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What Goes Up, Must Come Down

01 October, 2022


          
            What Goes Up, Must Come Down

The market's doldrums last week was fueled further by the Fed's interest rate decision last Wednesday to increase rates by another 75bps, taking the target range to between 3% and 3.25%, its highest since 2008. Market analysts and rate traders were anyway betting that the Fed will lift its benchmark rate by at least 75 bps next week, after consumer-price inflation data came in hotter than expected. We are expecting rates to peak around 4.25% in March 2023.

The Federal Reserve had to take drastic action to combat the high inflation. This will most probably lead to a drop in the Sensex as it will trigger a pull out of monies by the FIIs in a repeat performance of the 1st half of 2022. This has already been evidenced in the last few trading sessions of September.


Inflation worries

On a monthly basis, the CPI, which measures a basket of consumer goods and services, rose 0.1% from July. Economists had projected that inflation would fall from July to August by 0.1%, after holding steady at 0% growth from June to July.

While annual inflation eased for the second-straight month (still high), with prices up 8.3% year on year, a slowdown from the 8.5% gain in July and the 40-year high of 9.1% in June.

Core CPI, which strips out the more volatile categories like food and gasoline, measured 6.3% in August, up from 6.2% in July. The month-on-month gain of 0.6% was double what economists had expected.

The volatile gasoline category was the only area of the index to show a significant decline from July, dropping 10.6%. Almost all other categories saw price increases, including shelter, which increased 0.7% in August and is up 6.2% year-on-year, the largest increase since 1991.


If you look at the underlying trend — I look at labor costs and rent increases — they both are pointing in the wrong direction and going up at hefty paces,

Sung Won Sohn
President - SS Economics



So What Is The U.S. Fed Doing About It

The Fed has been tightening its monetary policy in recent months to help rein in the highest inflation in four decades, implementing back-to-back, super-sized rate hikes of 75 basis points to bring back the targeted inflation rate of 2%.

In the US, high demand has conspired with supply constraints to cause price surges in many industries, hitting energy and autos especially hard.

US Inflation in 2022 is set to peak at its highest level in four decades, while in the UK, predictions put it as high as 22% in 2023.


Less Reason For Panic Around Longer-Term Inflation

Economists expect inflation in the US to average 2.4% over 2022-26 as a whole (in terms of the personal consumption expenditures price index), only slightly above the Fed's 2% target. The year 2022 will deliver the worst for inflation (5.9%), but over 2023-26, inflation is expected to average just 1.5%.

Today's high inflation is a result of pricing pressures in a few categories which is not expected to persist. If inflation is attributable to specific issues in a few industries, then it is a problem that can be eventually fixed.

The chart above shows the contribution of each type of good to excess inflation, or the difference between cumulative inflation since the start of COVID. In the past 3 years, we’ve seen 9.3% in excess inflation.

  • A little more than a quarter of that total - 2.4% comes from auto, since prices have spiked as global vehicle manufacturing has been held back by a semiconductor shortage.
  • Energy prices have contributed about 2.8% of the excess inflation (not to mention spillover effects via input prices to other goods categories), and they have been the prime driver of higher inflation recently owing to the conflict in Ukraine.
  • Flight from stocks into housing has started contributing to the higher inflation rate.

But A Large Deflation Is In Store For Durables, Food, And Energy Between 2023-26!

  • For durables, a resolution of the semiconductor shortage should expand supply, meeting demand and deflating prices.
  • For food and energy, prices should subside as these industries adjust to disruption from the Russia-Ukraine conflict and other factors.
  • Market does not expect the price spikes in energy and durables to be replaced by new problems elsewhere in the economy. It is expected to be moderate wage growth and the absence of any long-lasting supply disruptions to keep general inflation at restrained levels.

Will Housing Be A Cause Of Concern?

Housing prices have gone high. If they stay, it will drive higher inflation over the next several years. However, we expect home prices to reverse course before they can add too much to inflation. The Fed’s interest-rate hikes have caused a sharp deterioration in home affordability, which is rapidly cooling off housing demand. As a result, we expect housing demand to drop 10% between 2022 and 2023, which will in turn drive a cumulative 8% drop in housing prices between 2022 and 2025.


Conclusion:

Inflation data is delayed, and we only know the result historically (lag indicators). This apart, inflation is always tracked on a YoY basis. In the last 5-6 months the Consumer Price Index has gone up drastically making a higher base.

For the inflation to stay up, the index must go up further from here, in the next 6-12 months, which is unlikely to happen. Hence the inflation will show a cool-off mathematically. It means, even if the CPI remains at the same level for the next 6-12 months, the inflation rate will cool-off mathematically due to the higher base from the past 5-6 months.

Further, the key Inflation drivers (lead indicators), being tracked on a daily basis show a downward trend already (especially oil & industrial commodities) which will contribute to the inflation coming down.

The FED can target either a hard or soft landing. A soft landing would see growth and interest rates normalize gradually. A hard landing could see a severe recession, triggering unemployment. From what we have seen, the Fed tightening will cool off the overall economy substantially in 2023 and 2024, extinguishing the inflationary fire before it spreads to the broader economy.

We urge you to have conversations with financial advisors who have seen and navigated these cyclical rises and falls. They are in the best objective position to help you understand and mitigate the risks of letting emotion get the better of you.

We urge you to have conversations with financial advisors who have seen and navigated these cyclical rises and falls. They are in the best objective position to help you understand and mitigate the risks of letting emotion get the better of you.

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