Is inflation really peaking?

AMERICAN Nobel laureate and economist Milton Friedman once said: “Inflation is taxation without legislation.” If so, global economies faced one of the most trying periods of taxation over the past one year. Even today, 85 per cent of economies worldwide are still grappling with an inflationary environment, with domestic inflation rates stubbornly over 2 per cent.

The inflation rate is a year-on-year calculation of the weighted average of a basket of consumer goods most representative of households in an economy. With Singapore’s June 2022 headline inflation rate at 6.7 per cent, it would mean that an item costing S$100 in June 2021 would be priced at S$106.70 just one year later. Households will need to pay a S$6.70 premium to enjoy the exact same product. When viewed in this light, inflation is indeed a tax on consumption.

The US’ headline inflation rate finally slowed somewhat to 8.5 per cent year on year in July, retreating from a 4-decade high of 9.1 per cent just a month earlier. Given the elevated inflation rates, households’ purchasing power will continue to be eroded. Negative income effects (where households decide to consume less, and/or downgrade quality) will also dampen economic growth, which will eventually put a lid on consumer prices. Between now and then, US policymakers will continue to be hawkish in their policy stance.

That said, various indicators seem to indicate that inflation has peaked, and that it will start trending lower, although average longer-term rates will still be higher than the average of the last decade.

The 3 main segments of US consumer inflation today are housing (owners’ equivalent rent), transportation, and food & beverage. These 3 segments constituted 88 per cent of the latest headline inflation in the US. We expect these main inflation contributors to trend lower in the months ahead, with knock-on effects for the rest of the world, including Singapore, given the US’ outsized influence as the world’s largest economy:

US housing and rental prices

First, housing sale and rental prices are expected to weaken with the steep climb in the US average 30-year fixed rate mortgage rates, from a low of 2.67 per cent at end-2020 to 5.13 per cent currently. This has already resulted in the decline of US construction permits and residential housing starts, which fell 9.6 per cent to a seasonally adjusted annual rate of 1.45 million in July 2022, from 1.8 million in April 2022.

Housing sentiment is also weak, with the National Association of Home Builders Housing Market Index falling six points to 49 in August, clocking the eighth consecutive monthly decline and the lowest reading outside of the pandemic era since 2014. The index had only just hit a high of 90 in November 2020.

Meanwhile, in the rental housing market, private consumption expenditure’s rental of tenant-occupied properties rose to 5.8 per cent year-on-year in June. But looking at data on actual rental contracts made on property platform Zillow, which has a 9-month forecasting capability, we found indications that the rental market will peak in January 2023.

Transport inflation

Second, transport inflation rose 16.4 per cent year on year in July, pushed up mainly by higher motor fuel and new and used vehicle costs. However, this is set to slow as cost-fuelled inflation pressures ease. Oil prices could also be peaking with US and Saudi Arabia boosting production, while demand from China fell more than 10 per cent compared to a year ago.

Additionally, global supply chain logjams have eased considerably, with the Federal Bank of New York’s Global Supply Chain Pressure Index dropping for a third consecutive month to its lowest level since January 2021, from an all-time high last December. Various other indicators such as the Baltic Dry Index, US PMI (prices paid and order backlogs), supplier inventories, and global shipping rates are also pointing to a general easing of supply chain pressures.

Food and commodities

Third, the decline in the Food and Agriculture Organisation’s global Food Price Index from a 34 per cent year-on-year growth rate in March 2022 to 13.1 per cent last month marks a softening of food prices as global demand and supply seek a new equilibrium. In addition, many commodities have been experiencing price declines from their respective 2022 peaks.

For instance, the prices of nickel, wheat, aluminum, and unleaded gasoline have seen drawdowns of more than 30 per cent from highs reached just a few months ago. Prices of sugar, cocoa, coffee, soybeans, corn, cotton, copper, lead, and zinc are down more than 10 per cent from their 2022 peaks.

All these suggest that cost-push inflation will continue to fall in the coming months. However, the demand side is a little more complicated because labour markets remain tight, with labour productivity low, while wage growth is still going strong.

Nevertheless, global central banks will remain steadfast in their monetary tightening to rein in aggregate demand, and eventually bring inflation rates back to their targets.

US wage growth this time had a close correlation with services inflation, due to pandemic-specific influences. The low-skill, low-productivity nature of the service sectors limits the upside in costs, with the current shortages being temporary. Although nonfarm payrolls in recent months remained strong, there have been tell-tale signs of a weakening in the labour market: for example rising weekly unemployment claims, declining job vacancies, and tapering household employment survey figures.

A shift in tone by the Fed in 2023

The key takeaway from an improving inflationary environment is that the Fed will shift from an extremely hawkish tone to a more dovish one in 2023. One clue is the lower-trending US inflation expectations, showing the improved credibility of the Fed’s policy tightening as perceived by market participants. Longer-term real yields should continue to point lower, although there may be bouts of upside pressures from hawkish Fed comments.

While we expect the current pace of monetary tightening in the US to bring about an end-of-cycle recession, we do not expect a severe downturn as there are no extreme imbalances in the financial system. It would be an income-statement recession, rather than a balance-sheet recession.

Until the Fed releases the doves, selective good-quality equities in growth sectors such as consumer discretionary and technology remain our top picks. Defensive stocks in the healthcare, utilities, and telco sectors will prove to be relatively more resilient in the increasingly volatile investment environment. Investment-grade corporate bonds should also be a larger feature in portfolios.

The writer is investment strategist, UOB Private Bank.