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Inflation has likely peaked - but if it hasn't, we're in trouble.

by , 21 July 2022
Inflation has likely peaked - but if it hasn't, we're in trouble.
The US consumer price inflation rate (CPI) for June 2022 was released last week, coming in at a shocking 9.1%. By comparison, the number for last year, June 2021, was 4.9%. And back then, this was seen as a huge problem. Remember, the US targets an inflation rate of just 2%.

That's the bad news. The good news is we're seeing definite signs the inflation rate is set to fall.

US gasoline prices are down over the last few weeks. This has been driven by a fall in oil prices as well as a reduction in refining margins. Other commodity prices are also lower. Wheat, corn and soybeans are all well below recent highs. This should soon start to reflect in US inflation data.

Beyond commodities, housing prices, which account for a massive 30% of CPI, look to be moderating. There is anecdotal evidence buyers are pulling out of deals due to higher borrowing costs, so sellers have had to reduce their prices.

The used car market is also returning to normality, after seeing a bubble caused by the lack of supply of new vehicles.

Finally, speculative assets like crypto currencies and NFTs have also plunged in value.  

In fact, the evidence that inflation is set to fall is so strong the US bond market is pricing in a significant chance that the Fed will start cutting rates as early as the start of next year.

Remember, the Fed guidance is for a rate cut only in 2024. If the bond market is correct, we could see a significant rebound in stock prices very soon. As I’ve said before, stock markets will react well before the actual rate cut occurs.

 

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And this!
 

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So, should you start buying right now?

Maybe not so quick, there is another possibility to consider. There is a fear inflation is starting to become “embedded”.

As inflation rises, and remains high for a significant period of time, people and companies start to price it into their decision-making. Workers begin to assume inflation will be high, so they ask for higher wage increases. Businesses also assume inflation will be high, and so they increase the price of the goods and services they produce (so they can pay their workers) and maintain profit margins.

In this world, just the expectation that there will be inflation, actually ends up causing inflation.

As I mentioned, inflation in the US has been above the Fed’s target for over a year. This is perhaps enough time for expectations to have changed. Also, the US unemployment rate remains extremely low. This gives workers a lot of bargaining power. So, wage growth could become a significant driver of inflation.

The bad news is, the only way for the Fed to deal with embedded inflation is to crush the economy to increase unemployment.

So, what do I think will happen?

Inflation will fall soon, barring a supply shock like a flare up in the middle east that disrupts oil production. The drop in commodity prices is just too steep for this not to be the case. However, we won’t see a return to 2% any time soon. The Fed, facing political pressure, will halt its rate-hiking cycle much earlier than advertised.  We may even get a rate cut in the first half of next year.

Since inflation won’t get back to 2% by then, we’ll have seen inflation remain above target for quite some time. Consumers and businesses will start to price this in. US workers have already seen real wages fall due to high inflation. This cannot continue indefinitely. They will demand wage increases that at least match their expected inflation rate. As a result, we will see some level of embedded inflation. But probably at a lower level than we’re seeing currently.

 

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I’d suggest looking at quality companies that pay solid dividends.

 
 

How should you play this?

There is no question stock prices are cheap. Especially given the earnings we’ve seen this season from US companies. My bet would be to look for a short-term equity relief rally. Markets should be encouraged by falling inflation figures and the potential for less aggressive monetary policy. That said, you need to keep a close eye on developments. If we start to see embedded inflation you want to stick with high quality companies.

The good news is after the significant stock market sell-off in the first half of 2022,
many great quality companies are trading at a discount. As I suggested last week, look for companies that make money no matter the environment. My preference is for high dividend stocks with strong track records of earnings and an established market position.

PS. Alternatively
check out my colleague Josh Benton’s Retire Rich with Dividends Report.  Inside, you’ll find comprehensive details on five quality companies paying big dividends right here on the JSE.




Inflation has likely peaked - but if it hasn't, we're in trouble.
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