Stocks gained again last week, as the S&P 500 hit more new highs, while the Dow is a chip shot from its first high this year, and small caps soared on hopes over rate cuts. As we’ve noted the past few weeks, August and September historically can be troublesome months and though new highs are great, we by no means are out of the woods yet.
Rate Cuts Can Be Bullish
We will discuss the inflation data more below, but market-based pricing suggests there is currently a little less than an 85% chance of a rate cut at the next Federal Reserve Bank (Fed) meeting in four weeks. If you remember last year around this time, we noted that a rate cut with the S&P 500 near all-time highs is rather rare, but that doesn’t mean it isn’t possible. In fact, the Fed cut rates twice last year with the index near all-time highs (in September and November). The good news is rate cuts near all-time highs have seen stocks higher a year later 20 out of 20 times and when last year’s September and November 2024 cuts reach one year we could have 22 out of 22. In other words, if the Fed cut rates in September and the S&P 500 is still be near new highs, it could be another positive driver for stocks.
Minor Cracks
We will keep this fairly simple, but the number of stocks in the S&P 500 that are above their 20- and 50-day moving averages is lower than it was a month ago, even though the S&P 500 has moved higher. We call this a negative divergence and it could be a clue there is weakness under the surface. Additionally, we are seeing other negative divergences from other indicators we follow. Again, this isn’t over-the-top bearish action, but this coupled with the negative seasonal period we are in could suggest a well-deserved break is possible.
Uncertainty Around the Fed’s Next Move
The market cheered the July Consumer Price Index (“CPI”) inflation report released on August 13, 2025, but mostly because it was perceived to be good enough to keep the Federal Reserve (“Fed”) on track for a September rate cut. The market-implied odds for a September cut rose from about 85% to 100%, according to the CME Groups FedWatch tool—implying investors thought a rate cut in September was a lock. However, the July Producer Price Index (“PPI”) report released the next day took those odds back down to 85%—a cut is still the base case, but not quite a certainty. The volatility around September rate cut expectations is something we’ve seen for a few months now, especially after payroll data. Rate cut expectations fell after a strong June payroll report and plunged below 50% on Powell’s hawkish comments following the Fed’s July meeting. Then expectations completely reversed after the weak July payroll report release.
All this to say, there’re been considerable uncertainty around the Fed’s next move, and that’s partly because the labor market is seen to be weak even as inflation remains elevated. So, the big question is whether the Fed prioritizes their inflation mandate or moves to protect the labor market. Keep in mind that we will be getting one more payroll report and one more inflation print before the Fed’s next meeting on September 16–17. But first all eyes will be on Fed Chair Jerome Powell’s speech at the annual central bank get-together in Jackson Hole this upcoming Friday.
The Fed Has an Inflation Problem
The market mood was good after the July CPI report release. As we noted above, markets seemed eager to embrace the more potentially rate-friendly environment. The Russell 2000 Index of small cap stocks jumped 3.0% compared to a still solid gain of 1.1% for the S&P 500. But things weren’t so happy in fixed income, likely on concerns by bond market participants that there was still some worrisome inflationary pressure underneath the surface and lower rates might increase inflation risk. The Bloomberg US Aggregate Bond Index was flat at 0.0% on CPI day and the Bloomberg U.S. Government: Long Index fell 0.5%.
Despite the market response, the overall inflation numbers were not so much good as not as bad as feared. Headline inflation climbed 0.2% in July to take the one-year number to 2.7%, while core inflation (ex-food and energy) climbed 0.3% to take the one-year number to 3.0%, a five-month high. Core inflation at 3.0% is still a long way off from the Fed’s target of 2.0%, and as you can see below, it’s moving in the wrong direction. Still, on the face of it, it looked like tariff-impacted inflation for goods was offset by disinflationary forces from shelter and that was reason for cheer.
The problem is that there was quite a bit of potential risk (and therefore uncertainty) lurking beneath the surface. We subtitled our Midyear Outlook 2025 “Uncharted Waters” and a look at the July CPI numbers gives a sense of why. The inflation data cut across the prevailing narrative. Core goods excluding autos, which has been used as a proxy for tariff-sensitive inflation, slowed to 0.22% in July from 0.55% in June.
The slowdown in core goods ex-autos does suggest that consumers are not yet bearing the full brunt of tariff-induced price increases. The most likely reason for the softer-than-expected reading is that pre-tariff inventory is still making its way through the supply chain, a factor that’s on the clock, especially with the return of reciprocal tariffs in August. It’s also possible that companies are finding some loopholes to blunt the impact of tariffs. If these factors stay in play, it could be that economists misjudged the impact that tariffs would have on inflation. That could be part of the picture, but we think it’s more likely that they misjudged the timing of the impact.
None of these factors guarantee that goods inflation will stay tame—it’s likely we’ll see continued pressure—but for now the pass-through looks manageable. But two major seasonal sources of demand for goods purchases—back to school and holiday shopping—are around the corner and the risk remains that as seasonal goods demand rises, inventories turn over, and newly implemented reciprocal tariffs start to bite, the impact of tariffs on goods inflation will become more prominent.
One thing to keep in mind is that rising core goods prices are a break from the 2023-2024 trend (and even the 25-year pre-pandemic trend) when core goods prices steadily fell. Now, tariff-related increase should be a one off, or “transitory,” and ideally, something the Fed can look through. The problem is that there was concerning acceleration in “supercore” inflation (services inflation excluding energy and shelter), which climbed to 3.3% year over year, a five-month high. The Atlanta Federal Reserve calculates something called the Sticky Price CPI excluding food, energy, and shelter. It measures inflation for items whose prices typically don’t change frequently, and it is now up 2.8% on the year, an eight-month high. The story here is that we may be seeing inflation broadening out rather than remaining isolated to those areas of the economy most immediately impacted by tariffs. Despite the positive market reaction to the report, if inflation in fact is broadening it could make the Fed’s task more difficult.
One key piece of services inflation we like to keep an eye on is CPI for “full services meals and snacks,” primarily seated restaurants, to gauge underlying inflationary pressure. That’s because it combines several drivers of inflation including:
- Worker wages
- Food inflation, and even energy prices (including transportation)
- Rent of restaurant premises
Inflation for restaurant meals is running at a 5.3% annualized pace over the past three months, a slowdown from the previous month but still quite elevated, and 4.4% over the last year. That’s well above pre-pandemic levels and in fact higher than at any point in the 2000s and 2010s, a level inconsistent with “normal” 2% inflation.
Normally, we would say this is a symptom of underlying inflationary pressures driven by strong labor income. But we know worker wages are easing, and it’s unlikely higher rents are a problem, which means the source of inflation is likely to be underlying food prices, and probably energy and transportation costs.
The Producer Price Index (“PPI”) data for July also told us that rising food costs are a problem. July PPI came in well above expectations, rising 0.7% month over month (close to 9% annualized). This was partly because wholesale food prices surged 1.4% in July (that translates to an annualized pace of about 18%). But PPI was hot even outside of food (and energy), and this was because of rising margins.
PPI for “Trade Services” doesn’t measure output prices, as wholesalers and retailers don’t change the product being sold. They add value through services that help sell more items (like sales promotions, warehousing, etc). So, PPI for this category measures changes in prices due to margins, i.e. the retailers selling price minus the price of acquiring that good. Margins jumped 2% in July and are up almost 7% over the year. This would be a good thing as far as companies are concerned but one business’s margin increase is another person’s inflation. One of the big reasons behind the 2021-2022 inflation surge was rising margins—companies were paying higher input costs for their goods, but passed all of that, and then some, to consumers. It looks like the same dynamic could potentially be happening now. It also tells you that companies believe consumers can take the bite of higher prices without reducing the quantity of goods they purchase as significantly.
Should the Fed Cut?
Should the Fed return to even a modestly aggressive cutting cycle, the primary risk is that the overall economy is not as weak as the post-jobs report narrative has made it out to be, and even if it is there may be more resilience built into the economy than meets the eye. We’ve talked about some of these factors in various contexts including:
- A surge in AI-related capital expenditures
- Strong consumer balance sheets
- No warning signs of a slowdown at this point from the stock market or credit markets
But even if the economy were more resilient, we’ve made the argument since the beginning of the year that rates don’t need to be as high as they’ve been sitting, a level the Fed still views as restrictive, with cyclical areas of the economy (housing, small businesses) bearing the brunt of higher rates even as the rest of the economy muddles through just fine.
We should also not lose sight of the segment of the economy that is most negatively impacted by lower rates, that is savers, including most retirees. Savers have been thrilled to be getting a more than 4% return on “cash” compared to the near zero interest rates of much of the 2010s. In fact, if rates are pulled down too quickly and inflation remains elevated, savers and retirees get hit twice, once on the lower return of short-term Treasuries and again on inflation eating up more of the return that’s left.
The Fed has put itself in a difficult position by not cutting rates earlier this year as it gets pulled in two different directions by its dual mandate. Tariffs cloud the picture considerably. Tariffs clearly raise prices but if they’re “one-off,” the argument for the Fed cutting rates is that hiring is weak, pulling economic growth lower. But if tariffs are not inflationary (and therefore the inflation problems are deeper), then the Fed really does have a big inflation problem on their hands, with inflation stuck about 1%-point above their target on the back of hot services inflation.
The jobs report shifted the balance toward emphasizing a slowing economy and cutting, and that appears to be the path we’re currently on. Overall, that’s good for markets (and the economy), especially if we get a Goldilocks scenario:
- Just enough economic slowing to support several cuts
- Not so much economic slowing that the economy is at genuine risk of going into recession
- Just enough forces containing inflation that the rate cuts don’t eventually force the Fed back to a hiking cycle
Right now, the stock market seems to think we’re in the Goldilocks zone, despite being in a volatile seasonal period. If we stay there, that would mean higher stock prices by the end of the year are likely, but it would also be an environment where continuing to diversify potential downside risk beyond bonds makes sense in case inflation stays stubbornly elevated.
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