Has inflation peaked?

US’ consumer price index rose by 8.5% year on year in July, below market expectations, on the back of lower energy prices. Risk assets rallied following the report as investors speculated that the Federal Reserve would soon temper its aggressive rate rises. The futures market is now pricing in 8 basis points less tightening by December1 and the bond market is pricing Fed rate cuts by February 2023. Investors appear to be positioning for a pivot in the Fed’s monetary policy. Over the last three weeks, there have been inflows into US bonds following sustained outflows since January. There have also been five weeks of continuous outflows from Treasury Inflation Protected Securities (TIPS)2 and commodities.

We previously indicated that inflation needs to peak, among other factors, for equities to have a sustainable rally. That said, the Fed would need more than one month’s inflation data to sound the victory in its fight against inflation. Easing supply chain disruptions and slower global growth would help moderate price pressures, as would the base effect.

On the other hand, food and rent costs are likely to remain high. It would also be important to monitor wage growth with labour costs being the largest cost component for US businesses. On balance, inflation may moderate going forward but remain higher than pre-COVID levels.

Historically, the trajectory of inflation has mattered more than the absolute level. Markets have delivered positive returns when inflation is elevated but falling. See chart. Between 1970 and 1984, during periods when US headline inflation was above 3.5% and falling, the S&P 500 delivered positive returns more than 67% of the time, with average 3-month median returns of 3%.

Eastspring’s Multi Asset Portfolio Solutions team retains a relatively cautious stance towards equities. Within equities, we continue to focus on strategies with attractive valuations and strong fundamentals. Value stocks encompass both these characteristics and have the additional benefit of light positioning. Meanwhile, as we wait for inflation to turn down more convincingly, low volatility strategies can provide investors a less bumpy exposure to equities.

Inflation regimes and S&P 500 median 3-month returns (1970 – 1984)

Potential to benefit from a Yen rebound

Source: BCA Research. 2022.

Sources:
1 As of 16 August 2022.
2 As of 11 August 2022. The Flow Show. Bank of America.

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