This Is What Happens After Peak Inflation (Hint: You’ll Like the Stock Market Results)
This Is What Happens After Peak Inflation (Hint: You'll Like the Stock Market Results)
It was nice relaxing this past weekend by watching a little football to take my mind (briefly) off the markets. But only briefly, since futures markets started trading around halftime of the four o'clock game.
My hometown Miami Dolphins upset the Buffalo Bills and are off to a great 3-0 start to the season. But I've learned to curb my enthusiasm for a few more months, until at least Thanksgiving. Buffalo had the early lead last Sunday, but the Fins came back to take the lead in the fourth quarter and hung on for the win.
That's a major pitfall that all sports teams fall victim to at times: blowing the lead.
Momentum shifts. The winning team lets a big early lead slip away. The opponent makes a big comeback in a stunning reversal of fortune.
A team's best-laid game plan works well at first, but they get complacent with an early lead and ultimately lose the game.
The Federal Reserve is desperately trying to avoid “losing the game” at all costs in its fight against inflation.
Last week's Fed meeting resulted in another 0.75% increase in the benchmark federal funds rate, as widely expected. This was the fifth rate hike this year, the most since 2005. Yet the Fed still keeps talking tough, forecasting even higher rates to come to beat inflation.
And financial markets are on the ropes right now as a result.
The Fed has already built an early lead against inflation, and its game plan is working, as you can see below.
The top chart displays the core Consumer Price Index (CPI, the blue line) and Producer Price Index (PPI, the red line), and it clearly shows that the year-over-year rate of inflation may have peaked already.
In fact, PPI peaked back in February at close to 10% year-over-year and has declined to just over 7% according to the latest data. Core consumer prices (CPI) peaked about the same time and have been easing too, but at a slower pace. Yes, core inflation is still rising year-over-year, but at an increasingly slower pace.
PPI is the one to watch here, because producer price inflation ultimately feeds into consumer price inflation as businesses pass along higher costs to customers. But this dynamic holds true in reverse, too.
If producer price inflation eases, as it has over the past seven months, then it takes the pressure off consumer prices, as the year-over-year core CPI will also decline.
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The Fed already hiked short-term rates from near zero to a range of 3% to 3.25% in just a matter of months, and slowing inflation data tells me its game plan against inflation is working.
But at last week's policy meeting the Fed revealed a new forecast that short-term rates could reach 4.4% by year-end 2022, and 4.6% by the end of next year! That's what hit markets so hard last week, with the S&P 500 (bottom of chart above) rapidly falling toward its June lows.
In the game against inflation, the Fed has momentum right now and clearly does not want to blow the early lead by easing up on its hawkish talk too soon.
That's why the Fed's latest economic projections were revised sharply lower as its interest rate forecast was revised upward. But are the Fed's projections to be believed, or is it just tough talk?
It's a bad idea to put any faith in the Fed's projections. In fact, just one year ago the Fed was forecasting that inflation at the end of 2022 would be just 2.2% and that the federal funds rate would still be comfortably near zero. Those projections missed the mark by a country mile.
So there's no reason to believe its new projections will be any more accurate. With inflation pressures easing already, it won't take much more to seal the win for the Fed. And then you can watch how quickly it drops the tough talk, claims victory, and pivots monetary policy.
For proof, look no further than the multitrillion-dollar fed funds futures market, where big money is wagered every day on the likely outcomes. Just as the Las Vegas sportsbooks are usually spot on in their predictions of football game outcomes, so too are the Fed oddsmakers in their predictions of Fed movements.
In fact, the cynic in me believes that the Fed doesn't really make policy at all. It simply watches market expectations and acts accordingly the vast majority of the time.
Even after last week's Fed meeting turned markets upside down, odds are currently 77% that the fed funds rate will be lower than 4% by the end of next year, according to real-time futures pricing.
In other words, the oddsmakers say the Fed has already won the inflation game and that rates are much more likely to fall from here than rise.
If that's the case, peak inflation is very bullish for stocks, as you can see in the chart above. According to analysis by BlackRock, in the year after an inflation peak the S&P 500 Index was up 75% of the time since 1927 and posted average gains of 11.5%.
And that includes much-stronger-than-average gains of 31.5% in 1974 and 33.2% in 1980, both periods when inflation was coming down from levels about as high as they are today.
Today, retail investor sentiment is as low as it was during the darkest hours of the great financial crisis in 2008-2009. So if you asked the average investor to forecast the S&P 500 return in the next year, you would probably get lots of -20% answers.
But in reality, stocks are much more likely to be up 20% a year from now than down, according to history.
Good investing,
Mike Burnick Senior Analyst, TradeSmith
P.S. Even if peak inflation is around the corner, it's hard to watch the gains you may have had earlier in the year evaporate into nothingness with the current state of the market.
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TradeSmith is not registered as an investment adviser and operates under the publishers' exemption of the Investment Advisers Act of 1940. The investments and strategies discussed in TradeSmith's content do not constitute personalized investment advice. Any trading or investment decisions you take are in reliance on your own analysis and judgment and not in reliance on TradeSmith. There are risks inherent in investing and past investment performance is not indicative of future results.
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