Inflation – The Stock Market Achilles Heel
The stock market is a forecasting instrument that anticipates and prices-in future economic conditions. The confluence of rising interest rates, inflation, China Covid lockdowns, and the war in Ukraine has resulted in months of selling. The relentless, indiscriminate selling has pushed the Dow Jones and S&P 500 deep into correction territory while pushing the Nasdaq deep into a bear market. As such, the market appears to be factoring in a worst-case scenario that may result in a Federal Reserve induced recession as a function of over-tightening of monetary policy and/or its inability to combat inflation responsibly for an economic “soft landing.”
The markets are anticipating sequential rate hikes through 2023; however, if inflation has peaked and the tightening cycle turns dovish, then the markets will likely turn the tide on this relentless selling. If inflation has peaked and yields stabilize, these oversold conditions could easily reverse course. For April, market conditions have not been this bad for the Nasdaq and S&P 500 since the Financial Crisis and the Covid 2020 lows, respectively. With signs of inflation peaking, the markets may have fully priced in a worst-case scenario for an inflection point from these oversold conditions. During Federal Reserve tightening cycles, markets typically generate positive returns with an average of a 6.6% return over the tightening period (Figure 1).
Figure 1 – Market performance during periods of Federal Reserve tightening cycles
Signs Of Peaking Inflation
There are many areas of the economy where inflation is receding or has peaked. Although energy prices remain elevated due to the Russia-Ukraine conflict, other commodities and inputs into the CPI composite that contribute to inflation are falling. There have been pullbacks in used car sales, easing supply chains (China’s Covid lockdowns are prolonging the supply chain recovery), copper, steel, grain, soy, freight, lumber, and aluminum prices.
Inflation is assessed via two means, the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) index. The core PCE index removes the more volatile food and energy prices, and the latest data shows the PCE is pulling back slightly.
Through 2022, the core PCE climbed 5.2% through March. That reflected a minor deceleration from the 5.3% pace seen in February. The month-over-month reading was even more encouraging of a deceleration. Core PCE rose 0.3% through March, in line with the February pace and staying below the 0.5% increases observed in October through January.
Supply Chain Bottleneck Easing
The persistent inflation is largely a function of supply chain issues worldwide. Shipping delays, supply shortages, and production bottlenecks have yet to be resolved. This creates a supply-demand imbalance with subsequent price hikes to offset increased costs associated with these supply chain issues. Freight rates have been declining since September 2021 and seem to be in a downward trend. March also marked the third consecutive month of declines in average delays for container ships. Lower freight rates should translate into removing a major inflation pressure point.
The Consumer
Consumers are not concerned about inflation worsening. Citi's US Inflation Surprise Index, which measures the degree to which inflation data surpasses or falls below estimates, has dramatically declined recently, signaling inflation expectations may have already hit their peak (Figure 2).
Figure 2 – Inflation sequentially dropping recently, indicating that inflation has likely peaked
The drop could be a harbinger of slower price growth. Analysts at UBS also said this month that they expect inflation will likely peak in March and then fall "sharply." These may be indicating that inflation may finally be reverting to pre-pandemic levels. Additionally, rising mortgage rates should cool the housing market and continue to put downward pressure on overall inflation.
Rates Hikes
The Federal Reserve increased interest rates by 50 basis points in early May, the biggest hike in two decades. This was on top of 25 basis points back in March, the first hike in more than three years. Powell said 50 basis point hikes might be needed at the next two meetings in June and July. Rate increases are also seen in the September, November, and December meetings. Powell did take the prospect of a 75 basis point rate hike off the table in an attempt to provide certainty and engineer a soft landing.
Conclusion
The confluence of rising interest rates, inflation, China Covid lockdowns, and the war in Ukraine has resulted in months of selling. The relentless, indiscriminate selling has pushed the Dow Jones and S&P 500 deep into correction territory while pushing the Nasdaq deep into a bear market. If inflation has peaked and the tightening cycle turns dovish, then the markets will likely turn the tide on this relentless selling.
Several inputs into the CPI composite that contribute to inflation are falling. There have been pullbacks in used car sales, easing supply chains (China’s Covid lockdowns are prolonging the supply chain recovery), copper, steel, grain, soy, freight, lumber, and aluminum prices. The Federal Reserve increased interest rates by 50 basis points in early May, which was on top of 25 basis points back in March. Powell said 50 basis point hikes might be needed at the next two meetings in June and July. Rate increases are also seen in the September, November, and December meetings. Powell did take the prospect of a 75 basis point rate hike off the table in an attempt to provide certainty and to engineer a soft landing.
Now that inflation seems to be abating and rates are rising to directly curb these inflation pressures, the markets may have priced in a worst-case scenario. As new data points enter the fray on the inflation front, the markets may be close to moving to an inflection point to move higher.
Noah Kiedrowski
INO.com Contributor
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