Global markets have been laser focused on inflation readings throughout 2022. While inflation was still a preoccupation for investors over the past week, another issue has emerged as a predominant market concern: the risk of recession and its impact to corporate profits. We discuss recent developments on both fronts below.
The U.S. Consumer Price Index (CPI) for August was released on September 13th. CPI rose 8.3% year over year, which was below the 8.5% reading for July, but higher than the consensus expectation of 8.1%. Food and energy price pressures had declined, but remained elevated. More troubling was the core measure, which excludes food and energy. It was higher than expected and above the July reading. Moreover, it was not driven by one particular category, and instead showed relatively broad pricing pressures.
Nevertheless, our view on inflation remains largely unchanged. We expect it to recede in the months to come. Shelter is the largest component of inflation, accounting for nearly a third of U.S. CPI. It is made up of lodging away from home, rent and housing-related costs. Rent and housing cost data increased in August, but home prices are under pressure as a result of substantially higher mortgage costs. These two categories have historically followed home prices with a meaningful lag. As a result, in our view it is just a matter of time before trends in the largest component within the CPI basket begin to subside.
Inflation may also fall victim to rising recessionary forces. In recent days, a few industrial conglomerates ranging from aluminum and steel makers to shipping and parcel delivery companies (Fedex) have warned of deteriorating conditions in their respective businesses. The earnings pressure is arising as a result of a combination of increasing costs and a meaningful shift in demand away from goods and towards services. While weakness overseas was also cited as a notable driver by some management teams, reduced demand is finding its way into the North American economy. We may finally be starting to see the impact of the demand-reducing actions of t U.S. Federal Reserve and the Bank of Canada.
A slowing of the global economy has the potential to have a lasting positive impact on inflation. This may prove to be a very constructive development for the longer-term return prospects of most assets. In the interim, we expect publicly-traded equity prices to remain vulnerable, as markets digest the risks to future corporate earnings. We also expect that the yields of high quality bonds, whose valuations have corrected substantially this year, may soon begin to stabilize and then gradually decline somewhat in 2023 as growth concerns eventually overtake inflation risks as the main market concern.
If you have any questions, please do not hesitate to contact us.
Drew M. Pallett LL.B. CFP
Senior Portfolio Manager and Investment Advisor
RBC Dominion Securities
Email: drew.pallett@rbc.com
Website: www.pallett.ca