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Has Inflation Peaked?

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Has Inflation Peaked?

Stocks rallied sharply last week based on the better-than-expected consumer inflation (CPI) data. Has the rate of inflation peaked for this cycle, though? At the risk of spoiling the ending, it looks like the worst year-over-year inflation rates are behind us. It might still be premature to break out the champagne with the headline rate still at 8.5% year-over-year and unclear timing to reach the target inflation rate.

First, the good news, the energy component that was a significant driver of the inflation spike has receded somewhat. While the gasoline component of CPI is still up 44% year-over-year, it was -7.7% in July. Gas prices are still well above year-ago levels, but the decline helps ease some strains on households and the economy.

In addition, some areas of consumer inflation that were particularly impacted by the reopening of the economy following the Covid shutdowns have begun to show improvement. For example, car rental prices spiked when the economy reopened due to a lack of fleet vehicles and the inability to replace the cars at a reasonable price due to a chip shortage. Car and truck rental prices fell to -11.9% year-over-year in July. Plus, hotel and used car prices rose at a pace lower than the overall inflation rate.

Now the more challenging part of the inflation story. Despite the decrease in the year-over-year headline rate of inflation versus the previous month, the sticky portion of the inflation components rose to 5.8%. The sticky elements take longer to adjust than gasoline, which can have more volatile swings. This elevated sticky inflation makes the timing to reach the 2% inflation rate more challenging.

One sticky part of inflation is rent. Rent of primary residence rose to 6.3% year-over-year, and rent tends not to fall very often. Even during the global financial crisis, which included the housing bubble bursting, the rent components barely dipped into the negative year-over-year. Directionally, house prices tend to lead rents, so activity around homes will be essential to watch. The rate increases from the Federal Reserve have cooled housing activity, and prices may follow. A lot of housing data is coming this week, including building permits, housing starts, and existing home sales.

Wages are another component that tends not to decline often. Despite the high unemployment rate during the global financial crisis, average weekly earnings only dipped into slightly negative territory. In July, average weekly earnings rose by 5.3% year-over-year, and the upward pressure is likely to continue while the unemployment rate remains low. In addition, the after-inflation (real) growth rate of earnings is negative, which should add to the reasons for the nominal level to remain elevated.

It is always instructive to look at what the collective wisdom of the markets is expecting for inflation. The 10-year breakeven inflation rate recently eased to 2.48%, implying that market participants think inflation will average this level over the next ten years. Interestingly, the breakeven rate peaked in late April. The 5-year 5-year forward breakeven inflation rate tells us what the markets think inflation will be over the next five years, starting five years from now. Looking at inflation five years from now helps remove some short-term price movements and focuses on the expected long-term path. This measure has declined to 2.24% and also peaked in late April.

Notably, the 2-year and 10-year Treasury yields are lower since they peaked in mid-June. The nominal yields on Treasuries would not be lower if inflation were expected to continue to accelerate. With the benefit of hindsight, the S&P 500 reached a closing low shortly after yields peaked and has rallied by almost 17%!

Another piece of evidence supporting the markets believing we have seen the peak in inflation is the outperformance of cyclical stocks versus staples. Cyclical stocks are more exposed to the economy than staples, implying that the Federal Reserve is less likely to be forced to continue to increase interest rates aggressively. The market seems to be looking beyond the economic slowdown with some relief on the inflation front.

Markets have cheered the better inflation news, but the timing and the path to a normalized environment remain unclear, with the sticky components of inflation remaining elevated. Despite this respite for lower-quality companies provided by the relatively positive inflation news, investors should focus on quality companies that can survive a possible recession and thrive once the turmoil passes. Investors should focus on an asset allocation that provides the financial means to persist through market volatility and an economic downturn since the economic backdrop remains challenging.

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