US inflation came in softer, but risks of further rate hikes remain

Figure 1: US inflation held steady in August

The softer-than-expected inflation readings were largely driven by methodological revisions made by the US Bureau of Economic Analysis (BEA) to three index components (Table 1). Portfolio management fees saw the largest downward revision, followed by computer software and accessories, while legal services were revised slightly higher.

Overall, these revisions suggest that underlying inflationary pressures may be more moderate than previously feared.

Table 1: Revisions to July PCE (YoY)

Persistent inflation risks keep further rate hikes in play

Despite the softer inflation data, we expect price pressures to remain elevated.

While recent revisions have lowered the overall level of inflation, the underlying trend has yet to shift meaningfully. Core PCE inflation has held at 3.0% for three consecutive months, still well above the Federal Reserve’s 2% target. While the three-month annualised rate of core inflation suggests that inflation had returned to the Fed’s 2% target in August, the one-month and six-month annualised rates remained above target at 3.0% and 2.7%, respectively. This suggests that the recent moderation in inflation may not yet represent a sustained downward trend.

Other measures also point to persistent price pressures. Fed Chairman Kevin Warsh’s unweighted inflation diffusion metric, which measures the share of PCE price components rising by more than 3% over the past 12 months, eased to 52% from 54%. However, this remains significantly above the 32% historical average recorded during the two decades before the COVID-19 pandemic.

We see several upside risks that could keep inflation higher for longer.

Energy prices are likely to remain an important source of inflationary pressure, despite signs that crude oil exports are recovering towards pre-war levels. According to maritime tracking firm Kpler, Gulf oil exporters exceeded pre-war export levels for around half of September as more producers resumed transit through the Strait of Hormuz despite the continued threat of Iranian attacks. The G7 countries have also agreed to release 100 million barrels of diesel and crude oil from emergency reserves and pledged to refrain from imposing energy export restrictions, which should help ease supply pressures.

However, energy prices are likely to remain elevated amid record-high tanker rates, soaring insurance costs and a severe shortage of refining capacity. Tanker availability has been particularly tight as the current shuttle system requires smaller tankers to transport crude through the Strait of Hormuz to the Gulf of Oman, where it is transferred to larger vessels bound for Asia. At the same time, Asian buyers are increasingly sourcing crude from the Atlantic Basin, requiring longer shipping routes that tie up tanker capacity for longer and further push up freight rates.

The loss of refining capacity in the Middle East and Russia has compounded these pressures by raising the price of refined fuels like gasoline and diesel. Ukrainian drone attacks have damaged numerous Russian refineries, while disruptions in the Middle East have further constrained refining capacity. As diesel is widely used across transportation, agriculture and manufacturing, higher fuel costs could raise transportation and production costs throughout the economy, potentially feeding through to food and other goods prices.

The risk of further disruptions to energy supplies has also not gone away. Continued hostilities involving Iran-backed Houthi forces, alongside ongoing attacks on energy infrastructure and vessels, could lead to sudden supply disruptions and further damage to regional energy infrastructure. These risks remain a key source of uncertainty for the inflation outlook.

Beyond energy, other sources of inflationary pressure are also building. Rising memory chip prices amid a global shortage driven by strong data centre spending are contributing to higher electronics prices. Food prices are also rising amid adverse weather conditions and transport disruptions. The UN Food and Agriculture Organization’s Food Price Index rose 1.5% month-on-month (MoM) in September, reaching its highest level since November 2022. Further tariff escalation could add to these inflationary pressures.

Meanwhile, the US labour market remains resilient despite some signs of cooling. Nonfarm payrolls increased by just 29,000 in September, below the downwardly revised 133,000 increase in August and market expectations of 90,000. However, we are not overly concerned by the weak headline figure given the volatility in monthly hiring data. The unemployment rate remained relatively low at 4.2%, while the rise from 4.1% in August partly reflected more people entering the workforce in search of jobs. The labour force participation rate, which measures the share of the population working or actively seeking employment, rose to a four-month high of 61.8% in September from 61.6% in August.

At the same time, layoffs remain low, with initial applications for US unemployment benefits holding at 197,000. Taken together, these indicators point to a labour market that remains broadly stable, characterised by relatively low hiring and low firing rather than a sharp deterioration in employment conditions.

The softer-than-expected inflation and labour market data suggest that the Fed can afford to be patient before raising rates further. Recent comments from Fed leadership, including New York Fed President John Williams and Fed Vice Chair Philip Jefferson, have also pointed to little urgency to hike rates. Markets are now pricing in a 78% probability of the Fed holding rates at its October meeting, according to CME FedWatch.

However, we believe the possibility of further rate hikes remains real. Inflation is still elevated and has yet to show a convincing downward trend towards the Fed’s 2% target, while energy, food, semiconductor and tariff-related pressures could push prices higher. With economic activity remaining resilient and labour market conditions holding up, further rate hikes remains firmly on the table.

We favour the digital economy but remain cautious on consumer discretionary

Our recommended positioning remains unchanged.

We maintain our cautious stance on consumer discretionary stocks, despite stronger-than-expected consumer spending in August. Inflation-adjusted spending, as measured by PCE, rose 0.6% month-on-month (MoM), up from 0.1% in July, with households increasing spending on big-ticket items such as motor vehicles and furnishings, as well as discretionary categories including clothing, food services and accommodation.

Upward revisions to personal income and the household saving rate also help explain the resilience of US consumers thus far this year despite persistent inflation. The revised data showed that households had higher incomes and more savings than previously estimated, providing greater support for spending. Higher-income households have continued to spend strongly, supported by the wealth effect from gains in stocks.

Figure 2: US consumer had higher savings than initially thought

However, we believe elevated inflation, higher-for-longer interest rates and weakening consumer confidence could weigh on consumer spending ahead. The Conference Board's measure of consumer confidence fell sharply to 81.9 in September from 88.6 in August, well below the consensus forecast of 89.0 and its lowest level since April 2014. Households became more pessimistic about business conditions and the labour market over the next six months, while their assessment of future income prospects also weakened.

The cushion supporting consumer spending is also shrinking. The personal saving rate fell from 4.6% to 4.1% in August, its lowest level since November 2022, while the boost from tax refunds is also fading. At the same time, weak wage growth could further constrain spending, with real average hourly earnings contracting for five consecutive months.

Businesses are already feeling the effects of a more cautious consumer. McDonald's US comparable sales growth slowed to 0.8% year-on-year (YoY) in the second quarter, down from 2.5% a year earlier, amid weaker traffic across the quick-service restaurant industry and execution issues around promotions. Nike's management similarly described consumers as cautious and pointed to weaker traffic and a broader lack of momentum across the lifestyle footwear market. Both companies were also affected by weaker consumer demand in China. These pressures have weighed on the broader US consumer discretionary sector, which is down 3.5% year-to-date as of 6 October.

We also remain cautious on unprofitable, high-growth companies. Elevated bond yields, driven by persistent inflation concerns and growing scrutiny of US debt sustainability, can weigh on the valuations of companies whose earnings are expected further in the future. Higher funding costs add to the pressure, particularly for companies that rely heavily on external financing.

In contrast, we continue to favour the digital economy, which stands to benefit from rising AI adoption. Within the sector, we see opportunities in internet companies and semiconductors. Among internet companies, Big Tech is seeing increasingly tangible AI monetisation as demand for computing accelerates, while AI agents could further drive computing demand and create new revenue opportunities as adoption grows. We also see opportunities in cybersecurity companies, as increasingly sophisticated and frequent AI-driven cyber threats raise the need for security spending.

Semiconductors are another area where we are positive. The sector has pulled back amid concerns over the sustainability of heavy AI capital spending, but recent guidance and earnings upgrades have extended the growth runway. We expect AI investment to remain strong as broader adoption drives continued spending on computing infrastructure and capacity, with hyperscalers estimated to spend approximately USD 800 billion in 2026. Demand should also remain supported by the shift towards inference and increasingly complex agentic workloads, even if frontier model development slows due to safety concerns. The recent pullback, combined with stronger earnings prospects, has made semiconductor valuations more attractive.

While we see attractive opportunities within the US digital economy, we remain cautious on US equities at the broader index level given elevated relative valuations. The S&P 500 currently trades at a 80.3% premium to the MSCI Asia ex-Japan Index, well above its 10-year average premium of 45.0%. We therefore maintain our underweight on the US market and continue to favour Asian markets such as Taiwan and South Korea, which offer comparable growth prospects at more compelling valuations.

For investors seeking broad US market exposure, we favour high-quality companies with strong balance sheets, resilient earnings and high returns on equity.

Table 2: Recommended products

Declaration:

This research report was prepared with the assistance of artificial intelligence (AI) tools. iFAST Financial Pte Ltd does not rely exclusively on AI for content generation; the content of this report – including all investment theses, ratings, price targets and conclusions – has been independently reviewed and verified by the research analyst(s) to ensure accuracy and professional integrity.

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.