Has inflation reached a peak?
Written and accurate as at: May 27, 2022 Current Stats & Facts
There is a lot of debate about whether we have seen peak inflation and peak bond yields. Official data such as retail sales are signalling that the consumer remains strong, though there are signs the economy is slowing. For example, the Economic Surprise index is deteriorating in most countries, which shows the degree to which economic data is beating or missing estimates. Consumer confidence is also weak and is at 40-year lows in the UK.
The combined effects of higher mortgage rates and fuel prices have been consistent with previous consumer slowdowns. This indicator tends to lead by around 12 months. Total financial conditions – which include rates, equities and credit spreads – have tightened reasonably and should lead to a headwind of 1.3% of US GDP growth by Q3 2022. We are also seeing signs that corporate pricing power may be easing while still at high levels.
There are signs that consumers are under some stress – particularly at the lower-income end – with credit outstanding rising rapidly. This may support current consumption but is unsustainable.
Freight shipping rates are beginning to drop, and there are early signs of a fall in US trucking rates. The freight rate may be a misleading signal due to a drop-off in Chinese exports. It's unclear how much of this is a genuine de-bottlenecking of supply chains. All of this indicates the economy is responding to tighter financial conditions. It is slowing down, and this is beginning to reduce inflation pressures. This belief can be seen in forwarding pricing of inflation, where both break-even yields and the 5-year inflation swap have rolled over since late April. This could be positive for the equity market since it aligns with the first scenario outlined above.
However, there are still two key unknowns
This slowing could be the prequel to a recession
A slowdown and a recession will look the same initially. It will also probably result in negative earnings revisions, which the market will not like, as we saw last week in the US.
Or could inflation fall enough to allow the Fed to declare victory.
Fed Chair Powell has stressed that the labour market is resilient enough to weather tightening policy. While this sounds reassuring, the question is whether a resilient labour market is consistent with inflation falling to target levels. If it is not, policy needs to tighten even more.
The labour force is very tight, and this is driving wage growth. Some measures suggest we need to see employment decline by at least 1% to reduce wage pressure.
China
Economic surveys indicate the Chinese economy is weak. Q2 GDP is expected to decline from 1.5% to 2%, with growth coming in between 3% and 4%. Beijing has responded with a larger-than-expected cut in its 5-year loan prime rate. China bears see this as a move to prop up private developers facing a funding squeeze, thereby preventing deterioration rather than providing stimulus.
The more bullish view is that while this may not be a sizeable move, it is a strong signal that the government will support property, similar to November 2014. Then it was the precursor to a big bounce in Chinese growth sentiment in 2015.
The property market appears to be deflating, but prices remain very high, and developers are still too leveraged. At best, the market stays flat, but the risk is to the downside, so any infrastructure related stimulus will only be offsetting this.
The other challenge is the lack of transparency over the extent of Covid and the actual level of restrictions.
Europe
The ECB struck a more hawkish tone in response to poor inflation data. The market is now being primed for a first-rate rise in July, with a possible 50bp move. This is unlikely but helped the Euro bounce off its lows against the US dollar.
Australia
There is little to read into the election outcome at this point. A majority government provides more clarity than a minority. We are also likely to see more emphasis on reducing carbon emissions in the coming years, which will impact corporate disclosures and investment.
US earnings
Overall quarterly earnings were good. Full-year earnings lifted from about 5% to 11% growth. However, the outlook looks overly optimistic, with a slowdown of 9% eps growth expected in CY23.
Last week demonstrated the impact earnings headwinds can have. Broadline retailers missed earnings expectations due to freight costs and the mix shift in consumption. Walmart and Target have joined Amazon in highlighting material gross margin pressure.
Underlying sales have not been particularly disappointing. But the impact of the unexpected mix shift caused problems as spending moved away from home, consumer electronics and sporting goods to travel, toys and luxury goods.
Inventories are also building in home furnishings and consumer electronics, while unit demand growth is dropping. This crimps a company's ability to push through price rises.
The share of "private label" sales are rising. This is partly due to improved product availability as labour issues improve. It may also indicate consumers are "trading down" as real income falls – potentially a signal of softer consumption.
The overall impact was significant hits to stocks in the previously defensive consumer staples sector.
This highlights the difficulty in identifying defensive pockets in this environment.