Stocks Reach Record Highs on Strong Earnings and Easing Inflation: The S&P 500 Index climbed to all-time highs in August, buoyed by exceptional earnings and encouraging July inflation data. The Index gained 2.7% for the month, extending its year-to-date return to 13.1%. Strength in energy, technology, and materials outweighed softness in utilities, industrials, and real estate. Internationally, the MSCI EAFE Index (developed markets) rose 2.0%, and the MSCI Emerging Markets Index rose 3.4%, lifting their year-to-date returns to 13.8% and 24.1%, respectively.

July Inflation Softened: July's Consumer Price Index (CPI) rose 3.4% year-over-year, a touch below June's 3.5%. Core CPI, which excludes food and energy, eased to 2.5% from 2.6%. Both readings matched Bloomberg's median forecasts. At the wholesale level, the Producer Price Index (PPI) cooled to 4.7% from 5.5%, while core PPI fell to 4.2% from 4.9%. The headline reading was below Bloomberg's median forecast of 4.9%, while the core reading was slightly above the median forecast of 4.1%. 

Fed Chairman Warsh Sees a Strong Economy but Unconvincing Progress on Inflation: Speaking at the Jackson Hole Economic Policy Symposium in late August, Federal Reserve Chairman Kevin Warsh described the underlying economy as solid, pointing to robust business investment, steady consumer spending, and full-employment labor conditions. Still, he cautioned that inflation remains well above the Fed's 2% target, noting that the trailing 12-month and six-month personal consumption expenditures (PCE) price indexes stood at 3.7% and 4.1%, respectively.

While more recent PCE readings have softened, Warsh stopped short of declaring meaningful progress on underlying inflation. "There should be no misunderstanding: the Fed's price-stability objective of 2%, as measured by the personal consumption expenditures price index, is a firm, fixed target," he said. "We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do." 

Bond Markets Post Mixed Results: Two-year and 10-year U.S. Treasury notes ended August at 4.34% and 4.75%, respectively, up modestly from 4.29% and 4.73% at the end of July. The Bloomberg U.S. Aggregate Bond Index gained 0.4%, while the Bloomberg U.S. Municipal Bond Index slipped 0.2%, leaving year-to-date returns at -0.3% and 0.2%, respectively.

Economic Expansion Gathers Momentum: The August S&P Global Composite Purchasing Managers Index (PMI) jumped to 56.0 from 54.5 in July, its highest level in more than four years. The improvement reflected stronger services activity, increased hiring, and firming demand, while easing inflationary pressures helped lift business confidence and push future output expectations to a nine-month high. At the end of August, Bloomberg's median forecast for third-quarter U.S. GDP growth stood at 2.5%, up from the 1.5% annualized growth reported by the Bureau of Economic Analysis for the second quarter.

August Payrolls Surge Above Expectations: On September 4, the Labor Department reported that August non-farm payrolls surged 162,000, nearly triple Bloomberg's median estimate of 55,000. Additionally, June and July payrolls were revised upward by a combined 55,000 jobs. Meanwhile, the unemployment rate held steady at 4.1%, and average hourly earnings rose 3.1% year-over-year, a modest deceleration from July's 3.2% pace. Both metrics were in line with consensus expectations.

S&P 500 Earnings Growth Surpassed 50%: S&P 500 second-quarter earnings-per-share (EPS) growth was exceptionally strong, with 86% of its members exceeding analysts' forecasts. According to I/B/E/S, second quarter S&P 500 EPS growth, measured year-over-year, reached 53.3%. This was more than double the growth rate estimated by I/B/E/S analysts at the beginning of July. The sectors reporting the strongest growth included energy (+143%), communication services (+114%), consumer discretionary (+91%), technology (+79%), and materials (+40%).

Rising Probability of Rate Hike: The surprisingly strong August payrolls data, along with other indications that the economy is on firm footing, provide support for the Federal Open Market Committee to increase the federal funds rate when it meets on September 16. As of Friday, federal funds futures implied a 62% probability of a 0.25-percentage-point increase, up from just 32% in mid-August.

Inflation in Focus: The Bureau of Labor Statistics will release August Producer Price Index (PPI) data on Thursday, followed by Consumer Price Index (CPI) data on Friday. Bloomberg's median estimates call for PPI and core PPI, which excludes food and energy, to rise 5.2% and 4.6% year-over-year, respectively, up from 4.7% and 4.2% in July. CPI is expected to hold steady at 3.4%, while core CPI is projected to ease slightly to 2.4% from 2.5% in July.

Markets: The inflation reports will be the last major economic data released before the FOMC's upcoming meeting. Upside surprises would increase the likelihood of a federal funds rate hike. Financial markets appear to have largely absorbed the likely impact of a 0.25-percentage-point increase. A modest increase in rates is unlikely to significantly affect the stock market's trajectory, given its powerful earnings support. Meanwhile, the bond market has absorbed the impact of a significant upward shift in interest rates over the past two months.

Roger Khlopin, CFA
Chief Investment Officer

Aaron Nghiem, CFA, CIMA
Senior Portfolio Manager