The October inflation data, reported last week, sparked a positive reaction across the financial markets. Both stocks and bonds responded favorably as stocks ascended while bond yields plummeted, increasing prices.
Following the Bureau of Labor Statistics release of the October Consumer Price Index report, the S&P 500 ended the day higher by 1.91%, and the Nasdaq rose by 2.37%. The small caps stood out, surging by an impressive 5.44%, as represented by the Russell 2000. Most major asset classes found something to cheer about in the CPI report.
The most encouraging news in the CPI report was that inflation remained steady in October after a 0.4% increase in September. October’s unchanged inflation numbers brought the year-over-year rise in CPI to 3.2%, down from 3.7% in September, and exceeded year-over-year inflation forecasts by 0.10%. Although inflation remains above the Federal Reserve’s target of 2%, it continues on a downward trajectory.
Investors should interpret the market’s strong reaction to the CPI coming in at 0.10% under expectations as a warning to approach risk assets with caution. While the CPI did outperform expectations, indicating a cooling of inflation, the reasons to question the market’s response become apparent when diving into the report’s specifics. It’s essential to contemplate the potential for similar market reactions to future CPI prints, but possibly in the opposite direction.
Core Services Ex-Shelter
The Fed’s preferred inflation measure, Core Services Ex-Shelter, rose to 3.9% year-over-year from 3.7%. The Fed heavily emphasizes this measure as it excludes lagging housing and energy services data, offering a more accurate picture of inflationary pressures.
With demand for services remaining high and inflationary pressures appearing persistent, there’s an indication that the Fed is unlikely to adjust rates in the near term.
Health Insurance CPI
The health insurance component of the CPI has been distorting the index downwards over the last year. If we examine the health insurance CPI year-over-year data, it reveals a 34% decline. Health insurance premiums have significantly increased post-COVID, by some estimates more than 7% last year.
The calculation method for health insurance price changes is intricate and complex. Delays in elective medical care during COVID-19, followed by a rush of postponed procedures, caused substantial distortions in this heavily lagging dataset.
The Bureau of Labor Statistics started implementing a correction in October 2023. In the next few months, we can expect increasingly more significant insurance inflation numbers as the moving average discards lower CPI figures from the calculation window.
In essence, due to the imperfect methodology of calculating CPI, the market’s dramatic reaction to a mere 0.10% expectations beat in CPI is immaterial. It falls well within the margin of error. Inflation is on a downward trend, but the rate of change is decelerating, while the measure of inflation the Fed is focused on increased year-over-year.
The key takeaway for investors is that the market’s jubilance from the CPI print indicates significant risk in a market ready to react positively or negatively to even minor economic indicators and events. In such times, the trend in stocks is upward, and indeed, the trend is your friend. However, it’s critical to be aware of the risk and adjust your positions appropriately, lest the next piece of news or data delivers an unforgettable risk management lesson.