As we came out of the second quarter frenzy over inflation and tighter monetary policy, we reminded clients that this heightened state of alert would ultimately drive market yields higher and create, at best, a slowdown in the economy; at worst, a recession. While that didn’t sound like a positive message at the time, it carried a silver lining and that was that this slowdown would help cool inflationary pressures and potentially reduce the need for aggressive rate hikes. This was important messaging as Canadian investors were not only dealing with a rough first half in the equity market, but with their fixed income portfolio as well. August was always going to be critical for us, given that this is when we would receive US price data for the month of July – the month when demand destruction started.

 

 

Sure enough, we saw two reports this week that validated our view that inflation has begun to abate. July consumer price figures showed no change in prices for the month of July (at two decimal points, there was actually a small decline in the CPI). Outside of the pandemic-induced meltdown in 2020, this was the first time the headline index declined since January 2019. This also coincided with the end of one year of interest rate hikes by the Federal Reserve that took the Fed funds target up to 2.5% - where it stands today. Core CPI, which excludes food and energy prices, also moderated in July to a month-over-month pace of 0.3% - the lowest since September of last year.

 

 

Some have argued that this break in headline and core CPI doesn’t mean much given that the labour market remains strong and wage growth is still high. Furthermore, this strength and the re-opening of the economy should be stoking demand for services and hence service-related prices can keep accelerating. That might be true, however, the index that measures services prices rose by only 0.2% in July, which was the weakest since December of last year.

 

As they say, one number does not make a trend and it is premature to say that services demand is weakening in the US, especially in light of last week’s employment data. If demand is robust, then you would assume that price increases being felt by retailers would be passed on. If, however, consumers are reacting to the recent rate hikes and hunkering down, then that ability to pass on higher costs diminishes. It’s also possible that July is our first sample of this shift in consumer behaviour.

 

Then again, input price pressures are also starting to ease as we saw in Thursday’s produce price report for July. Headline PPI for finished goods actually fell 1.9% from June, whereas economists had expected a modest 0.2% rise and, like the CPI, this was the first monthly drop since the pandemic. This brought the headline PPI inflation rate down from 18.5% in June (which was the highest since 1975) to 15.5%. That is still a massive number, but a 3% drop in an annual inflation rate is also significant.

 

Since inflation is just a mathematical calculation of today’s prices versus those of a year-ago, the headline numbers are not as important as the trend in monthly movements. For example, CPI inflation was still 8.5% in July versus 9.1% in June. Yet, if I take the 3-month moving average of the monthly changes, this works out to an annualized pace of 9.5% - higher, but down from 11% in June and 11.3% in March. Even if we got a modest 0.3% rise in prices for August, the annualized number drops to around 6.5%.

 

 

 

Given that gasoline prices continue to decline in the US, there is a good chance that consumer prices could come in flat yet again. This week, the average price for unleaded gasoline across the US fell to $3.99, which is the lowest since early March and is a sharp decline from the highs above five bucks back in June. For July, the average price at the pumps fell about 9% compared with the average for June (in the CPI report, the drop was 7.7%). If we hold at $3.99, this would represent a further decline of 11%.

 

Market narrative was beginning to shift even before this week’s dual inflation surprises, but that pivot has intensified for sure. From zero faith in the Fed’s ability to engineer a soft landing several weeks ago, analysts are now talking about a larger window and increased flexibility to trim back the magnitude of rate hikes in the meetings to come. This shift has allowed the S&P500 to skate past its early June highs which, as I discussed last week, was a key technical level. Bonds, which have also recovered since the dark days of June, are seeing a bit of a fade.

 

 

 

No doubt, investors are happy with developments of this week and individuals are going to be relieved that portfolios are recovering alongside declining fuel prices. Housing-related wealth, on the other hand, is a different kettle of fish as prices continue to slide. As we noted in a previous commentary, that deterioration in prices is unlikely to stop any time soon, unless mortgage rates were to decline. And that will require an about face by central banks.

 

Ally and I remain constructive for stocks, as we have since the second quarter, and are making minor adjustments in the equity portfolio towards undervalued segments. There are still risks to the market though. Remember, we are just a few months from the US mid-terms and if this week’s Florida drama is anything to go on, the ride into November could get rocky. The bigger threat is that notions of a more relaxed Fed, falling energy prices and healthier stock markets actually re-invigorates business and consumer activity. If so, and demand allows for higher input costs to feed through, then this calmer inflation environment might be short-lived. This will definitely be on our list of things to discuss at this Monday’s Pyle Group conference call (dial in details can be found below).

 

Toll-free dial in number: 1-800-806-5484

Local dial in number: 416-340-2217

Participant Passcode: 6137690#

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.