Here’s Why Inflation Will Keep on Slowing
Our leading indicator of inflation growth tells us the Consumer Price Index is headed even lower when the May data is released. That should support the outlook for stocks...
Wealth Signals features commentary that filters out market "signals" from the "noise" that is the mainstream financial news media. We focus on what matters – which, invariably, is not what you’ll hear on CNBC or read in the Wall Street Journal. On the basis of these signals, we’ll also issue macro-driven trade ideas to get ahead of the trends and themes that will dictate market direction.
If you’re an American grocery shopper, you’ve likely been following an unorthodox market indicator over the past few years: the price of eggs.
During that time, “everybody and their brother had a story about what egg prices were doing,” said Amy Smith, vice president at consulting firm Advanced Economic Solutions, as quoted by CNN. In her view, eggs were “the poster child for what was going on with inflation.”
As the price of gas surged, and the cost of chicken feed rose – compounded by global supply chain issues – the price of a dozen eggs (and of a delicious sunny-side-up) more than doubled.
But over the past couple of months, that’s changed...
In January 2023, at the peak of “eggflation,” you were paying close to $5 a dozen at the grocery store. But egg prices have been falling. And as of the end of April, you could take home a carton for around $3.27. Omelet lovers, rejoice.
Egg prices aren’t an indicator we track closely at Porter & Co. But they’re a good boots-on-the-ground confirmation of something our data does tell us...
Prices are easing before our eyes. And the custom-made cost index we’ll look at today shows they’re poised to slow even more.
That means the Federal Reserve is close to ending the rate-hiking cycle... which is great news for stock investors.
If interest rates are about to drop, that means it’s cheaper to borrow funds. Then, institutional investors will be more willing to increase leverage. That, in turn, will increase the appeal of risk assets like stocks, over safety assets like bonds.
And the change will support a rally in the S&P 500 Index…
The Indicator You Need to Watch
Over the last 15 months, the Fed has raised interest rates by 500 basis points (that’s five percentage points) from a range of 0% to 0.25%, to 5% to 5.25%. And as according to the Fed’s wishes, higher interest rates are weighing on inflation. According to the U.S. Bureau of Labor Statistics, the Consumer Price Index (“CPI”) has fallen from 9.1% growth last June, to 4.9% in April.
Our proprietary Combined Prices Received Index (“CPRI”) is telling us that inflation will continue to fall.
Every month, regional federal reserve banks – there are 12 of them in the U.S. – ask purchasing managers at hundreds of industrial producers in their local districts about general business activity. We focus on results from the reserve banks of Dallas, New York, Philadelphia, and Kansas City, as a reflection of the entire U.S. economy.
We drill down on one indicator in particular: “prices received” by manufacturers for their goods. That’s what customers pay for goods. It foreshadows CPI – which is released several weeks after data from the regional federal reserve banks sees the light of day.
So, by following this data, we’re ahead of the game. And the CPRI, which combines data from these four reserve banks, says that inflation will continue to fall.
As you can see above, our index predicts big moves in the CPI by a few months. Back in April 2009, the prices received index bottomed out. Three months later, CPI did the same.
A similar story played out in 2011… our index peaked in March, and inflation started to decline seven months later.
Fast forward to post-COVID America… our gauge was an early indicator once more. The prices received index peaked in October 2021 and started to decline in November. It would take another eight months until CPI hit its peak. Ever since, it has been following our combined index lower.
And the drop in inflation growth isn’t done. As our chart above shows for May, prices received have yet to hit bottom. The combined reading is back to pre-pandemic levels, a far cry from the September 2021 peak. The last time it was here, CPI was just 1.2%.
And that brings us back to the outlook for interest rates…
What to Do Before CPI Drops More
Since inflation growth tends to lag our index, the change implies it could still be a while before CPI troughs. Based on past precedent, even if the CPRI rebounded in May, it would take at least five or six months for inflation to do the same.
More importantly, the steady decline in inflation tells the Fed that its policies are working. Excess dollars have been removed from the system and inflation is easing. And, as prices and economic activity stabilize, it will give the central bank room to lower interest rates once more.
That will support a long-term steady rally in the S&P 500 Index.
One way to invest in this scenario is the SPDR S&P 500 ETF (SPY).
The fund tracks the performance of the S&P 500 Index. It invests in all the member companies, weighting them by market capitalization. The current dividend yield is 1.6% and pays out on a quarterly basis.
Since SPY is a basket of stocks, investors may not participate in the huge rallies experienced by individual companies’ shares during a bull market rally. But diversification can spare downside pain during a bear market selloff.
Scott Garliss
Porter & Co.
Stevenson, MD