09.12.22 Persistent inflation is probably the largest financial challenge faced by the global equity and bond markets. Given the choice between combating inflation or supporting the economy and financial markets, the Federal Reserve has already chosen the inflation fight over just about everything else. Last week the European Central Bank hiked its benchmark rate by 75bps in the face of an impending energy shortage. Plunging inflation would be welcome news to both stock and bond markets. Thanks to its interest rate connection, the S&P 500’s price/earnings (P/E) ratio has been inversely related to inflation. Today’s high inflation rates are considered an outlier by market participants who are counting on price growth to stumble. Historically, inflation readings in the eights have corresponded to P/E ratios of around 10x. Given the current market P/E ratio of closer to 20x, it’s no wonder investors, and the Fed, are closely eyeing CPI, which will be released September 13 (tomorrow).
Economists are calling for an 8 per cent increase in inflation for August, down slightly from the 8.5 per cent July reading. They’ve also penciled in a one per cent month-on-month contraction in prices, led in large part by a 9 per cent plunge in prices at the gas pump. If the forecasters are correct, this inflation trend would align with our “July peak” narrative.
While an 8 per cent year-over-year price gain is concerning, several indicators we track suggest today’s current pricing pressure will ease. First are food and energy prices as quoted in daily commodity markets. The national average price for a gallon of unleaded gasoline was $3.82 at the end of August. That’s down 38 cents, or more than 9 per cent for the month.
Another positive metric is the decreasing share of small businesses that are raising prices. A recent survey of small business owners by the National Federation of Independent Businesses (NFIB) found that 56 per cent of its members raised prices last month. While high, this is down from 65 per cent two months ago. Historically, inflation trends tend to track the NFIB survey. In Q4/20 only 13 per cent of small businesses were raising prices, which was consistent with modest inflation. By early 2021, however, the share of businesses raising prices escalated, corresponding to inflation ascending toward its highest readings in over 40 years. The good news is the NFIB survey peaked two months ago and is heading lower. We expect inflation to follow suit.
Remember supply-chain shortages? It appears that bottlenecks are becoming a thing of the past, at least when measured by the prices paid among manufacturers. Probably one of the most dramatic reversals in pricing pressure comes from the Institute for Supply Management (ISM) survey: the prices-paid component of the ISM’s Manufacturing Index fell precipitously last month, marking the fifth straight month of declines and falling to its lowest since June 2020, according to Bloomberg. While not as closely correlated as the NFIB survey, the prices-paid component has been a good directional predictor of inflation. If past is prologue, inflation readings could weaken quickly.
Weaker inflation trends would be welcome news to risk takers. It would mean the Fed and other central banks would not need to tighten financial conditions as dramatically has they’ve projected recently. Interest rates would ease, helping corporate profit margins and household income. Lower mortgage rates would support a sagging housing market. The dollar, which has been an impediment to international competitiveness, would ease. Weakening inflation has the potential to boost stocks and bond markets globally.