In this week’s video insight I ask the question has inflation peaked, and is this leading optimism in the stock market? Stocks rallied sharply last week based on the better-than-expected consumer inflation (CPI) data. Consequently the U.S. Central Bank and the Reserve Bank of Australia will keep increasing interest rates this year, but then cut them next year thanks to a recession. Are these expectations reasonable? I look at some charts to answer this in the video.

Transcript

Roger Montgomery:

Many of you will know the market has bounced quite convincingly. Led by the NASDAQ and the S&P 500, the ASX S&P 200 has also bounced rather convincingly. It wasn’t that long ago that REA Group shares were trading at $96. Most recently they’ve traded above $131. So the bounce seems convincing, and it feels as though peak inflation is already passed. In fact, that’s leading optimism in the stock market right now. People believe inflation is peaked, it’s going to come off, and consequently the U.S. Central Bank and the RBA will keep increasing interest rates this year, but then cut them next year thanks to a recession.

Are these expectations reasonable? Well, let’s look at some charts. In the first chart you can see here that wholesale inventories are at the highest level in 20 years, so are retail inventories, suggesting companies don’t need to buy more stuff. In other words, that should put reduced pressure on the supply chain. The supply chain pressure index is coming off and the supply of deliveries index as well as the backlog of orders have fallen considerably, suggesting bottlenecks in the supply chain are definitely easing. If we look at this next chart, you can see prices for random access memory, the Commodity Research Bureau’s prices index and the Baltic Dry Shipping Index have all fallen from recent highs, suggesting supply chain pressures are definitely easing. This is translating into lower expectations for inflation, which is obviously a good thing. And you can see that in the chart on the bottom here, the search term “inflation”, the trend for that search is declining. Perhaps that means expectations for inflation are declining, and that’s a good thing.

And of course, that’s leading expectations for interest rates to stop rising next year. What you need to also understand is inflation can be broken up in other ways as well, not only by supply and demand, but also by goods, food and energy, services and so on. And you can see services form a very large part of the inflation equation. In fact, services make up 73 per cent of core CPI, and services are driven by people, and people are paid wages, and wage inflation is very, very strong right now because there is a huge gap between the number of unemployed and the number of available jobs. In fact, there are roughly 1.7 jobs being advertised for every unemployed person in the United States. Until that gap closes, wage inflation isn’t coming down. If wage inflation isn’t coming down, then neither is core inflation. That means that the U.S. Federal Reserve might pause on raising interest rates next year, but they might not start cutting interest rates. And that could prove to be a real disappointment for the market.

And finally, let’s have a look at the charts for earnings expectations in the U.S. market. On this final chart, you can see that for the top 400 stocks, the top 600 stocks, and the S&P 500, the next 12 months earnings per share expectations have all rolled over.

If the market is too optimistic about what’s going to happen to interest rates next year, and earnings are starting to roll over, then there’s a very real risk that this particular rally could peter out. That’s all we have time for today.