Evidence Mounting That Inflation Has Peaked

Uncertainty about monetary policy is rising as the Federal Reserve approaches a stretch of critical policy meetings, starting in March. Markets also notched another lackluster week, and yet another sign of rising prices did little to shake the inflation narrative.

News of a possible impending Russian invasion of Ukraine did little to settle nerves either, as U.S. officials continue to warn that an invasion could come at any moment. Russia has now amassed somewhere between 169,000 and 190,000 military personal near Ukraine and Crimea. A kindergarten, a school and several buildings were reportedly struck with mortar shells in the Donbas region of Ukraine. This remains a highly dynamic, unpredictable situation that will likely have an immediate impact on markets if, or when, decisive actions are taken. 

There’s no denying that market sentiment is downbeat, and there seem to be more questions than answers presently (a word on that later). There are several crosscurrents of uncertainty, but we stand by our view that the drivers of inflation are peaking, which should help calm markets as the year progresses. And the Fed will raise rates this year but has no desire to push aggressively and risk flirting with a recession.

Wall Street wrap

Input prices accelerate for businesses: The producer price index (PPI), or the input costs businesses pay their suppliers, accelerated in January, rising 1 percent month over month and 9.7 percent on a year-ago basis (core PPI rose 0.8 percent; 8.3 percent year over year). That compares to advances of a revised 0.4 percent increase in December and marks the strongest PPI print in eight months. Price increases were broad-based, notably in costs for hospital outpatient care, food and vehicles.

The latest PPI is further justification for the Fed to begin raising rates in March, with the real debate on whether it’ll be a 50- or 25-basis-point hike. Markets are also pricing in chances for a Fed policy mistake, miscalculating inflation and moving too quickly. Again, we think markets may be overestimating just how hawkish the Fed is going to act.

Looking forward: So much of what we read about inflation is based on backward-looking data, so what’s the road ahead look like? To us, it appears the pillars propping up inflation are starting to crumble. For example, the number of small businesses looking to raise compensation has fallen back slightly, along with plans to raise prices. Businesses are having a slightly easier time filling jobs and finding the right candidates for the job. Inventories are clawing back toward satisfactory levels, allowing businesses to meet demand. Delivery times are improving, and fewer orders are went unfilled. Overall, companies are expecting supply chains to recalibrate while labor and productivity are improving. The data give us confidence in our forecast.

Lastly, the market is reflecting lower inflation expectations. The five-year forward inflation breakeven rate fell to 2.04 percent (derived from the yield on Treasurys). This is the Fed’s intermediate-term inflation barometer and represents market expectations for the rate of inflation five years from now. The current level is the lowest since March of last year, the same time we started getting more elevated inflation reads. Evidence that inflation has lost its momentum will continue to build in the data with each passing week.

Back in 2020, our call that inflation would exceed expectations due to stimulus and a reopening economy proved quite prescient. We saw inflation coming back then, but we see the trend reversing this year.  

Spending still strong: Inflation, Ukraine, the Fed and churning markets have all weighed on sentiment, though consumer behavior indicates a more positive demeanor.

Retail sales, for example, rose by a seasonally adjusted 3.8 percent in January compared to December, the best monthly gain since March 2021. Unemployment is low, wages are rising, and consumers have cash to spend even as inflation reached multi-decade highs in the month. January’s reading is a sharp reversal from a 2.5 percent decline in December.

The big picture: The Conference Board Leading Economic Index, or LEI, decreased 0.3 percent to 119.6 in January. It’s a slight pullback after rising 0.7 in December and 0.8 in November. Still, 119.6 is well above pre-pandemic levels of 112 in February 2020. Published monthly, the LEI combines 10 leading measures of economic activity, such as the S&P 500, consumer confidence, building permits, unemployment levels and more, into a single number that serves as a barometric reading on the economy. The LEI is seen as a gauge of the business cycle and typically dips prior to a recession and begins climbing before an expansion. While the LEI declined in January, we’re far from establishing a declining trend that would be a recessionary signal. Consumers’ outlooks, stock prices and initial unemployment claims (which correlated with a spike in the omicron variant) were headwinds to the LEI read in January. The parameters negatively impacted by omicron are likely to reverse as cases trend lower.

Overall, the LEI still points to continued economic growth, though at a slower pace than last year. The Conference Board forecasts GDP growth coming in at around 3.5 percent in 2022.

Upside of downbeat sentiment: The AAII Investor Sentiment survey is in the gutter. Bulls represent just 19.2 percent against 43 percent bears. This is just one way to parse overall investor sentiment, but going back to the first week of 1988 there have been only 27 instances when bulls represented just 19.2 percent or less (that’s out of 1,781 observations). Since 1988, investor sentiment has been this low just 1.5 percent of the time.

Let’s go deeper. In all 27 instances when AAII sentiment dropped to these levels, investors who bought stocks the day after the reading had 52-week returns from that date that were positive in all instances. Many favored stocks have dipped sharply this year, so this contrarian sentiment indicator is worth keeping in mind going forward.

The week ahead

Here’s how the week sets up:

• Monday: Today is Presidents Day; markets are closed. However, we’ll get a look at IHS Markit manufacturing and services reports from the eurozone. A central bank rate decision is also coming from China. 
• Tuesday: A few key monthly reports are due in the morning. The ISM services and manufacturing indexes for February will provide a more current view of prices, inventories, labor and the general climate from the view of supply chain managers across industry. Consumer confidence for February will reflect continued inflation, a mending labor market and an improving omicron situation.
• Wednesday: Eurozone inflation for January may also be notable.
• Thursday: We’ll watch for revisions to GDP, initial jobless claims and new home sales for January.
• Friday: The week closes with a bang. We’ll be watching to see if the personal consumption expenditures (PCE) price index for January will drop. This is the Fed’s preferred inflationary metric and is the one we prefer to use in building our outlook. Core PCE inflation will be important here because core PCE strips inflationary outliers at both ends of the curve (the top and bottom 16 percent) to get a “median” look at rising prices. Essentially, core PCE reveals whether inflation is broad-based or being driven by a few outliers. Consumer spending, consumer sentiment and five-year inflation expectations will also give markets plenty to chew on to close the week. 

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