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Inflation may be ‘much more persistent’ amid August CPI data: Economist

Truist Chief Market Strategist Keith Lerner and Oxford Economics Chief U.S. Financial Economist Kathy Bostjancic join Yahoo Finance Live to discuss the August CPI print and what it says about the current health of the U.S. economy.

Video Transcript

- The market to bring in our panel. Keith Lerner is the Truist co-chief investment officer. And Kathy Bostjancic Oxford Economics Chief US financial economist. Nice to see you both on what is a very important day and an ugly day thus far for the market. Kathy, we'll start with you and take you back to what triggered all was the inflation report. What caught you by surprise?

KATHY BOSTJANCIC: Hi. Happy to be with you. Yeah. It was a shocking number. Really, the core reading is what surprised us. It was 6/10 of a percent. So it was double the increase of what we expected on the month. Headline was boosted by the core. But as expected, energy prices were down sharply. And food prices were up quite a bit. And that's just a continuing trend.

But it's a core number, core services and core goods. Now, core services are being lifted by higher rental costs. That's not a big surprise. But you also saw medical costs, transportation costs in the service sector high. And core goods, maybe that was the biggest surprise kind of broad based, and particularly with new vehicles, continuing to rise.

- Keith, what's your reaction to the huge drop that we're seeing today? The Dow now off over 1,000 points. S&P off pretty substantially. NASDAQ off just around 4 and 1/2%. What's your big takeaway?

KEITH LERNER: Well, first, great to be with you, even though we're seeing a lot of red today. I think the big takeaway is the inflation is still a problem. This kind of resets the market outlook. I think heading into this report, the market was up about 6%, hoping to see slower inflation. And if you remember, Esther George recently said that she was looking for at least three months of improvement in CPI.

Well, we don't have that. We don't even have the first month. So this, again, puts the market back on the defensive. And it reinforces a key theme that we've been discussing really over the last several months is that there's scar tissue left because of the inflation side. That means the Fed is going to stay higher for longer. And I think that's going to continue to cause challenges for this market. So we remain a little bit more defensive and up in quality.

- So Kathy, how much does this latest inflation print really move the needle then? Because, obviously, a lot of investors sort of parsing through every bit of economic data that comes out right now.

KATHY BOSTJANCIC: Yeah. This is potentially a big game changer in the sense that, as was said, the market was anticipating we were going to see several months of improvement. And we did see improvement in July. But now the question is, was that a head fake and is inflation much more persistent and stickier than we thought? And it may be. And that means that interest rates have to go higher for longer than expected. That really changes the calculus of what the bond market's priced in and now that the impact has spilled over on the equity market.

What to watch going forward? I think retail sales is the next big release on Thursday. And then beyond that, it's really, how does the consumer and labor market withstand continued tightening of financial conditions led by the Federal Reserve? Our view is that we're actually going to be heading into a mild recession in the first half of next year. And part of that is really going to be the fact that earnings growth is slowing quite a bit and even declining.

- And Keith, you agree with that in terms of where we're headed with the recession? And how much longer do you expect this pain to continue as far as equity?

KEITH LERNER: Yeah. Our base case is that the odds of recession are relatively high early into next year. We thought back in June the market had priced in a recession prematurely. However, even after the CPI print, what this means is the Fed is going to continue to have to tighten. And we also have the most aggressive global central bank tightening we've seen in the last 30 years. So we think that is going to slow things pretty markedly by the end of the year. And we think the odds of a recession next year are at least 50%.

As you think about the overall market, I think this is going to continue to wear on the market. The big challenge right now is as those rates are moving higher even in the midst of a slowing economy, it's going to put some downward pressure on valuations. And you're seeing that more acutely in the growth areas of the market. Look at technology today, communication services, discretionary. All down 4%. That's the biggest part of the market. Those three sectors represent around 50%. So our message is to still remain somewhat more defensive. Areas like staples, health care, utilities. Energy is the one cyclical area.

In a day with all red, I will point out one positive, maybe some offset is sentiment is already very depressed. We saw in this morning the Bank of America fund manager survey showed global equity managers had the lowest allocation to equities in history and the highest cash allocations since 2001. So at least some of the news at least is-- people are braced for bad news. And we got that today. But position is somewhat light. So that's a modest offset to the macro picture, which in our view is still challenging.

- Kathy, let's talk about the size of the hike that we could see next week. Nomura forecasting a 100 basis point hike. What do you think is most likely?

KATHY BOSTJANCIC: You can't rule out 100 basis points. I don't think that's most likely. But these were quite miserable inflation numbers, frankly. And the Federal Reserve is looking at this and saying, we've got to slow down the labor market. We have to slow down demand and reduce the pricing power that companies still seemingly have. So you can't rule it out. Our view right now is probably 75 basis points next week followed by another 75 is a possibility in November.

- So Kathy, for people who are sitting at home thinking, oh, the housing market is cooling, perhaps things will be a little bit better, what are you thinking right now in terms of what we should be piecing together from the data that we saw pertaining to housing and rents?

KATHY BOSTJANCIC: Yeah. So rental prices are probably poised to continue to rise, unfortunately, until the middle portion of next year because rental prices tend to lag home price changes by about a year. Now, home prices are-- the year on year rate is decelerating. And we think that could continue and may even accelerate. As you pointed out, with interest rates rising, 10-year yields now climbing to 340 or so, that's going to push mortgage rates up. That's just going to make it a lot less affordable for homebuyers. And that's going to put some further pressure on the housing market, which I think when you look at the indicators, is already in a recession and is leading the overall economy.

- Kathy Bostjancic and Keith Lerner, thanks so much for joining us this afternoon.