The sharp decline in gas prices (down 30% since June) fooled investors into thinking inflation was easing, but August’s CPI report told a different story. Stickier categories like shelter and healthcare kept prices higher than expected, leading to core inflation (ex-food and energy) rising +0.6% last month, twice consensus estimates, and bringing year-over-year cost-of-living increases up +6.3%. Including food and energy (we exclude them to make ourselves feel better but for questionable analytical reasons) rose +0.1% monthly and a strong +8.3% on a 12-month basis, suggesting the much-prayed-for abatement in inflation has yet to arrive.

Stocks and bonds reacted as one would expect (investors were clearly positioned for better news). The yield on two-year Treasuries, which are believed to be the instrument most sensitive to Fed policy, rose +17 basis points to 3.748% (they hit 3.798% at one point during the trading day), their highest level since November 2007 (before the Great Financial Crisis when rates were somewhat normal). Stocks were decimated with the Dow Jones Industrial Average losing 1,276 points (-3.94%), the S&P 500 177.72 points (-4.32%) and the Nasdaq 632.84 points (-5.16%), wiping out gains from the last week. The recent rally was due to a number of factors all of which should were either illusory or transitory. The reality investors have to face is deeply embedded inflation that is going to require more Fed tightening for longer than expected.

In the September issue of The Credit Strategist, I forecast a price target for the S&P 500 in the low 3000s (15x earnings of $200-$220). That still seems to be the most prudent case. The Fed will raise rates by 75 basis points next week (I don’t see them raising by 100 basis points as some are now suggesting) and then by at least another 75 basis points by year-end (likely 100), leaving them at 4% or higher. This means they will have raised rates by ~400 basis points since March, a remarkably compressed period of time by historical standards. The significance of this is that the economic drag from these hikes has yet to fully work its way through the economy. With Fed officials speaking with near unanimity that rates will stay elevated for a prolonged period of time, the prospects for growth are poor (and Wall Street estimates need to be downgraded).

Accordingly, investors should reduce their expectations for equities and play defensive ball. In a bear market, it’s not what you make, it’s what you keep. And we are still decidedly in a bear market.