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Markets see Fed unrelenting on rate hikes as US inflation shows no weakness

US headline CPI inflation rose 8.2% year-on-year in September (versus consensus expectations of 8.1%), compared to 8.3% in August. On a monthly basis CPI rose 0.4% (consensus: 0.2%) compared to a 0.1% rise last month. This headline reading was driven by increases in shelter, food, and medical care.

Core CPI inflation, which excludes food and energy, came in at 6.6% (consensus: 6.5%) year-on-year, which marks the highest reading in 40 years. This compares to a 6.3% rise in August. On a monthly basis, core CPI rose 0.6% (consensus: 0.4%), versus 0.6% rise in August.

Rob Clarry, Investment Strategist at UK wealth manager Evelyn Partners, says: Today’s inflation report surprised to the upside, derailing hopes for a Fed pivot in the near-term. This comes as investors were praying that some initial signs that labour market conditions were easing could prompt a rethink by the Fed. For example, the latest Job Opening and Labour Turnover Survey (JOLTS) revealed that US employers had de-listed more than 1 million job vacancies in August. Meanwhile, the Bureau of Labour Statistics (BLS) also noted that there was a 16.5% drop in the number of jobs created in September from August.

But this report poured cold water on these hopes. Looking forward, the inflation outlook remains challenging for two main reasons.

First, the decision by OPEC+ to cut oil production by 2 million barrels/day will put upward pressure on energy prices. This undoubtedly puts President Biden in a difficult position ahead of the mid-term elections. Meanwhile, his Administration’s calls on US oil producers to increase their output has also fallen on deaf ears. President Biden is now said to be considering releasing more reserves to curb the impact of the production cut.

Second, while goods inflation looks like it is continuing to ease, services inflation remains elevated. Unfortunately for markets – and the economy – services inflation tends to be ‘sticker’, which means that prices tend to change relatively slowly. This suggests that inflation is unlikely to come down at the pace the markets had been hoping for.

On the rates outlook: Markets reacted significantly to the upside surprise, with the dollar strengthening to its highest level since September on a trade-weighted basis as speculators increased their bets that the Fed would increase rates by another 75bps hike at their meeting on the 2 November. Expectations for a peak in Fed rates in March 2023 increased from 4.6% yesterday to 4.8% after the announcement. Higher interest rates also represent a headwind for the equity market, where S&P 500 futures fell around 2.8% immediately after the release.

Along with the hawkish tone adopted in the Fed minutes released yesterday, all this reaffirms our view that the Fed will continue to stay the course with interest rate hikes. In our view, for the Fed to change course we need one, or more, of (i) labour market easing (ii) a sharp deceleration in inflation (iii) something to ‘break’ which threatens financial stability.

Given that interest rate hikes act with a 12-18 month lag, we expect the US economy to face a challenging 2023. Investors should therefore adjust their portfolios to account for this. In the equity space, we favour increasing the share of defensive names in portfolios. We also see value in the role fixed income can play as a form of disaster insurance –- and favour US treasuries over UK gilts given recent volatility in policy.

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