Greg Smith: Peak inflation and what that means for markets

Global stock markets have had a tough time of it in June. Photo / Bloomberg

Opinion

OPINION:

Global stock markets have had a tough time of it in June. The S&P500 was down around 8 per cent for the month, as was the STOXX50 in Europe. Across the ditch the ASX200 was around 9 per cent lower. By comparison the NZX50 got off relatively lightly falling less than 4 per cent, although still hovering near bear market territory (with a decline of 20 per cent since the January 2021 high). The NZX50 has fallen 16 per cent in the first 6 months of 2022.

Concern over the impact of monetary tightening amidst elevated levels of inflation has been a key driver of global investor angst this year – the S&P500 has fallen around 21 per cent this year, marking the worst first six months of any year since 1970.

There are many similarities with the same period 52 years ago in that a period of high inflation dominated that environment. Markets have reacted very quickly to price in the worst-case outcomes as it relates to inflation and the economy, so far in 2022 - an upward repricing could play out should the bear-case scenarios not transpire. Historically, large market drawdowns are generally followed by equally strong rebounds at some juncture. Back in 1970 the S&P rallied 27 per cent during the second six months of that year.

What is yet to be determined is whether global economies go into recession, and this is also related to how long high levels of inflation stick around. The below chart shows the performance of the S&P500 in the US since 1950 when a 20 per cent drawdown in the index was followed by a recession (lighter blue line), and also in the times when it wasn't (darker blue line). Perhaps unsurprisingly, when a recession was avoided, the market performed strongly on the upside.

Investors remain concerned that economies will not be able to handle a period of sustained interest rate tightening. This is despite assurances from many central bank officials (particularly in the US) that fears here are 'overblown.' There will be some impact of course, but the question is the quantum and duration of any weakness. This is already starting to feed through. US spending adjusted for inflation fell 0.4 per cent in May, weighed by a decline in real disposable incomes. This was a sharp reversal from the 0.3 per cent gain in April, though up 2.1 per cent on a year-over-year basis.

This year has been one when markets globally have repriced in higher levels of inflation and the interest rate tightening that has come with it. After unprecedented levels of stimulus during the pandemic, the "punch-bowl" has had to be taken away. The piper has to be paid. The war in the Ukraine has of course greatly exacerbated matters as it relates to the inflationary pressures the world was already facing.

But there is also some evidence that inflation is actually on the way down.

Simple mathematics tells us that we are likely close to (if not past the point) where we top out in terms of the size of the year-on-year inflation numbers being seen. The risk therefore is that inflation begins to soften, central bank responses are potentially moderated, and we ultimately see markets rebound as a result.

Indeed, on that front, US core personal consumption expenditures prices in May rose 4.7 per cent on a year ago. This was down on the 4.8 per cent expected, and an improvement on the 4.9 per cent in April. The one-year reading has now fallen for three straight months after peaking at a 5.3 per cent pace in February. The measure (the Fed's preferred one) strips out volatile food and energy prices which are weighing on consumer wallets. Including these, headline inflation remained strong, rising 0.6 per cent on the month and year on year coming in at 6.3 per cent, holding near the highest level since 1982. This is however down from the 6.6 per cent printed in March.

The ASX200 was around 9 per cent lower in June. Photo / Getty Images

Fed Chairman Jerome Powell has remarked in recent days that he also is watching headline inflation numbers as well. A key driver here is fuel, which (propelled by the war) is causing a pinch for consumers worldwide. Upward pressures here may also ease. The OPEC+ cartel has agreed to stick with a planned output increase of 648,000 barrels per day from August. President Biden said he'll request more output at the Gulf Cooperation Council forum. Oil dropped nearly 8 per cent in June, the first monthly decline since November.

Inflation has already softened in a number of other areas. Shipping rates have been a hot topic during the pandemic with these surging due to supply chain blockages, and ultimately having been passed onto consumers. As the chart below shows, these are well down from their highs as congestion has started to ease. While high prices for many commodities are linked to the war (the timeline for which is unknown), there is cause to believe that the global reopening will continue to take some of the heat out of inflation elsewhere.

Inflationary pressures have obviously been highly relevant to kiwi consumers, but also businesses. ANZ's Business Outlook this week had the less than upbeat title "On the skids." It noted that business confidence fell seven points with 62.6 per cent of respondents saying they expected economic conditions to worsen over the next 12 months, versus a net 55.6 per cent that were negative in May. Supply-side issues continuing to dominate the list of biggest problems for firms, which is consistent with the view that inflationary pressures are still intense. The question begs, what if inflation also hits the skids – will the mood then brighten?

Inflation outcomes clearly hold a massive key for the economy, consumer well-being, and the markets. A tight labour market is driving wages higher, which has sparked notions of a 1970's wage price spiral. A key difference however was that 50 years ago it was all about supply side disruption (and the oil shock). This time around, while supplies have been interrupted, it is also as much about the demand side, and (despite the war) these pressures may be starting to abate as the economy cools.

Just how long the central bank tightening experience endures remains to be seen. We know full well that most central banks are resolute in their quest to bring down inflation to the extent they can. At the same time officials will also not want to send economies into a tailspin. Fed Chair Jerome Powell has recently commented that the Fed could well change tack if the economy were to stutter. The RBNZ has yet to employ this language, but where the Fed goes others tend to follow.

Either way this could mean that the tightening process endures over a shorter timeframe than is currently priced in by markets – either because the economy stutters, or perhaps on the scenario that markets are not pricing in – that inflation is being brought under control more quickly than expected.

- Greg Smith is Devon Funds Management Head of Retail.