We realise this is getting tedious and perhaps even a little boring but this is important. Inflation. The thesis is this : we have hit peak inflation already and are, on a balance of probabilities, likely to see a reversion to mean as early as Q1 next year, at least insofar as how CPI is currently measured (we may not agree with the calculation assumptions but we will leave this discussion for another day).
So, why do we think this is the case? We begin with a fact that is consistently forgotten (or just not mentioned) by commentators and people who should know better; inflation is not the absolute value in prices, it’s a rate of change. Put another way, inflation going down doesn’t necessarily mean that the price of goods comes down. Rather, the growth in price decreases or put differently prices stop going up.
With that, let's look at some data starting with the all important inputs. In doing so we will limit ourselves to the US of A given that, for equities investors at least, the actions of the Fed arguably matter more than those of the RBA.
We begin with the below chart showcasing the retail price of gas (i.e. petrol):
We then move to wheat, represented below:
So, what do these charts tell us?
Let’s cut straight to the price paid at the pump by consumers. The declines in wholesale pricing are now trickling through, albeit a little slower than expected. Remember, whatever the wholesale price may be, the end price includes the cost of refinement, transportation and a mark-up. Which also happens to be the reason why declines in spot prices are not immediately passed on to the consumer. So, while we remain firm in our conviction that oil prices are likely to remain elevated (on a historic basis), the recent ~20% decline in Brent is undoubtedly going to be reflected at the pump.
Looking to the price of wheat; after a rather frenzied trading period in the months following the Ukraine invasion, futures have seemingly come off by around 20-30% since May. While this may have been partially the result of a bumper crop in Australia and a reset of weather in producing geographies, it will almost certainly have flow-on effects. What do we mean by this? The answer lies in the fact that 20% of wheat production is actually used in feed. In other words, this also represents a substantial decline in input cost for meat producers. From a trading perspective, the significant decline in long-positions by institutional money, from $55bn USD to $35bn USD now or about $20bn USD in agricultural commodities, is not only a good indication of which way the wind is blowing but it also offers significant price reprieve in the wholesale and spot markets.
Having visited two of the biggest categories in the CPI calculation, lets now look to two more before going global and seeing if there are scenarios that could rock the boat.
The two other elephants in the room when it comes to CPI are housing and healthcare. Here the data is probably more likely to be mixed. Looking at housing, while the Fed’s rather hawkish stance has seen significant declines in headline property values, where things get a little messier for CPI is rent. This is due to regulatory quirks depending on jurisdictions in the form of rent controls. The states that first come to mind here are California and New York. California, for example, has legislation capping rent increases at 5% + CPI (capped at 10%). Landlords were effectively seeing negative real growth in their yields over the past two years as additional Covid-related measures and moratoriums on evictions were put in place. As the normalisation continues to occur we will probably see distortions taking place (for example, landlords hiking disproportionately to retrospectively catch up for CPI, i.e. the increases would exceed caps).
Next we move to healthcare. Here the most important category is insurance. While we have seen significant growth in premiums as a result of Covid, most firms (and analysts) in the space expect premiums to start tapering on growth while outright declining next year. We probably sit in this camp too given the politically sensitive nature of the sector, especially in the run up to critical US mid-term’s.
All this is combined with the fact that we are quite possibly seeing a rather mild recession. Though this will be one like no other, with unemployment likely to stay at low levels. We can’t quite fathom this aspect of the economy, never have we seen negative growth and a labour shortage go hand-in-hand. It may imply the validity of the great resignation as a result of Covid. As of the beginning of this year, there are now 3m fewer people employed than before the pandemic with the highest quits/resignations on record of 4.5m in November of last year. We shall leave the long term implications of this for another time (especially given that a significant proportion of these resignations would be skilled workers).
For those of you that may need a little more convincing, the below is an interesting chart showing that the prices of raw materials while growing are doing so at a pace 60% less than the peak:
So, what does this mean for the Fed and the marginal investor?
The rather telling signal should be the rally on the FTSE when it became known that a recession was inevitable in the UK. What does it mean? Lets face it, we care for valuations and, as a result, monetary policy. We expect that the rhetoric may not change in the medium-term, central bankers, especially during times of slowing growth and election cycles, tend to stick to script (no, we are not questioning the so-called independence of the Fed here). The cynical side of us does wonder whether bankers who have, for close to a decade now, been trying to find a way to push rates above the 0-bound have not been breathing a sigh of relief at the markets giving them a somewhat easy way out.
In many parts of the world, and here especially, rates had got so low that central banks have been looking for any reason at all raise them. IT IS IMPORTANT TO UNDERSTAND: they (central bankers) will continue to take whatever sentiment, markets and most importantly the media narrative will allow, restocking the war chest for the next time they need to cut. Our call is that the Fed will continue to take whatever the bond market offers them and, as the easing of supply pressures feed through the system, use recession as an excuse to take the foot of the pedal.
What might rock the boat?
The global picture remains rather cloudy. Looking first at the EU, it remains a rather messy scenario. They are currently dealing with both diverging economic fortunes and unpalatable energy prices. Rather telling has been the almost unprecedented bid for oil in European markets. We have recently seen German producers move toward straight burning crude for industrial usage given that the price of LNG. At $100 USD oil trades at 5.5 MMBtu per barrel. To provide some context, LNG is (at the time of writing) trading at circa. 8 USD MMbtu. Meaning that, as winter approaches, we will see increased bid on crude which would then have flow on effects for global CPI number and thus the Fed’s stance. Basically, the first factor is this: how bad will the EU winter be?
Next is the larger elephant in the room. It has been pleasing to see that China has now recorded a record trade surplus, $101bn USD, for the month of July. There are two ways of looking at this for an equities investor. First that, despite Covid woes, supply chains and bottlenecks are easing - Beijing’s Covid-zero policy to date representing a significant hurdle here. Second, it decreases the likely scale of fiscal stimulus coming out of lockdowns and still dealing with woes in the property sector. On the latter point, it might not seem relevant but think for a moment of what fiscal stimulus may look like (i.e infrastructure spending) and the impact on raw materials as well as associated prices.
Staying on the topic of China, we look to other headlines (i.e. Taiwan).
For investors what should be watched when it does come to Taiwan is not the grandstanding but what happens after Xi’s coronation for a third term and coming out of lockdowns. If the numbers get out of hand, there may well be an escalation across the Taiwan straits, especially with a world distracted by Russia. We have previously said that Beijing would be watching the Russia/Ukraine situation with great interest as it will give them an idea as to what they can get away with on the global stage when it comes to Taiwan; a similar logic and “justification” could be wheeled out by Beijing.
War, or the possibility thereof, is a time-tested means of shoring up domestic approval ratings or keeping the populace distracted (if one is an autocrat). For recent evidence, the approval ratings in Russia for Putin and his Ukraine war, at least according to the most independent/dependable source available, are supposedly 83% and 77% respectively. Never mind the geopolitical implications of China “retaking” (as they would see it) Taiwan; Taiwan is one of the world’s leading semiconductor producers and conflict would likely send prices for these critical components skyrocketing once again. On the other side, an embargo on China would obviously be unhelpful for CPI data easing.
As it currently stands, we are firmly of the belief that we have hit peak inflation and are likely to see a reversion to just above the top end of inflation targets as early as the end of Q1 next year. That said, the world is complicated and the above scenarios, likely or not, could delay this.
Markets & Commentary
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