength narrow to its largest companies, Japan is seemingly offering some breadth.

If oil and gasoline prices come down, energy-driven inflation pressures can ease quickly and grant the Fed some flexibility on its next move. Housing cost pressures tend to ease more slowly, meaning they could continue to squeeze household budgets even as headline inflation improves. The questions now are how quickly households might feel relief from easing price pressures and whether that relief would be drastic enough to maintain spending and sustain corporate profits. 

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By Stephen Evans, CFA

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