For the equity markets, public enemy number one continues to be inflation as it pressures central banks to raise rates at a historically unmatched pace. The latest surprise print in headline inflation of 8.6% is evidence that inflation continues to be stubborn. As we approach the mid-point of the year, we still view the government as being on ‘auto-pilot’ as the expectation is for them to raise rates consecutively by at least 0.5% over the next 3 meetings. After the July rate hike, the Fed fund rate is expected to be at least 2%, and although that is not at the Fed’s target level of 2.75-3%, it is in the neighborhood. In our belief, whether we see the Fed pivot towards a slower pace of rate increases depends on whether we see coinciding signs of cooling inflation. Although we expect inflation to stay above historical levels, markets often care more about the direction of a trend rather than the absolute number. Hence, evidence of inflation peaking may be interpreted as a key turning point to help stabilize the current bear market. Below are some green shoots that may hint that inflation will eventually see its highs for this cycle. All this being said, this incoming data is just the start and will likely ebb and flow which will cause market volatility. Investors will need to be patient for inflation to peak.
Supply Chain Improvements
In the chart below, the ‘Marine Exchange of Southern California’ has reported that the number of container ships backlogged in Los Angeles & Long Beach ports are now back to pre-2020 levels. These ports have gone from a November high of 86 container ships at anchor or loitering in the vicinity to now zero ships.
The Cass Freight Index is another indicator we track that measures monthly freight volume and activity. After surging by more than 30% Year-over-Year for much of 2020-2021, the year-over-year pricing has dipped negative. As shown in the chart, the Cass Freight Index (blue line) has been a reliable indicator of the direction of inflation (grey line). Historically the Cass Freight Index leads CPI by six months, suggesting that the Year-over-Year CPI (inflation) number could decrease soon.
Rising Inventories & Expected Discounting
Major retailers, including Target, Best Buy, and Urban Outfitters, have begun reporting higher inventory levels. Walmart has also recently announced that inventory levels were up 32% y-o-y in Q1, with management expecting that it will take at least 1-2 quarters to right-size this position. The clear method to achieve this is to mark down prices, and therefore consumers should expect to see discounts in the coming months.
The sales rate of newly built homes has also fallen below pre-pandemic levels after reporting a 17% drop in the latest April data. With mortgage and borrowing costs rising 40-60%, demand for housing has pulled back. Therefore, housing is another area where slower sales have caused the inventory of newly built homes to jump to a nine-month supply, whereas a six-monthly supply is generally considered the balance between buyers and sellers. As often is the case, volume trends precede pricing trends, and therefore this could be hinting at softer “shelter/housing” costs that have kept CPI stubbornly high.
Finally, car prices, which were once seen as “ground zero” for supply chain disruptions and inflation, are also beginning to decrease. As evidenced by the Manheim Used Car Index, we have seen prices drop four months in a row. (See chart below). It may surprise investors that new and used cars accounted for 1.97% of the 3.93% rise in inflation over the past 12 months. Simply put, cars represented half of the increase in inflation! Fundstrat Research calculates that should this trend continue, used car prices could shave off a full 1% from core CPI within two months. Inventories of autos should also see a lift as the Morgan Stanley Automotive team notes that the semi-chip shortage could be ending. They see strong foundry shipments, a slowdown in consumer electronics, and a re-opening of supply chains in China to help alleviate chip shortages.
Softer Labor Market
The labor market has been very strong, with unemployment at a 50+ year low of 3.6%. A “tight” labor market like this has increased labor costs which tend to be a stickier expense for corporations. One signal that higher interest rates are having the intended cooling effect on inflation is to see some cracks in the labor market. There are some early indicators that the labor market is softening, and therefore wage gains could normalize lower, and unemployment could normalize higher. JP Morgan has noted that the labor force participation rate ticked up for people aged 16 to 64 to 74.4%, which matches the pre-pandemic peak. As pandemic-related constraints dissipate, the labor market is returning to balance. And although still early days, average hourly earnings increased by less than expected in May.
We are also beginning to hear more about layoffs. The most evident sign of job losses comes from start-up companies facing more pressure to cut costs as their ability to access capital begins to wane due to higher rates. In May there were a reported 17,000 layoffs amongst start-ups, which is more than a 4X increase compared to April’s print of 3800. As the chart below shows, we are beginning to match layoffs not seen in this sector since the start of the pandemic.
In more traditional sectors like retail, Walmart and Amazon have also noted “overhiring” due to Omicron. Investors should note that Amazon added more than 800,000 jobs since the end of 2019 as they aimed to work around COVID 19 protocols and avoid risks of outages. Similarly, Costco increased employment by 140,000, and Walmart added 100,000 workers. Therefore, as Covid declines, it would not be a surprise to see layoffs increase in these sectors.
Most Commodities Seeing Lower Prices
With record oil and gasoline prices monopolizing the headlines, it is important to note that most other industrial commodity prices are no longer rising. As the IHS Markit charts display, many key industrial commodity prices like iron ore, lumber, and copper are actually down in price Y-o-Y. Although oil and natural gas prices are still up Y-o-Y by 66% and 167%, respectively, it is still a good sign that the broader commodity spike seems to be settling.
To conclude, several indicators that we follow are just beginning to signal that the Fed’s rate hikes and tightening cycle are starting to put a dent in some of the inflationary pressures. That being said, it is still crucial to remain cautious about the possibility that early signs of moderating inflation will spark a sustainable market recovery. After all, the Fed has communicated its willingness to tighten to more restrictive levels to achieve price stability at the cost of economic growth. Moreover, inflation in services may offset the deflation in goods, leaving inflation elevated for longer than expected. Finally, global risks may continue to hamper investment sentiment as increasing geopolitical pressures in Ukraine, and a bumpy re-opening of the Chinese economy may lead to renewed shortages. We look for these trends of cooling inflation to continue for another couple of months before we can comfortably confirm that inflation has peaked.