Welcome to Disinflation Nation.
After more than two years of rising prices, the inflation rate is falling – and fast. The consumer price index rose just 3% year-on-year in June, the smallest increase since March 2021. Over the past 12 months, it has fallen 6.1 percentage points, the largest fall of its kind since 2009, when inflation spiraled into a deflation had turned. The last time the CPI rate fell by 6.1 percentage points or more from above 9% was in May 1952, when the index fell 7.4 points to 1.9%.
Let’s think about what a great achievement that is. Yes, headline inflation numbers remain too high. Core CPI, which removes food and energy from the equation, is 4.8%, well above the Fed’s 2% target, and average hourly wages continue to rise 4.4%.
But there’s a truism investors should fall back on: It’s direction that matters, not level. And since the direction of inflation is down, the direction of the stock market is up. It really is that simple, and it’s one of the reasons why the stock market has soared in 2023.
And it could well continue to rise. Paul Hickey of the Bespoke Investment Group notes that the gap between the finished goods component of the producer price index, which dates back to the late 1940s and fell 3.1%, and the CPI hit 6.1 percentage points in June, the widest of all times. That may mean that margins will remain stable or that consumer inflation will be less of a problem.
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In any case, a record gap between the two was usually a good time to buy stocks
S&P 500
In the three months following such an event, the value increased by an average of 3.6% and by 19% in the following year. “Previous periods when the spread reached record levels typically followed with above-average stock returns and occurred very late in a recession or in the early stages of an expansion,” writes Hickey.
At the moment it seems neither one nor the other. Despite an inverted yield curve, falling leading indicators and manufacturing surveys remaining in contraction territory, the US economy has yet to slip into recession. John Higgins, chief markets economist at Capital Economics, continues to expect a slowdown in the second half of the year, so he looks to history for examples of recessions paired with bull markets.
He found five: that which occurred at the end of the Civil War; the slowdowns towards the end of World War I and World War II; the recession of October 1926 to November 1927; and the downturn that coincided with the end of the Korean War. Each of the recession rallies have occurred at a time when valuations were either very cheap or in bubble territory, and since neither is currently the case, he expects the stock market to fall soon.
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“Our forecast is that in the midst of a recession, there will be a setback in the second half of 2023 before moving forward,” he writes.
There is another possibility: the US is already out of recession and entering a new phase of expansion. That’s what Hickey favors based on his comparison of PPI to CPI: “Using this metric would add credibility to the view that a recession is not on the horizon, but rather in the rearview mirror.”
Wouldn’t that be a nice surprise?
write to Ben Levisohn at [email protected]
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