Stocks rallied strongly last week on better-than-expected consumer inflation (CPI) data. But has the inflation rate peaked for this cycle? At the risk of spoiling the ending, it looks like the worst year-over-year inflation rates are behind us. It may still be premature to break the champagne with an overall rate still at 8.5% year-on-year and an uncertain timing to reach the target inflation rate.
First of all, the good news, the energy component which was a major driver of the surge in inflation has receded somewhat. While the gasoline component of the CPI is still up 44% year-on-year, it was -7.7% in July. Gasoline prices are still well above year-ago levels, but the decline is helping to ease some pressures on households and the economy.
Additionally, some areas of consumer inflation that have been particularly affected by the reopening of the economy following the Covid shutdowns have started to show improvement. For example, car rental prices skyrocketed as the economy reopened due to a lack of vehicle fleets and the inability to replace cars at a reasonable price due to a shortage of microchips. . Car and truck rental prices fell -11.9% year-over-year in July. Additionally, hotel and used car prices have risen at a rate below the overall inflation rate.
Now the hardest part of the inflation story. Despite the decline in the headline inflation rate year-over-year from the previous month, the sticky part of the components of inflation rose to 5.8%. Sticky elements take longer to adapt than gasoline, which can have more volatile fluctuations. This persistently high inflation makes it more difficult to reach the 2% inflation rate.
A sticky part of inflation is rent. Primary residence rent is up 6.3% year-over-year, and rent tends not to drop very often. Even during the global financial crisis, which included the bursting of the housing bubble, rent components barely dipped into negative year-over-year. Directionally, housing prices tend to drive rents, so monitoring activity around homes will be key. Federal Reserve rate hikes have cooled real estate activity and prices may follow. Lots of housing data is coming in this week, including building permits, housing starts and existing home sales.
Salaries are another component that tends not to drop often. Despite high unemployment during the global financial crisis, average weekly earnings only dipped into slightly negative territory. In July, average weekly earnings rose 5.3% year over year, and the upward pressure is expected to continue as the unemployment rate remains low. Furthermore, the (real) growth rate of income after inflation is negative, which should add to the reasons why the nominal level remains high.
It is always instructive to look at what the collective wisdom of the markets expects from inflation. The 10-year break-even inflation rate recently fell to 2.48%, implying that market participants believe that inflation will reach this average level over the next ten years. Interestingly, the equilibrium rate peaked at the end of April. The 5-year forward break-even inflation rate tells us what the markets think inflation will be over the next five years, starting five years from now. Looking at inflation five years ahead helps to suppress some short-term price movements and focus on the expected long-term path. This metric fell to 2.24% and also peaked in late April.
Notably, 2-year and 10-year Treasury yields have been lower since peaking in mid-June. Nominal yields on Treasury bills would not be lower if inflation was expected to continue to accelerate. Looking back, the S&P 500 hit a closing low shortly after the peak in returns and rebounded nearly 17%!
Another piece of evidence supporting markets believing we have seen the peak in inflation is the outperformance of cyclical stocks versus commodities. Cyclical stocks are more exposed to the economy than commodities, implying that the Federal Reserve is less likely to be forced to continue to aggressively raise interest rates. The market seems to be looking past the economic slowdown with some relief on the inflation front.
Markets cheered the better inflation news, but the timing and path to a normalized environment remains unclear, with persistent components of inflation remaining elevated. Despite the respite given to lower-quality companies by the relatively positive inflation news, investors should focus on quality companies that can survive a possible recession and prosper once the turmoil passes. Investors should focus on an asset allocation that provides the financial means to weather market volatility and an economic downturn, as the economic backdrop remains challenging.