Inflation Will Fall, But When?

While analysts decry any further Fed rate hikes that risk an ever deeper recession, investors observe an economy powering along with a strong consumer, full employment and higher corporate earnings. The Fed is determined to tighten credit as long as it takes to slash inflation back to pre-Covid rates near 2%. However, price trends remain stubbornly upward. The big questions for investors are, when will the Fed break the back of high inflation and what will happen to stock market valuations and company profits when it does? For the many pundits airing their allocutions, warning the Fed off any further tightening, they may be talking their book of stocks. After 11 months of portfolio pain, the masses are pinning for the irrationally exuberant profits of 2021 before inflation progress of import has even begun. An 8.1% core Producer Price Index (PPI) is nothing to celebrate.

Manufacturing inflation has fallen sharply as we shift from a stay-at-home Covid durable goods buying spree to a get-out-and-experience-life spending splurge. Manufacturers are still growing, but prices are falling as supply chain inflation has almost normalized over the past 5 months. However, the goods producing sector is relatively miniscule in comparison with the service sector. It’s a hopeful sign, but only a small step in the right direction.

The service sector comprises about 77% of our economic output and is a far more important clue as to consumer spending and current inflation trends. Both manufacturing and service inflation have calmed down faster than end product consumer price indices  (CPI) reported by the Government. Yet, inflationary Service sector pressures continue to grow at an unsustainable pace. Company manager surveys above 70 or 80% indicating higher prices, are alarming for a country like the US. The inflation boil will dial back to a manageable simmer when under 60%, but with the current re-expansion of the economy (GDP) in the 2nd half of 2022, there are few signs that another disinflation wave is upon us. This means higher for longer short-term interest rates until consumer spending is significantly curtailed.

Forecasters for a big “R” recession, a little “r” or no R at all, are all guessing more than normal this unique cycle. There is great certainty that the Fed will keep rates higher until inflation is much lower, but the proxies for falling prices have yet to manifest in reality. Until we see how the labor market and corporate profits behave as inflation falls (when it falls), it’s difficult to gauge the glide path along which the economy is flying. As we have been observing for months, there are NO signs of an “R” or an “r” on the horizon as ongoing excess Covid stimulus has maintained elevated individual checking accounts and spending habits. Long term Federal Covid stimulus in the pipeline will keep economic growth, full employment and inflation more buoyant longer than most expect. Our forecast continues to target the 3rd quarter of 2023 before Fed tightening eventuates in core CPI inflation of 4 to 5% range and core PCE of 3 to 4% range. Too many are looking for the next uphill expansion before we have a meaningful downhill journey. The catalysts for a growing economy and sustained Bull market in stocks will remain elusive until then. It appears that earnings weakness in stock market valuations will not be dramatic in mid January – mid February when Q4 of 2022 earnings reports come out. Thus, it may take more time to see reduced profit forecasts that could be reflected by new lows in the stock market. Our near-term market forecast from early October was for a firm low leading to a rally into late November to early December. The closing high on December 2nd continues to hold back recent rally attempts during this period of widely expected seasonal strength. While we still expect at least a modest cyclical low in stocks in late January, the oversold negativity of option traders and small investor surveys allow for another push higher in equities first before new overbought technical appear.

 

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