Peak inflation signals the beginning of the end

It has been a torrid year for investors, especially those in long-duration fixed income strategies. But high-profile events can signal market turning points.

Was the recent gilt market meltdown the equivalent of the AOL-Time Warner merger ringing the bell shortly before the top of the dotcom bubble in 2000?

Fed on a mission

After getting it wrong on the transitory nature of inflation, the US Federal Reserve (Fed) has ditched its forecasting models and become increasingly data-dependent. To regain credibility, it has stuck resolutely to 75 basis point (bp) rate hikes each meeting while employment growth remains solid and sequential inflation is well above target.  

While this shows the Fed is serious about tackling inflation, the main problem is that the key metrics it’s tracking are relatively backward-looking, meaning it is now on course to overtighten. The Fed recognises this risk, but is rightly more concerned about the consequence of failing to do enough to curb inflation.

In our view, softer data is coming soon, and this will allow the Fed to downshift the pace of its hiking in December and again in January before stopping. If we are wrong and the data remain firm, the Fed will likely keep going to 5%. Either path leads to recession in 2023.

Supply chains improving

Core inflation likely peaked at 6.6% year-on-year in September.

This is partly because inflation is about to lap some big increases last autumn, but more importantly it’s because supply chain issues are rapidly easing. Shipping costs have collapsed and supplier delivery times have shortened.

One of the reasons inventories are building rapidly is that demand has softened, but this should lead to discounting in the months ahead. US import prices, aided by a strong dollar, have been falling now for a several months. Used car prices have dropped sharply at the wholesale level and should begin to feed into lower retail prices. Goods prices were flat in the September CPI. We expect persistent deflation in goods prices to emerge in the months ahead.

A useful summary measure is the New York Fed’s global supply chain pressure index, which is calculated using a broad range of transportation cost data and manufacturing indicators. This appears to be on a rapid path to normalisation.

When will the labour market turn?

With goods prices likely to ease, attention will turn to services prices, which are a significantly larger share of CPI and historically stickier. September’s ugly core inflation print was driven by services, most notably rent and medical costs.

Rents are problematic for the Fed due to the long lags in the calculation. September’s spike was driven by surging new leases 12-18 months ago. Rent inflation will fall slowly, but there is a case to look through this given housing is already rapidly deteriorating and higher-frequency rental data softening. There should also be some relief from medical costs as health insurance premium inflation resets lower next month.

The rest of services inflation will mainly hinge on the labour market, wage costs and pricing power. Monetary policy operates with a lag. The Fed is on course to deliver more than 400bp of rate hikes inside a year. This has triggered a broad tightening in financial conditions and should negatively impact borrowing and investment decisions in the months ahead.

The consumer is also now running on fumes following revisions to the national accounts, which show they have been dipping more aggressively into excess savings than previously realised.

Recession ahead

With an aggressive Fed further diminishing the chance of a soft landing, we now see a recession starting in the spring (our previous forecast was 2H23).

Companies began to guide down ahead of this earnings season, a pattern I expect to be increasingly repeated over the next few quarters. The initial response to profit disappointments will be to cut excess vacancies and slow payroll growth. Then consumer income and spending will come under pressure, leading to even worse profits and more extensive cost cutting.

Overall, we expect a relatively mild 1% drop in output from the peak to trough. This should be sufficient to push unemployment up to around 5% and ultimately drive inflation back to target. The prospect of Fed cuts towards the end of next year and through 2024 should bring some relief to beleaguered fixed income investors.