An analysis of September inflation data in the U.S. gives us hope that we will see a steady slowdown in price growth over the next few months. This does not mean that the Fed will immediately stop raising rates, but in 2024, if not earlier, we may see the rate move down again from the cap of 4.5-5%, says Andrei Movchan, founder of Movchan’s Group of Investment Management Companies
The American stock market reacted to the news about the September inflation in the USA by falling (S&P 500 fell 120 points), and then it rose just as fast (+ 200 points). Two days after the release of the data quotations returned to the initial level. The “jumps” are explained by the current market structure – the fall was triggered by robots, which were set to take short positions if the inflation data was worse than forecasted (and it was – 8.2% against the forecasted 8.1%). Investors who had decided to cash in on volatility and trend-following robots also started buying. Demand leveled off – the index returned to its initial values.
But we should be more interested in long-term trends. And here the picture is quite interesting.
Components of inflation
The 8.2% inflation rate over the past 12 months was mainly due to the increase in fuel and food prices since last winter. This is not surprising – food production requires enormous energy costs. But energy prices have gone down since the summer, and now they are even slowing inflation: for September the price increase was 0.4%, but excluding energy and food – 0.6%.
The downward trend in commodity prices (and hence products) is quite stable, OPEC hastily cuts production quotas (so far virtually) by 2.5%, and the price of oil continues to go down. The developed economies are likely to be in recession; on the other hand, the failure of investment in the oil industry is behind us, so there is a drop in demand and a rise in supply ahead.
Consumer and investment goods have also passed the peak of price increases. Used cars rose 7.2% year-over-year, up 42% in February and 16% in April. Year-over-year price increases for new cars reached 13% in April and slowed to 9% in September.
The cost of various services is still rising (not all services – for example, transportation, rent and utilities are rising, and medical services have stopped), but the cost of services is a derivative of the cost of goods and household income. The market for services is fueled by a decline in the share of new savings in income, but with commodity prices falling and a recession accompanied by a decline in the value of savings and an increase in their share of income, services will rise in price more slowly.
Moreover, the cost of a number of services is closely related to the level of interest rates in the economy: rents are a prime example. Meanwhile, the Fed’s monetary policy outlook is clearly not in favor of rising prices.
Today’s Fed rate of 3.25% seems, at first glance, to be well below inflation. But we should not forget that inflation is a historical indicator, measured 12 months backward, and the rate is a factor in the future. In that sense, it’s more accurate to compare the rate to September’s inflation for the year ahead – 4.8% per year (without food and energy – 7.2%). That’s just two rate hikes of 0.75% from parity (without food and energy, of course, further, but food and energy will just keep pushing inflation down).
Meeting the rate.
Judging by trends, within four to eight months we will see a steady decline in current annual inflation – perhaps to the 4% level (5% without food and energy). This does not mean, of course, that the Fed will stop raising rates now. Before the recession starts, it is possible to fight inflation to the fullest. We can expect inflation and the rate to meet at around 4.5%, the rate could even go as high as 5% in the short term (one 0.75% increase and two 0.5% each), but that appears to be a visible limit on the 9-12 month horizon.
The inflation problem for the U.S. is local in time and caused by transitory factors. If our reasoning is correct, it will be solved in the foreseeable future. When that happens, the Fed will be concerned about achieving its GDP growth target amid continuing balance sheet cuts (now almost a one-way road), and the Fed has only one tool to do that – to cut the rate. In this sense, we may see another rate move down from the 4.5%-5% ceiling as early as 2024 (if not sooner – you have to prepare for the 2024 presidential election in advance).
If so, the investment markets of the not-too-distant future will be characterized simultaneously by continued growth in credit risk and reduced corporate profitability (due to pandemic, recession, rising resource costs after the Fed rate hike), declining multiples (due mostly to the rate) and the potential for long-term growth in quality debt assets due to the rate cut that has begun. This combination of macro indicators, unaccustomed to us from the past 30 years, will still increase risk aversion, but risk-free will mean a much wider range of assets than now.
The laggards on this journey are the countries of the European Union and Great Britain. Their economic situation is worse than that of the United States: European inflation is heavily influenced by gas prices, and European central banks cannot afford rapid rate increases because of the fragile economic equilibrium. Acting too fast can be dangerous in terms of “quantitative destruction,” as analyst Ian Harnett of RAM Ltd. called the process – no one understands the size of the “leverage” grown in government securities and the drop in their value that rising rates will cause, and it is government securities that are the basis of European pension assets and the capital of the banking system.
The dramatic 1% increase in British 30-year government bond yields in four weeks (roughly a 25% drop in the value of the securities) is a perfect illustration of the side effect of a reasonable desire to boost the economy with tax cuts, help the needy with budget payments and simultaneously beat inflation above 10% with a rate hike.
And yet the EU and Britain, albeit with mistakes, losses, and political turmoil, including the coming to power of the opposition in some countries, will go the “American” way and eventually find a balance of inflation, rate, and growth. It will just happen a little later, which means that at some point rates in the U.S. will already be falling, but not yet in Europe. The dollar to basket exchange rate will also be declining, despite the “flight to quality”, and this will add to the novelty of the situation.
We can assume that going forward we will see developed country equity markets rise, which will start once the players believe in defeating inflation. High quality debt securities will move up as well, while emerging market stocks and debt, like junk bonds, will be “working off” the effects of the crisis – the number of defaults, scandals, and problems will be high there. Is it worth it to take positions in these markets right now? It’s probably too early. But recent inflation data suggests it’s time to get ready for it.