Yes, it seems that investors have recently been betting that inflation has finally peaked, meaning the Federal Reserve could soon reduce interest rate hikes. A measure that will boost the economy and higher risk assets, such as investing in stocks. But this may be too optimistic a view. Although there are signs that inflation is easing, other signs suggest that we are going to have to deal with it for a while...
What are the signs that inflation is subsiding?
The economy has already been cooling for weeks. The model GDPNow The Atlanta Federal Reserve estimates that the US economy contracted 1,6% during the second quarter. This data suggests that the economy could already be in recession. The job market remains strong, but it is often the last domino to fall. So, if the economy is already cooling, that means demand is already slowing and inflation should start to ease soon.
Atlanta Fed CPI growth forecast. Source: AtlantaFed
In turn, supply chain disruptions are decreasing. Many economists argue that inflation was mainly caused by such disruptions at a time when the pandemic was shifting consumer demand from services to goods. Now interest in stock investing is returning to services. There are signs that supply pressures are also easing. Therefore, if supply can meet demand, inflation should fall. Food and energy prices contributed significantly to the growth of inflation, especially since they started from low supports after the great impact caused by the pandemic. But now that prices have been high for some time, year-on-year price changes are likely to be much smaller in the future, and could even be negative if commodity prices continue to decline.
Additionally, retailers can use their overloaded inventories to help lower inflation. They have tons of products to get rid of, and they will likely do everything they can (such as lowering prices or giving refunds without accepting the products back) to reduce their stock. And how small changes in demand at the retail level can lead to progressively larger changes along the supply chain (the «whip effect«), inflation could slow down.
Different types of whip effect. Source: Beetrack
And investors expect inflation to fall. Expectations are very important for inflation. When people believe that prices will be higher tomorrow, they will demand higher wages today and try to buy as much as they can before prices rise. These factors push payroll and raw material prices upward, which harms the cycle. Fortunately, the latest data shows that investors do not expect inflation to grow as much over the next five years as was expected a few weeks ago. That could slow or stop the inflation cycle.
What problems can we find for investing in shares?
As we have seen, there are solid reasons why inflation should go out with a bang. But, unfortunately, they are not everything. The pressure exerted by inflation has been growing, and history shows us that inflation has a habit of being sticky. Plus, there are some wild cards that could create new inflationary pressures. It's not just food and energy that have driven up prices. The consumer price index (CPI), includes a measure of “core CPI” that shows how prices have changed in different sectors (excluding food and energy) and is also at a record level. In fact, more than 90% of the sectors it registers show inflation greater than 5%. And what is more worrying, investment prices in services stocks are the ones that have risen the most lately. The broader the pressures, the longer inflation will stay.
Historical evolution of the CPI vs underlying CPI. Source: Bankinter
History has taught us that inflation usually goes very slowly. Like in the 1970s, for example, where it soared several times after falling, and lasted longer than investors expected. One reason is that inflation can take a while to leave the system.
What influence does investing in real estate stocks have?
This can now be seen in the cost of buying or renting a home. House prices have risen sharply since the pandemic, and that has contributed to rising inflation by boosting economic growth. After all, investing in real estate stocks is one of the engines of the economy. But that has also driven up rental prices. There is a shortage of homes to buy and the prices of those available are out of reach of many potential buyers. This has caused demand to shift to the rental market. Therefore, rental prices may continue to rise for a while, even if home prices begin to fall. Being the largest component of the CPI basket (it has a weight of 32%), it can offset a fall in other sectors and keep inflation at a high level for a while longer.
The cost of housing is the most important component, and it may not have peaked. Source: US Bureau of Labor Statistics
In addition, there are two major dangers that could trigger a new spike in inflation: the war in Ukraine and Covid. Food and energy prices have been greatly influenced by the war in Ukraine, and a worsening conflict (or Russia's decision to cut off the gas supply before winter) could cause prices to skyrocket again. Meanwhile, Covid continues to replicate with new strains, so there will be some risk of the virus again disrupting supply chains in key countries such as China.
With all this uncertainty, where are we headed?吝
With what we have been discussing, we have seen that inflation may have peaked. But it is likely to remain high for some time, probably higher than the market expects and certainly much higher than the Federal Reserve's 2% target. Fed officials know that if they pivot from raising rates to holding (or even lowering) rates when the economy is still relatively resilient, they risk heating up the economy again and causing inflation to accelerate. . Therefore, they will most likely wait for evidence that inflation is returning closer to its target. And that could take much longer than investors expect. The only scenario in which we see inflation falling significantly is a harsh, demand-destroying economic recession. But that wouldn't be a good outcome for stock investing. Basically because inflation would likely only go down after the economy slowed, leaving investors facing a stagflationary environment of low growth and high inflation, a historically difficult environment for investing in stocks.
How inflation affects investing in stocks. Source: IG
In our view, there are too many unknowns and too many scenarios to concisely predict in a single outcome, and investors are possibly too optimistic about the best case scenario. In this type of environment, it makes sense to diversify our stock investment across sectors that would perform well in different scenarios. We could move a portion of our equity investment into the commodities sector to protect ourselves from higher inflation and long-term US Treasuries in case a harsh recession brings down growth and inflation.