Welcome to Disinflation Nation, where the rate of inflation is falling at a rapid pace. In June, the consumer price index (CPI) only rose by 3% compared to the previous year, marking its smallest increase since March 2021. Over the past 12 months, the CPI has decreased by 6.1 percentage points, the largest decline since 2009 when deflation took hold. Interestingly, the last time the rate of CPI fell by 6.1 percentage points or more was in May 1952, when it dropped 7.4 points to 1.9%.
The Significance of this Accomplishment
Let’s take a moment to appreciate the significance of this achievement. Although overall inflation numbers are still relatively high, with core CPI (excluding food and energy) sitting at 4.8% – well above the Fed’s target of 2% – and average hourly earnings continuing to grow at a rate of 4.4%, we can rely on a fundamental principle as investors: it’s not just about the level but also the direction.
The Impact on the Stock Market
The good news is that with inflation trending downwards, the stock market is on an upward trajectory. It’s as simple as that. In fact, one of the main reasons why the stock market has experienced significant growth in 2023 is due to this favorable direction of inflation.
The Potential for Further Growth
And there’s a strong possibility that this upward trend will continue. According to Paul Hickey from Bespoke Investment Group, in June, the difference between the finished-goods component of the producer price index (which dates back to the late 1940s) and the CPI reached a record-breaking 6.1 percentage points. This suggests that profit margins are holding steady or that consumer inflation may not pose as big of a problem as anticipated.
A Record Gap and Its Implications for the Stock Market
For investors, a significant gap between two key indicators has historically signaled a favorable time to buy stocks. The S&P 500 has seen an average gain of 3.6% over the three months following such occurrences, with a subsequent rise of 19% over the next year. This observation suggests that when the gap reaches record levels, it tends to coincide with above-average equity returns. Additionally, these events typically occur either late in a recession or in the early stages of an expansion, indicating potential opportunities for investors.
However, the current situation seems to defy categorization. Despite an inverted yield curve, declining leading indicators, and ongoing contraction in manufacturing surveys, the U.S. economy has yet to enter a recession. John Higgins, chief markets economist at Capital Economics, anticipates a slowdown in the second half of the year but is searching for historical precedents where recessions were accompanied by bull markets.
Higgins identified five instances: the end of the Civil War, the downturns near the conclusion of World Wars I and II, the recession from October 1926 to November 1927, and the contraction that coincided with the end of the Korean War. Notably, each of these recessionary rallies occurred when valuations were either exceptionally low or in bubble territory. Since neither extreme is currently present, Higgins expects a forthcoming decline in the stock market.
According to another perspective, it is plausible that the U.S. has already experienced its recession and is now entering a new phase of expansion. This view is favored by comparisons between PPI and CPI made by Hickey. If this metric holds true, it would lend greater credence to the notion that rather than a recession looming ahead, it is more likely in the rearview mirror.
Certainly, such a realization would be a pleasant surprise for investors.
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