Why The Fed Will Still Raise Rates After The CPI Report (NYSEARCA:SPY)

Last week, markets sent the S&P 500 (SP500) up by around 2.2% in response to the non-farm payroll report. Investors bid stocks higher on expectations that the Federal Reserve would raise interest rates by less than expected. Instead of a 50 basis point hike in February and another increase in March, markets want a 25 basis point hike, a pause, and a pivot.

Investors need to retire the word “pivot” in 2023. The Central Bank said it would not consider cutting interest rates until 2024. Even after the Consumer Price Index fell in December 2022 as expected, the Fed will still watch for trends over several months.

CPI Rises By 6.5%

The U.S. Bureau of Labor Statistics posted CPI for all urban consumers falling by 0.1% in December. It increased by 6.5% Y/Y. Inflation rates slowed after the index for gasoline decreased. It is the largest contributor to the decrease, offsetting increases in shelter indexes.

Investors already anticipated the drop in energy prices. In the last year, WTI crude prices fell after peaking at over $120 in mid-2022. Although the crude oil ETN (OIL) fell by 25% from its one-year high, the VanEck Vectors Oil Services ETF (OIH) is near its high. The discrepancy suggests that energy investors should continue adding to integrated oil firms like Exxon Mobil (XOM), ConocoPhillips (COP), and Chevron (CVX).

All three firms score an A+ on profitability.

Valuations are high, but these firms will invest in growth in 2023. For example, Chevron Chief Financial Officer Pierre Breber said that its capital budget is at the top end of its range. Its project in Kazakhstan will add meaningfully to its growth in 2024.

Shelter Costs Rise

BLS reported shelter costs rising by 0.8% and up 7.5% in the year. Food costs grew by 0.3% or 10.4% in the last 12 months. As Seeking Alpha news highlighted, egg prices rose by 59.9% Y/Y and up by 11.1% month-over-month. Bullish readers might dismiss the avian flu from a few months ago as distorting prices. Still, consumers need eggs for everything from baking bread to making a cake.

Despite commodity prices like wheat falling, food prices roses. For example, breakfast cereal (+13.0% Y/Y), flour (+23.4%), poultry (+12.2%), lettuce (+24.9%), bakery products (+16.3%), and coffee (+14.3%).

Higher food costs erode disposable income levels. However, profits for packaged food companies will not fall. Companies like Kraft Heinz (KHC), PepsiCo (PEP), and Coca-Cola (KO) are sustaining marketing and promotional activities to support demand. Conversely, consumers will cut spending where they can. For example, despite Beyond Meat (BYND) rising by 43% from its 52-week low, Conagra Brands (CAG) sells more affordable foods.

CAG stock will likely sustain its gains as its profits expand. Consumers will continue to substitute Beyond Meat’s offering with cheaper alternatives.

Medical Care Index

The medical care index rose by 0.1% in December. This includes medical care services, health insurance, and hospital and related services. Investors cannot apply the value of investing in CVS Health (CVS). The stock has company-specific risks. It fell from around $104 to below $90 ahead of its plan to buy Oak Street Health (OSH) for $10 billion.

Similarly, Rite Aid (RAD) has leadership risks. The company added an interim CEO to replace Heyward Donigan, who left the company.

Markets also rotated out of healthcare plan stocks. UnitedHealth (UNH) and Cigna (CI) fell. Drug firm Pfizer (PFE) peaked at around $54, trading at below $47 at the time of writing. Pfizer has a notable value at these prices. The stock has strong value and profitability grades:

Federal Reserve Response

Markets rallied strongly ahead of the latest CPI report. It may “sell the news” from here. Investors will not commit to a direction until the Fed meets on Jan. 31 – Feb. 1. It will raise interest rates by at least 25 basis points. Inflation is nowhere near the 2% target. It will need to keep rates at elevated levels throughout 2023 to send inflation rates near 3% to 4% by the end of the year.

The Fed needs to recognize limitations in its interest rate and quantitative tightening tools on inflation. The war between Russia and Ukraine continues. Still, commodities like wheat and natural gas prices are at pre-war levels.

China’s abrupt end to the zero covid policy could reverse its economic slowdown. It also reversed punitive regulations against the real estate and technology sector. This could increase global demand, raising U.S. inflation rates. In addition, the increase in Covid cases would disrupt China’s supply chain. Supplies of goods may fall faster than the decreased demand. This dynamic is a risk that increases inflation rates regardless of Fed policy.