Will Markets Rise as Inflation Falls?

Inflation has taken a big toll on the markets in 2022. Rising prices have emboldened the Federal Reserve to tighten monetary conditions at a historically fast pace, which has sapped demand for risk assets while also raising the cost of capital for individuals and businesses. It’s made for a challenging year for investors.

Inflation has also meant higher costs for materials, inventory, and labor for corporations, which erodes the value of current and future earnings. Since stock prices are based on expectations of future earnings, it makes sense that sticky inflation is highly undesirable over the long term. When considering the trade-off between the short-term pain of tightening financial conditions and the long-term positive of having inflation under control, the latter should always be preferred.

It should make sense then that seeing inflation fall from high levels has generally been beneficial for equity markets. Since 1960, the consumer price index (which measures inflation) has gone above 6% on five occasions, in 1970, 1974, 1979, 1990, and 2022. In every instance before 2022 when CPI peaked and started falling, stocks staged relatively powerful rebounds. If we see more signs in the current cycle that inflation has peaked and started falling, I would expect a similar market outcome in 2023.(1)

The good news: signs of easing inflation pressure continue to appear.

One of the key areas where price pressures have all but evaporated is in supply-constrained and other goods categories. Supply chains are finally back to normal after two years of pandemic-related hitches, and the Global Supply Chain Pressure Index (chart below) was at its lowest level in October in almost two years.

Another strong reading within the supply chain was the Institute of Supply Management’s supplier deliveries index, which measures the ability of producers to fill orders fully and on time. This index was near its best level since 2009, and 90% of surveyed panelists said that deliveries had been on pace with or faster than the previous month. Do readers remember the time when hundreds of cargo ships were stuck off the ports of Southern California? As I write, the backlog was down to six ships waiting to unload.

One of the big categories within the consumer price index (CPI) that has driven elevated inflation figures has been the owners’ equivalent rent component. This component makes up about 25% of the entire CPI, and it measures what an owner would pay if they rented their house, which is ultimately a reflection of strength in the housing market. It’s worth noting that the owner’s equivalent rent tends to lag home prices by about a year.

In this category, Fed policy may be having its most outsized effect, with rising mortgage rates pulling many buyers out of the market. Home sales have fallen every month since February, though prices have continued to tick higher due to very tight supply. Even still, price pressures have abated to levels last seen in the summer of 2020, and rents also decelerated to under 5% year-over-year in October.(3) It’s clear from the chart below that owner’s equivalent rent continues to contribute greatly to the headline number, but it may also be very close to a peak.

Finally, a useful leading indicator for inflation expectations is the 5-year breakeven inflation rate. This rate shows the difference between the 5-year U.S. Treasury bond yield and Treasury Inflation-Protected Securities’ (TIPS) yields. As you can see in the chart below, the spread reached a high point in late March and has been easing ever since – a sign the market thinks the worst of inflation could be behind us.

?Bottom Line for Investors

Investors looking for signs that the bear market may be over would be best suited to looking for signs that inflation has peaked, in my view. Since stock ownership means having a claim to ‘real’ cash flows, it follows that companies can benefit from passing along higher costs to consumers (short term), or having inflation remain under control (long term). The latter outcome is the better one.

As the Nobel laureate Eugene Fama once pointed out, “inflation tends to be highly persistent once you get it. Once it goes down, it tends to be highly persistent on the downside.”6 I think there are signs it’s headed that way.

1 Goldman Sachs. 2022.

2 Federal Reserve Bank of New York. October 2022. https://www.newyorkfed.org/research/policy/gscpi#/interactive

3 Wall Street Journal. November 18, 2022. https://www.wsj.com/articles/u-s-home-sales-fell-for-ninth-straight-month-in-october-11668784188?mod=economy_more_pos5

4 Fred Economic Data. November 10, 2022. https://fred.stlouisfed.org/series/CUSR0000SEHC01#

5 Fred Economic Data. November 23, 2022. https://fred.stlouisfed.org/series/T5YIE#

6 The Planning Center. 2022. https://www.theplanningcenter.com/inflation-exchange-between-eugene-fama-david-booth/

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