While US (and global) inflation began to surge in the first half of 2021, it was only in 2022 that the markets genuinely started to worry.
These concerns coincided with central banks signalling they were (belatedly) worried about inflation and would do “whatever is necessary” to bring inflation under control.
From this perspective, while a sizeable portion of the inflation surge over the past 2 years has been supply-side driven, an overheated demand cycle has played an important role, particularly in the US.
After being initially very complacent in terms of the inflation outlook, the US Fed was forced to raise interest rates aggressively to cool this excess demand, which they in part created. The Fed was, of course, aided by massive US government income support spending during the pandemic.
This sharp rise in interest rates had a significant valuation impact on equity markets in 2022, and it is currently fuelling fears for the US economic outlook over the coming year.
However, the Fed remains “hawkish” with numerous Fed speakers voicing concerns that inflation remains too high. Inflation hawks (the Fed included) point to the muted deceleration in core inflation (and sticky wage growth) as a warning that inflation is at risk of becoming structural.
While inflation has certainly proved sticky in recent months, our analysis suggests that we are on the cusp of a significant deceleration in US inflation. This should “all things equal” be supportive for risk assets.
Some Rays of Light in the Recent Inflation Detail
In line with consensus, annual US core consumer price index (CPI) inflation slowed only marginally from 5.6% year-on-year (YoY) to 5.5% YoY in April (released May 10). The month-on-month (MoM) rate of change registered a still high 0.4% rise (4.8% annualised).
So, for now inflation remains too far above the Fed’s ~2% target to justify an imminent policy shift to lower interest rates. Moreover, while employment conditions are cooling, the labour market remains tight. Consequently, the Fed is likely to retain a tightening bias while keeping interest rates unchanged for some months yet. However, we feel there were some encouraging signs in the April release.
The details of the report – from the perspective of the Fed’s breakdown of core inflation into core goods, shelter, and core services ex-shelter – confirm that price pressures are easing, and this easing should build momentum.
Firstly, while the core goods component accelerated to 0.6% MoM, the driver of that increase was a 4.4% MoM spike in used cars and trucks. This was also the second largest contributor to the monthly core CPI. However, the closely watched Manheim Used Vehicle Index has rolled over and foreshadows a decline in the used car component. We expect core goods inflation will resume the downtrend that has been in place for some time now, given an unclogged supply chain and slower underlying goods demand (see figure 3).
Encouragingly, in the same week the US Producer Price Index (PPI) was also lower than expected for April. The headline index was down to 2.3%. Core PPI rose only 0.2% monthly, versus 0.3% expected. So, the pipeline inflation pressures influencing goods pricing are clearly on an improving path (see figure 4).
Secondly, the shelter (housing) component – which has for some time been the largest contributor to the core CPI index– decelerated from 0.6% MoM to 0.4% MoM. Importantly, leading indicators of shelter inflation (rents on new leases reported by real estate internet platform Zillow) indicate that shelter inflation will continue to moderate. Indeed, the Zillow read-through suggests that the shelter component (which is 40% of core CPI) could ultimately take more than 1% off core CPI.
Finally, core services inflation ex shelter was only up 0.11% MoM, driven by lower travel and hotel pricing. This very low read may not be sustainable, although the trend looks to be relatively benign for “super core-CPI”, which is closely watched by the Fed.
The Fed will take the moderation in core services excluding housing as a tentatively good sign, even if they will want more evidence of progress before moving away from a tightening bias.
Nonetheless, we see these trends as encouraging and expect evidence of moderating inflation to build over coming months.
Emerging Inflation Tailwinds versus Growth Headwinds
The prospect of a significant step change in core inflation over the balance of this year should lead to lower US interest rates before year end and should “all things equal” be supportive for risk assets.
Of course, there is still the question of how much damage the Fed’s aggressive policy response has done to the US economy.
Investors continue to debate whether the US will in fact slide into recession and whether there will be significant further financial strains beyond the banking stresses that have emerged over the past couple of months.
Our view is that the economy will slow significantly but not get into major trouble. This is in part based on supportive labour market dynamics. The prospect of Fed rate cuts by year end should also help cushion the downturn.
We acknowledge a degree of caution is necessary with the elevated risk of recession and emerging banking sector strains, but we see the 6-12-month outlook for lower inflation as a significant positive.
We believe a step change in inflation sets up a plausible path for stocks and bonds to both do reasonably well over the coming year, although the growth outlook appears to be the key risk to our benign view for equities – hence our relatively neutral tactical view. Australian inflation will take longer to peak but market sentiment is likely to be dominated by the trend in US inflation.
Some Perspectives on the Longer-term Inflation Trend
Beyond the next 12 months, the inflation debate remains live and the prospect of somewhat higher trend inflation is significant. In the longer term, it is quite possible that the trend rate of inflation (i.e., the 5-10-year outlook) is higher than the past 10-20 years.
Influences such as deglobalisation and the energy transition look to be somewhat inflationary, all things equal. However, ongoing demographic ageing (sluggish trend growth) and technological innovation should continue to have a dampening influence on the long-term inflation backdrop. Indeed, although only in its early days, the AI revolution could prove to be a significant deflationary force via its potential impacts on productivity and (reduced) labour demand.
Our best estimate is inflation averages on the high side of the Fed’s 2% target over the next 5-10 years. However, we doubt we are set for anything like the 70s or 80s periods of structurally high inflation despite the elevated current readings.
In summary our analysis suggests we are about to move out of a 2-year “transitory” phase of high inflation into a low-to-moderate regime. There are longer term upside risks around the inflation implications of the energy transition and labour market demographics (worker scarcity) but investors also need to consider the downside risks from the ongoing technology revolution, so we continue to follow the inflation backdrop very closely.
Our Investment View
From a tactical (6-12-month) perspective, investors should prepare for a significant slowdown in the US and global growth pulse over the coming year. However, we expect a significant drop in inflation over the next 6-12 months, which will allow central banks (led by the Fed) to lower policy rates. This should clear the path for either the goldilocks scenario of a soft landing, or, at worst, a relatively mild US recession. This is likely to set the stage for further gains in equity markets and provide a reasonable backdrop for fixed interest. We retain our modest overweight to global and domestic equities and a neutral position in bonds.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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