When Will Inflation Peak? – A Mid-Year Outlook

If you’ve watched the news in the last couple weeks, a lot has been said about the start of 2022 being the worst first half stock market performance in 50 years.   It doesn’t take much effort to find headline, after headline, after headline describing the poor market performance this year.

Entering this week, several important economic data points were on the calendar.  The most noteworthy was the CPI report revealed Wednesday morning.  Many economists were hoping for some indications that inflation had peaked in May.  Unfortunately, the 9.1% annualized inflation rate in June exceeded previous months and is the highest inflation rate measured in this current cycle (see chart).

 

Not surprisingly, this was a huge disappointment and has renewed fears that inflation is an out-of-control train and the only way to stop it is a recession (or worse).  By the end of the day, the futures markets had forecasted a full 1.0% hike in the Fed Funds rate in the Federal Reserve meeting later this month.

Not that we need to rub salt in the wounds, but to recap 2022:

• Equity markets are down over 20%
• Bonds are down nearly 10% and have not been the traditional “safe haven”
• Gold is down 5.5%
• Cash has lost over 9% of its value over the last year (inflation)
• The borrowing cost of a new mortgage is approximately 84% higher than a year ago

The average investor is getting tired and weary.  After all, I would argue that investors haven’t experienced a true “bear market” in nearly 15 years.  Yes, technically speaking the COVID-19 related -33.9% drop in 2020 is classified as a bear market.  However, both the speed of the decline and recovery likely did not have the same affect on investor behavior as common longer term bear markets.  It was akin to an incision with a razor blade which heals with barely a trace, while a cut from jagged glass will leave you with a scar the rest of your life.

Enough of the dismal report. You might be asking yourself, “How do I invest in an environment like this?  Will the rest of 2022 be more of the same?”  Let’s discuss.

We are in the beginning of the quarterly earnings season, where public companies report their earnings for the second quarter of 2022.  What you are likely to see in the coming weeks are corporate leaders reducing their earnings expectations for the rest of the year.  Wall street analysts are also beginning to reduce their year-end “forecasts,” essentially coming back in line with reality.  It’s one of the reasons I feel the prediction of one year calendar year returns is “rubbish” as mentioned in our January 2022 Outlook piece.

Looking throughout history – as well as my own 20+ years of market observation – once a trend is firmly established (up or down), most of the time those trends tend to overshoot past equilibrium.  Momentum has a lot to do with market direction, particularly during periods of volatility and stress.  Therefore, I think it is likely that throughout the rest of this month (July) the broad stock market could continue to slide and revisit the mid-June lows, and probably go a bit lower.  However, I still believe we are somewhere near a bottom (in both time and price) and the back half of the year should see improvement.  Ultimately, nobody can call the bottom correctly and we’ll only know it was the bottom after the fact.

Why do I feel we are near a bottom?

Stripping away all the noise, the bottom line is that stock prices are lower this year mainly because the Fed is raising interest rates.  Could it really be that simple?  Yes.  However, clarifying why the Fed is raising interest rates will help you understand what needs to happen for markets to bottom and turn higher.  After all, we need the Federal Reserve to pivot from the aggressiveness of its rate hikes for the stock market to turn higher . . . and before the Federal Reserve can reduce the pace of its rate hikes, inflation must peak.

The Fed is aggressively raising interest rates to fight against inflation.  Higher interest rates means that it costs more for corporations, governments, and individuals to borrow money.  Therefore, increasing the cost of borrowing reduces the amount of total spending in the economy (thus slowing down economic growth).  As an oversimplified example, if I borrow $30,000 at 2% interest, my cost of borrowing that money is $600 per year.   If I borrow the same $30,000 at 6%, my cost of borrowing increased to $1800 per year.  The higher interest rate caused my borrowing to be more expensive and thus, the extra $1200 in additional cost means that I won’t be able to spend that money elsewhere (shopping, dining, travel, etc).   This is how higher interest rates reduce economic growth, which as a result, decreases the rate of inflation.

In order for the Federal Reserve to slow down the pace of interest rate increases, inflation must peak.  When will inflation peak?  As previously mentioned, the June CPI number was surprisingly high and did not reflect any signs of peaking.  Well, here’s the good news: the consumer price index (CPI) is backward looking and is essentially reporting information that has already happened.  Even though the reported number was high, many of the underlying dynamics that comprise the report have already shown substantial reversal.  For example, in the past 4-6 weeks:

• Used car prices have fallen at the fastest pace since the early 2000’s
• Energy is down more than 25% and oil is nearing $95 a barrel
• Retailers are marking down prices to clear record levels of inventory
• A majority of commodities prices have declined significantly (see chart below)

It is reasonable to believe that we may have seen the peak inflation report and things should be improving going forward.  If so, and subsequently the Federal Reserve shifts from an “aggressive” approach to a “measured” approach on interest rates, it’s probable that markets will begin to turn higher in the second half of 2022.

As always, our team is here to assist if you have questions or concerns.  We realize these are difficult times to navigate, which is ultimately is the precise reason we are here to partner with you.