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INFLATION continues to be hotter than expected, as last week’s monthly US Consumer Price Index print shows.

Core CPI grew 5.9% year-on-year. It was down from 6% in May, but the market was expecting it to decelerate to 5.7%.

Meanwhile headline CPI (which includes energy and food) stayed high at 9.1%.

Despite this, the market’s reaction was relatively muted. The S&P500 fell 0.9% last week, following a solid rebound on Friday. US 10-year bond yields fell 16bps, with the inversion tightening from -3bps to -21bps.

This suggests the narrative of central bank over-tightening — followed by recession and the need for rate cuts in CY23 — remains in control.

In this context, the market is focusing on the current recession in US manufacturing and sees CPI as a lagging indicator.

The role of the consumer will be critical in determining the scale of a slowdown and needs to be watched carefully.

Locally, the S&P/ASX 300 fell 1.1% last week.

US inflation

We are seeing broad-ranging price declines in a number of areas, suggesting flat or negative month-on-month CPI figures in the next couple of months.

Some key factors:

1. Commodity prices are generally weaker due to a combination of disappointing Chinese economic data, slowing global manufacturing and a stronger US dollar. Action in the oil futures market suggests a deteriorating outlook for oil fundamentals, bringing it closer to an already negative view in financial markets. Weakness in oil prices is now flowing through to gasoline.
2. Global supply chain indices are showing material declines.
3. The outlook for food inflation is improving as soft commodity prices continue to decline. Corn, wheat and milk prices are all down materially from their highs. Better harvests and some easing of Ukrainian supply constraints are helping here.
4. In the US, used car and house prices are also finally rolling over, though they remain at historical highs.
5. Wage/price spiral concerns are easing at the margin. The labour market remains tight, but weekly jobless claims are now rising, taking some pressure out of the market. There are no signs of wage pressures growing in measures such as private sector average weekly earnings.
6. A third of CPI comes from shelter and “rent of primary residence” which accelerated from 5.2% in May to 5.8% in June. There are indications that growth in asking rents has peaked, which points to a slow-down in the rent component of CPI as well.

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Gas remains the outlier to easing commodities. European gas prices are rising on Russian supply curtailment. Hot weather is seeing the same in the US.

However in aggregate these movements in price indices are starting to feed through to inflation expectations. Long-run inflation expectations fell to 2.8% in July (down from 3.3% in June) according to the latest University of Michigan survey.

US breakeven inflation rates have also fallen markedly over the past month. The two-year breakeven rate has fallen from about 4.5% to about 3%, for example.

The US consumer: not going down without a fight?

Compared to the end of June the expected peak in the Fed funds rate has been brought forward from Apr 23 to Feb 23, but the peak rate is at a higher level.

This reflects a view that the economy will deteriorate faster and deeper than previously thought — and that short term inflation remains too high.

There is a recession in global manufacturing driven by the effects of higher interest rates, energy prices and US dollar, combined with the roll-off of stimulus and normalisation of spending patterns post-Covid.

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New orders are dropping and earnings are being revised down. This is not a positive for markets.

But it’s important to note we still don’t know the degree to which ongoing strength in US consumption can offset the manufacturing downturn.

We note:

1. Consumer confidence remains stronger than expected. The University of Michigan June survey had the index at 51.1 in June, versus 50 in May and 49.8 expected. Retail sales numbers for June grew 1% month-on-month, versus +0.9% expected.
2. Quarterly commentary from the big US banks, while wary on the longer-term, noted that current conditions remain positive. JPMorgan Chase CEO Jamie Dimon said: “Consumers are in good shape. Jobs are plentiful. They’re spending 10% more than last year. Businesses, you talk to them, they are in good shape… We’ve never seen business credit better — ever — like in our lifetimes”. Citi CEO Jane Fraser said: “Little of the data I see tells me the US is on the cusp of a recession”. Bank CFOs are saying consumer spending remains resilient, with a mix shift to travel and entertainment. They are seeing low levels of credit losses.
3. Jobless claims are deteriorating, but not at a scary rate.

The upshot is that the consumer may be more resilient than expected due to strong initial savings balances, a still-tight employment market, good wages growth and a softening in short-term inflationary pressures.

The question is whether this relative strength in the consumer will partly offset the recession in global manufacturing, leading to an overall economic outcome that is better than currently feared.

The current consensus view is that resilience in consumer spending is simply a head-fake and a summer splurge, with the hangover coming in 2H22.

This needs to be watched closely. We could be facing a scenario where the savings buffer for consumers is sufficient to see them through the peak in inflation and we see a slowdown, but not a material consumer recession.

We note markets are already very bearish. The ratio of consensus US upgrades to downgrades and changes in target prices has not reached the lows of previous market downturns. But it is in a very pessimistic range by historical standards.

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Measures of shorting are already at the low points of previous cycles. The S&P 500 P/E has retraced to the Covid low point and is close to pricing in a recession.

This means it does not take much to beat very depressed expectations.

Energy crisis ongoing

There are a number of ongoing market concerns, including the fact that Covid remains disruptive and the outlook for manufacturing is deteriorating.

The energy situation remains the wildcard and could deteriorate further.

US gas prices are up on hotter weather. European prices have risen in response to tighter supply due to scheduled maintenance on the Nordstream pipeline. The latter will be closely watched — it is due to reopen this week. The risk is it becomes a geopolitical bargaining tool.

Higher energy prices are seeing Europe enter a recession much deeper than expected in other regions. The bearish European economic outlook was reflected in the very brief EUR-USD parity party this week.

Meanwhile, winter is coming.

Germany needs to be at 80% gas storage level by October to be ready for colder weather. Current storage levels are 64.7%. They need to add 0.19% a day to get there.

This was not a problem prior to Nordstream maintenance, but there will be serious issues if it doesn’t come back online in a timely fashion.

China macro weaker

China continues to struggle with impact of the zero-Covid strategy, adding to current market concerns.

Beijing has announced new financial stimulus measures. Packages put in place last year are seeing some benefit in infrastructure investment.

But the real estate sector remains a mess.

New home sales and starts are down dramatically. This is a large proportion of the Chinese economy. It is feeding through to broader economic softness, with weakness in steel production and prices. It is also an additional drag on global commodity prices.

Retail sales recovery post the partial reopening has also disappointed.

The silver lining for Australia is that Beijing is looking to resume Australian coal imports to avoid its own energy crisis.

Markets

Metals & Mining (-6.6%) led the S&P/ASX 300 lower last week, driven by weaker global industrial data and a stronger USD.

Staples (+1.3%) and Healthcare (+3.4%) were pockets of strength, benefiting from a pull-back in bond yields and an uncertain economic outlook. The rest of the market was flattish.

As it has been for a while, the market is grappling with uncertainty over how bad the upcoming recession will be. It was quiet week on news flow as we move towards reporting season.

About Crispin Murray’s Pendal Focus Australian Share Fund

Pendal’s head of equities Crispin Murray has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

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