Yesterday the market got behind the Fed’s idea that inflation is transitory after a calm consumer price index (CPI) reading. 

Will that change today after a sizzling producer price index (PPI) reading? Remember that any gains in PPI can often get reflected in CPI down the road as companies react to higher wholesale prices by passing them along to the consumer. And then there’s the other side of the coin—where companies absorb these prices, which can impact margins. Either way, inflation tends to pack a wallop. 

Major indices didn’t immediately react much to a July PPI reading of 1%, which was way above the Wall Street analyst consensus of 0.5%. That followed yesterday’s CPI coming in about as expected and well below the June level. The July PPI was equal to June’s, so that kind of takes a bit of the transitory argument away. Also, core PPI, which strips out volatile energy and food prices, was the same as the headline figure, so there’s no hiding behind that. 

Weekly jobless claims of 375,000 were more in line with estimates and pretty much down the middle compared with recent numbers. There doesn’t seem to be much improvement going on here, but it’s not getting worse, either. The number probably won’t have much influence today. 

Instead, investors are likely to spend their time trying to make sense of these contrasting inflation indicators, which might explain why major indices initially went nowhere in pre-market trading on the PPI reading. Does this strong PPI give the Fed more reason to begin its tapering earlier than expected, or will the Fed wait for another month of data to try and get more clarity? If history means anything, we can probably bet on option two. 

Inflationary Showdown Shows Slight Slowdown

Wednesday’s Consumer Price Index (CPI) report told investors mostly what they already knew: overall inflation is running hot. But that’s not what the market was keen to focus on. Instead, investors appeared to be looking at the core CPI, which jumped 4.3% year over year as expected but only 0.3% on a monthly basis—a tad less than the 0.4% analysts estimated. 

On top of this, the Fed’s “transitory” narrative suddenly seemed a bit more believable as a slowdown in used car prices likely allayed fears of a monetary sudden-brake shock. Used car prices rose only 0.2% in July, a small bump compared to the prior month’s steep 10% surge. 

But again, this morning’s PPI seems to be at least a partial counterargument to the transitory view. A single month’s data isn’t a trend, but this is certainly one to keep an eye on. 

Big cyclical sectors like Energy and Financials were already on the upswing this week even before yesterday’s bullish CPI data. Strength in these sectors helped give the blue-chip Dow Jones Industrial Average ($DJI) a lift so far over the other major indices. 

Small-Caps Still Scuffling

So where does that leave small-caps, which are often known for their solid performance during economic recoveries? The small-cap Russell 2000 Index (RUT) is still scuffling a bit, pretty much flat so far this month and well below its 2021 highs. It did rise a bit on Wednesday, but again got outpaced by the $DJI. It’s basically still stuck in a volatile 5-month “rut” despite the strong and steady doses of easy-money policy. 

It might be worth watching to see if RUT can break out of the slow pattern it entered after emerging from its early summer selloff. Which way RUT goes from here might help provide clues about the market as a whole, because RUT can be an early leader up or down. 

Since May, mega-cap Techs have been helping pull up the SPX while some of the other sectors struggle. Analysts are talking about how the rally has less “depth,” meaning it’s more dependent on a few big gorillas to keep it going. While yields aren’t in the kind of territory we saw last spring, it’s worth watching that relationship between yields and FAANGs for clues about where the market goes next. 

If inflation growth is actually slowing—and one CPI report isn’t a trend—that could drive optimism that the Fed won’t clamp down right away, perhaps keeping yields from overheating and mega-caps from melting down. Now the PPI report may have people rethinking that. The tug of war continues. 

The Sweet And The Sour Impact Of Washington

Stocks got a nice assist from Congress earlier this week when the Senate passed the infrastructure bill. On the opposite side of the equation, markets seem to be ignoring a debate in Congress over the debt ceiling. Treasury Secretary Janet Yellen encouraged the parties to find a solution, and for now, the thinking on Wall Street seems to be that there will be one. However, that doesn’t mean a smooth process. 

There was eventually a solution in 2011, too, and the U.S. didn’t default on its debt payments. But it did see its credit rating lowered, and stocks took a pounding that summer. We’ll see if Congress can avoid getting to that point this time around. As a reminder, the debt ceiling has been raised numerous times since the 1980s, with both parties voting to do so. The last time was in 2019, under President Trump. 

If the debt ceiling fight starts to ramp up, volatility could eventually return. It’s not really a big factor right now, but don’t be surprised if we see some intraday volatility continue in the coming weeks. 

For instance, yesterday Kansas City Fed President Esther George said it was time for the central bank to begin pulling back its bond-buying program. There’s been similar language from other Fed officials recently. No single person at the Fed sets policy, but at least a few seem to be chomping at the bit, so to speak, to start tapering.

It could take six or nine months before you actually start to see some shovel-ready projects or even some of the architectural and engineering firms starting to lay all of this out. It is a huge undertaking. Long term, it could have a big impact on some of those companies. But again, it takes a while to get going. 

TD Ameritrade® commentary for educational purposes only. Member SIPC.

Image by Alessandro D'Andrea from Pixabay