Colleen B. from Little Rock, AR asks: Seasons Greetings Mitch, I’m curious what happens in the markets now that inflation looks like it has peaked already. If inflation isn’t getting any worse, shouldn’t the stock market start to do better in the new year? Thank you and Happy New Year!
Mitch’s Response:
Thanks for writing, Colleen, and Happy New Year to you as well! I see better days ahead.1
Your question is about how a peak in inflation may impact markets, potentially in a positive direction. For readers who have not been following the inflation story very closely, Colleen is referring to various measures of inflation having peaked around June 2022. The chart below shows the Federal Reserve’s preferred inflation gauge, the personal consumption expenditures (PCE) index. As readers can see, it appears by this measure that inflation peaked in June 2022.
PCE Index (Year-Over-Year Change in Inflation)
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Even though more data points are needed to confirm whether inflation has indeed already peaked, I think there are clear components of inflation data that are firmly in a downtrend. Goods inflation that stemmed from supply constraints like closed factories, higher shipping costs, and snarled supply chains has largely faded; shelter and owners’ equivalent rent components operate on a lag, but recent data like falling housing prices and lower prices on new rental leases offer hope; finally, the impact of higher prices for used cars, semiconductors, and airfares appears to have run its course. Energy prices have also retreated from peaks.
To be fair, however, upside surprises to inflation were commonplace in 2022. Many economists and consensus estimates were wrong, even my own. With every inflation miss, the Federal Reserve responded by digging deeper into its hawkish stance, pushing the terminal fed funds rate higher in the process. Expectations for peak fed funds now stand at 5% in May 2023, but the market may still be too optimistic about when rates will start to come down.
The primary reason is the unpredictability of services inflation, which stems from companies taking advantage of pricing power to raise prices. But it also comes from issues in the jobs market, where labor scarcity continues to drive up wages. This will be the key factor to watch in 2023.
To your question about the impact on markets, we know that since 1960, the consumer price index (which measures inflation) has gone above 6% on four occasions, in 1970, 1974, 1979, and 1990. In every instance where CPI peaked and started falling, stocks staged relatively powerful rebounds. It follows that peaking inflation in this cycle would arguably be a tailwind for stocks.
The issue clouding this outlook, however, is uncertainty over how high the Fed will go and how long they will keep rates at elevated levels. The market may be too optimistic about the Fed’s willingness to cut rates in 2023, as there are plenty of historical cases of loosening too soon before the inflation battle is won. But it’s also true that the Fed has succumbed in the past to job losses and recession as a trigger for easing monetary policy. If inflation gets down to acceptable levels sometime in 2023, providing the Fed more flexibility, then markets will have a much clearer path for a sustained rally.
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Disclosure
2 Fred Economic Data. December 23, 2022. https://fred.stlouisfed.org/series/PCEPI#
3 Zacks Investment Management reserves the right to amend the terms or rescind the free 4 Ways to Protect Your Retirement from Rising Inflation offer at any time and for any reason at its discretion.
4 Zacks Investment Management reserves the right to amend the terms or rescind the free 4 Ways to Protect Your Retirement from Rising Inflation offer at any time and for any reason at its discretion.
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