Much like a restless teenager on a road trip will often pose the question “are we there yet ?” to his/her parents, market participants have been doing the same with regards to peak inflation. However, while the response from the parents may be more definitive, the response for market participants are anything but definitive.
Just as a parent may take a quick glance at google maps to see the time remaining to destination, let us examine my inflation radar.
A quick word on how the journey started
Once, the reopening had started, households armed with an unprecedented amount of fiscal stimulus had started pushing up aggregate demand in the economy. Given the low levels of demand from which we were starting due to the pandemic related shutdown of economic activity, is what perhaps led the FED to mistakenly assume that the inflation spike would be transitory in nature. What they didn’t anticipate was the degree to which global supply chains were scrambled and they certainly couldn’t have anticipated the war in Ukraine. The war added to the rising prices of energy and food commodities; compounded by global chip shortages, persistent supply chain disruptions and a shortage of labour resulted in some of the highest inflation prints in four decades and loss of credibility of the world’s most important financial institution.
Is the worst behind us ?
Let’s dive into the components of my inflation radar and follow where the data takes us. There are six main components on my radar and the closer the data points are towards the centre indicate the degree to where we currently are in relation to the conditions causing the highs of inflation.
Supply Chains
Outlook: Positive
The data suggests that supply chain pressures are beginning to dissipate providing much needed relief to businesses grappling with high shipping costs as well as the time required to receive deliveries from overseas suppliers.
Data Source: NY Fed
My preferred indicator is the global supply chain pressure (GSCP) index which incorporates the following metrics that provide a good gauge of global supply chain conditions.
The Baltic Dry Index which measures raw material shipping costs around the world
The Harpex Index which measures container shipping prices
The US Bureau of Labor Statistics (BLS) Import/Export and Inbound/Outbound Air Freight Indices which measures air freight prices to and from the US
The Purchasing Manager Index (PMI) surveys focusing on manufacturing firms across seven interconnected economies: China, the euro area, Japan, South Korea, Taiwan, the United Kingdom, and the United States. The GSCPI specifically uses the following PMI subsets: Delivery times, which captures the extent to which supply chain delays in the economy impact producers, Backlogs, looking at order volume that organizations have received but have not been able to complete yet; and purchased stocks, which is an inventory measure.
The risk to the supply chain outlook turning negative hinges significantly on China’s zero Covid policy. If we see new outbreaks in China and further lockdowns, it will continue to disrupt the supply chains and put renewed pressure on the supply side dynamics.
Commodities
Outlook: Positive
Commodity prices are coming down from their peaks. The Bloomberg Commodities Index which tracks more than 20 commodity futures including energy, metals, and livestock has declined 19% from its peak.
The retreat of WTI from its peak of ~ USD 120/barrel to the mid 90s is a healthy welcome for consumers and businesses alike. Other commodities like copper futures are down almost 40% from their mid-March high. Wheat futures have seen the biggest two-month decline since 2003 and Soybean futures have dropped about 10 percent since the end of June. There is also anecdotal evidence of the easing of the supply disruptions from the Ukraine-Russia war as grain shipments from Ukraine appear to have tentatively restarted.
Wages
Outlook: Neutral
Labor force participation rates have been increasing and there are initial signs that wage growth is showing signs of slowing. However the job market still remains extraordinarily tight with 1.8 jobs available per person in the US. As a result, I continue to believe that while we aren’t heading towards a wage-price inflationary spiral, we will continue to see higher wages be a hindrance to a faster pace of inflation moderation.
Inflation Breadth
Outlook: Neutral
Excluding the two most volatile components of CPI (Energy & Food), inflationary pressures are widespread across the economy. The heat map below shows the trend in the components since the beginning of this year (red for worsening and green for improving). While the July data showed a reprieve in the majority of the components, I encourage investors to be cautiously optimistic and remind investors that a single data point doesn’t constitute a trend.
Data Source: US Bureau of Labor Statistics
Housing - While rising rates are bringing down home prices, owners equivalent rent which accounts for ~20% of the CPI basket tends to lag actual home prices by up to 12 months. While rent price increases appear to have slowed, they will continue to hold firm at these higher levels.
Goods - There is evidence that a handover is occurring as consumers shift from the pandemic related goods buying boom to services related purchases. I expect durable good prices to continue to fall in the upcoming months. This is further evidenced by the increase in inventory levels relative to sales.
Services - Services inflation is much sticker than goods inflation and are seeing upticks in the services inflation data which will continue to be detrimental to inflation moderating at a faster pace.
Monetary Policy & Money Supply
Outlook: Positive
Monetary Policy: The fact that the Fed was late to the game when it comes to fighting inflation has been well documented. Larry Summers, the former US Treasury Secretary went as far as saying that Jay Powell’s recent comments regarding the ‘neutral policy rate’ as “analytically indefensible”. However, we should still heed the notion of ‘Don’t fight the Fed’. As Chair Powell continues to reiterate that the Fed will remain data dependant and promises to be nimble, I expect them to continue to hike rates going into next year and ultimately settling around the 3.5-3.75% range. While the latest print and the subsequent prints may slow the magnitude of the rate increases, it certainly won’t be enough to pause the hikes. As one Fed official put it “The Fed remains data dependant, not data point dependant”.
Money supply: As the Fed continues quantitive tightening and shrinks its balance sheet, money-supply growth (as measured by the Fed’s M2 Monetary Aggregate) is down to 5.9% year over year, well below its February 2021 peak of 27%. The historical average going back to 1960 is 7.2%.
Inflation Expectations
Outlook: Positive
The University of Michigan’s expected inflation rate over the next 1 year and for 5-10 years from now are showing signs of stabilizing. This data is particularly important given the reliance from the Fed on this data when it coming to gauging if inflation expectations are being unanchored. I believe the 5-10 year expected inflation is the more important data point to gauge the relationship between inflation exceptions and actual inflation as Janet Yellen mentioned at a speech in 2016 at the Boston Fed that although many theoretical models suggest that actual inflation should be most closely related to short-run inflation expectations, as an empirical matter, measures of long-run expectations appear to explain the data better.
1) Specifically, survey measures of long-run inflation expectations are broadly correlated with estimates of inflation's longer-term trend. See Clark and Davig (2008); see also Faust and Wright (2013), who make a related point in the context of inflation forecasting.
There's also evidence in the TIPS breakeven that the market’s inflation expectations may have peaked. TIPS (Treasury Inflation-Protected Securities), and the TIPS breakeven uses the yields on TIPS to measure expected inflation. The 5-year TIPS breakeven has fallen 100 basis points since March, suggesting investors broadly expect inflation to fall.
So how much longer ?
I started this note with the question “Are we there yet ?” and perhaps the best way to conclude would be to answer “How much longer ?” before we can say inflation has peaked.
I believe the worst is likely behind us and we are heading towards the right direction but we aren’t out of the woods yet and I remind investors that we remain a very long way from the Fed’s inflation target, hence I caution against any overly enthusiastic reaction similar to that we saw from the markets immediately on the back of the July data. It’s important to remind ourselves that one data point doesn’t constitute a trend and further evidence is required of inflation moderating. By historical standards inflation continues to remain high and widespread.
My base case is for inflation and growth to both slow as we head in the later parts of this year and 2023 and the Fed hiking cycle concludes with rates at around 3.5-3.75%.
Given this backdrop, I would continue to recommend equity investors to remain cautions and be selective in choosing individual securities, prioritizing value and high dividend paying companies. Investing in high conviction names at attractive entry points would be a much safer bet than trying to time the inflation peak and the subsequent market bottom notwithstanding any further escalations of geopolitical tensions. I continue to prefer North American equities over European or Emerging Markets. However, investors should be wary of companies that derive a significant proportion of their revenues outside of the US given the strength of the US Dollar.
I am constructive on bonds in this current environment. Yields are attractive again and if my base case plays out, fixed income provides a healthy risk/return outlook. I prefer Investment Grade credits with durable free cash flow and solid balance sheets over High Yield credit.
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