Inflation – has it peaked and what could be next for investors?

High levels of inflation have been a key feature of the post-pandemic global economic recovery. As we move towards the end of 2022, the question is what level of inflation should investors prepare for over the next year?

What inflation will look like in the future, is the million-dollar question right now. After a lower-than-expected reading for US inflation in October, there’s some expectation that we’re close to a peak for price growth, and prices will move lower in the coming months. If this happens, the global economy will have dodged the 1970s style ‘great inflation’ that plagued financial markets for years.

What the central banks say

Since central banks have the monetary policy tools to try and control inflation, it’s worth looking at their projections for price growth in the coming months.

Central bank forecasts aren’t always accurate, and the major central banks were the ones who called inflation transitory up until 2021. However, now that they’ve accepted the global economy has an inflation problem, it might be worth giving their inflation outlooks more credence.

The Bank of England is expecting inflation to fall sharply in the next two years, with annual price increases expected to decline to 5.2% in the fourth quarter of 2023, 1.4% in the fourth quarter of 2024 and reaching 0% inflation at the end of 2025, although of course this is not guaranteed.

In the US, the Federal Reserve (Fed) is predicting that core PCE, its preferred measure of inflation, will fall to 3-3.4% in 2023, 2.2-2.4% in 2024 and 2-2.2% in 2025. This means that after 2023, US inflation rates are expected to move back towards the Fed’s target rate of 2% annual price growth.

Both central banks foresee a fairly rapid descent back to target rates of inflation and in the UK, inflation is expected to drop below the 2% target in two years’ time. It’s worth noting that these central bank projections are looking for a slowing in price growth, not disinflation (a fall in prices). This could likely be a better outcome for the global economy. That’s because disinflation has usually accompanied long and deep recessions.

Analysing slowing inflation

Unlike the 70s, when inflation was broad-based and therefore harder to bring under control, this time, inflation’s mostly been focused on automotive, energy, and shelter costs.

In the US, energy prices have risen by 17.6% in the past year, electricity prices are up more than 14%, new vehicle inflation is up 8.4% and shelter costs are up nearly 7%. Food prices have jumped more than 12%, however, this is partly due to the rise in energy and transportation costs.

Energy

The price of energy is unlikely to continue to rise to the same degree next year. We’ve already seen large downward swings in the price of gasoline and other energy commodities more recently.

Added to this, while replacing Russian energy is unlikely to happen overnight – the US and its allies’ embargo on Russian oil imports is due to begin in December – the process to shift away from reliance on Russian energy is starting to happen.

Growth in US oil production is already notable. US crude oil production is expected to jump by 480,000 barrels per day to 12.31 million, which is more than the prior peak in US oil production reached in 2019.

Global natural gas consumption is also expected to continue to fall in 2023. After falling 0.8% in 2022, it’s expected to drop 0.4% in 2023.

The housing market

In the US, owners’ equivalent rent costs, one component of shelter price inflation, is at its highest level since 1990. This matters as shelter costs are a major component of the Consumer Price Index (CPI), making up nearly 30%.

However, house prices also currently look like they’ve peaked, and could be on track to reverse in the coming months.

In the US, the Case-Shiller US National Home Price Index has turned lower. In the UK, the Nationwide House Price Index saw a sharp slowdown in October, with annual house price growth dropping to 7.2% from 9.5% in September. Monthly prices fell 0.9%, the first monthly decline since July.

This decline in US and UK house prices is to be expected after mortgage rates have surged on both sides of the pond.

US and UK house price growth

Source: Bloomberg, to 31/08/2022.

Production and supply chains

The price of imported goods is also expected to decline in the coming months and there are clear signs that production and supply chain constraints are starting to ease.

The New York Fed’s Global Supply Chain Pressure Index (GSCPI) declined for five straight months to September. Although it did tick up moderately in October, due to upward pressures from Taiwan delivery times, outbound air freight from Asia, and UK backlogs most likely caused by Brexit. However, the annual rate of the GSCPI suggests global supply chain pressures are falling back in line with historical levels.

New York Fed’s Global Supply Chain Pressure Index

Source: Bloomberg, to 31/10/2022.

Semiconductors

These small pieces of plastic with special electrical properties usually cost just a few dollars each. However, they serve as a foundation for computers, mobile phones, electric cars, and other electronic devices.

When production of semiconductors slowed during the pandemic, this wreaked havoc on supply chains and inflation surged. Well over a third of all US manufacturing requires semiconductors as a direct input. That means, a disruption to the production can vastly affect supply chains. This has knock-on effects on inflation as the availability and production of semiconductors is key for the global inflation outlook.

The global semiconductor market increased by nearly 14% in 2022, however growth is expected to slow in 2023 to a 4.6% annual rate. This is a big change and reflects rapidly rising interest rates and slowing global demand. A decline in demand for semiconductors is good for the prospect of a slowdown in global inflation.

Don’t forget about government intervention

Other factors that could weigh on inflation in the coming months include tighter fiscal policy (government spending and taxes) across the world, particularly in Europe and the UK. In the UK, the chancellor is trying to fill a £50bn fiscal black hole. This will help constrain demand and should help bring down UK inflation, which is now in double figures.

The takeaway for investors

It’s worth noting, if you strip out shelter costs, new cars, transportation services and services less energy costs, monthly US core CPI for October would’ve been negative at -1.6% month on month.

This opens the door to a slower pace of rate hikes from the Fed and has big implications for financial markets.

While the link between inflation and stock prices is complex, asset prices can respond well to lower levels of inflation for a few reasons. It protects revenues and profits, and the value of dividends. It also reduces the discount rate (an important part of determining the value of future cash flows), which has normally been good news for tech stocks.

If we continue to see inflation fall, as we expect, stocks could be in a better position to stage a meaningful recovery rally in 2023. Of course, nothing is guaranteed though.

This article isn’t personal advice. If you’re not sure what’s right for you, ask for financial advice. All investments and any income they produce can rise as well as fall in value, so you could get back less than you invest. Past performance is not a guide to the future.

Kathleen Brooks is Founder of Minerva Analysis, a market analysis company. Hargreaves Lansdown may not share the views of the author.