Over the peak

Sky-high inflation numbers continue to garner much attention, but are they already yesterday’s ‘fish and chip wrapper’?

By Greg Smith, Head of Retail at Devon Funds.

After a traumatic first half of the year for financial markets, the second half of 2022 has started off on a much brighter note. After losing more than 16% in the six months to June, the NZX50 rallied 5.7% in July. This is the strongest monthly gain since the April 2020 rebound (after markets had lurched downwards in March 2020 at the start of the pandemic). It is a similar story across the Tasman where the ASX200 also rose by 5.7% last month. Many other global markets, which saw steeper declines in the first half, were even more robust. In the US, the S&P500 rose 9.2% last month, marking the best July since 1939.

The title of our Special Interest piece a month ago was titled “Turning point.” In that article we suggested that “high levels of pessimism, high cash balances and depressed market multiples” could mean that we were almost at the end of this year’s volatility. Whilst early days, this could well be proving the case already, with the markets rebounding with some gusto in July.

So, what has been the catalyst?

Markets had priced in a substantial amount of bad news during the first six months of the year, with investor angst centred around rising inflation, rising interest rates and the rising prospect of a recession. All three subjects are logically inter-related, with inflation at the epicentre.

Markets last year discounted rising levels of inflation as a problem associated with the pandemic, and something that would likely be transitory. Central banks then pivoted to the idea that it wasn’t, a matter that was put to rest by Russia’s invasion of Ukraine in February, which turbo-charged the prices for a host of commodities. 

The war is still ongoing of course, but the heat has come out of a host of commodities. Oil has fallen below US$95 a barrel. Weakness in the energy complex will be taking further heat out of inflation. Many base metals have weakened as have soft commodity prices. The price of wheat has dropped by more than a third in recent months. So, are markets now finally pricing in the narrative that inflation might not be quite as entrenched as some are thinking? Central bank efforts to cool red-hot demand look to be having some success.

Supply chains, whilst not back to normal, are also slowing freeing up, as highlighted by the below graphic from UBS.

Shipping costs have also eased from the record levels that were seen in 2021.

Backward looking inflationary prints have meanwhile continued to punch out some big numbers. In the US, annual inflation hit 9.1% in the June quarter. In New Zealand the CPI came in at a higher than expected 7.3% for the same period. Although across the Tasman, Australian CPI came in at 6.1% for the past quarter, which was slightly lower than consensus forecasts of around 6.2%.

But are the June quarter inflation numbers already yesterday’s “fish and chip wrapper?”

Source: JP Morgan

The world’s central banks are clearly sticking to the task at hand in terms of trying to get multi-decade highs in inflation down, but at the same time there are signs that the tightening that has occurred has already had some initial success in this regard.

A print in early August showed that US manufacturing activity expanded in July for the 26th straight month. The latest Institute for Supply Management reading registered 52.8 (anything above 50 indicates expansion), which was above estimates. While growth slowed, this was largely due to a fall in prices.

This is significant. The ISM prices sub-index fell to a two-year low, well below economists’ forecasts. Cost pressures may be easing for companies, and this also supports the view that we are possibly on the other side of the inflationary hill.

It is a similar situation in Australia, where on the face of it, inflation is rising at the fastest rate in two decades. The Melbourne Institute prices gauge rose 1.2% in July.  Interestingly however the  headline rate was 5.4%, lower than the official headline annual rate of 6.1% in the year ended June 30. As noted, lower energy prices will also be providing relief – Aussie petrol prices fell in late July, and oil has traded lower since.

The AIG Australian Performance of Manufacturing Index also showed that prices are easing. The overall index fell 1.5 points to 52.5 points in July, suggesting a slowing in industrial activity. However, input prices eased.

Markets surged in late July as the Federal Reserve unanimously voted to raise interest rates by 75 basis points for the second straight meeting in a row. This marks the most aggressive tightening since the 1980s, taking the benchmark rate to a 2.25%-2.5% target range. Officials remain committed to bringing inflation back down towards 2%.

Investors were receptive to comments from Jerome Powell that forward guidance was effectively “dead” with officials making decisions on a meeting-by-meeting basis, dependent on economic data. The hawk’s wings have been clipped, possibly in an acknowledgement that a lot of heavy lifting has already been done in the efforts to tame inflation.

Chair Jerome Powell said that a “soft landing” was still the aim but noted that ongoing increases in rates were appropriate to “expeditiously” combat exorbitant levels of inflation. Officials noted that pockets of the economy (including spending and housing) were slowing. However, he also noted that job gains in recent months had been ‘robust’ and that the labour market was tight, with unemployment at 50-year lows and vacancies around record levels (a similar situation to NZ and Australia). Significantly, Jay Powell said the US was not in recession. This view was backed up Powell’s predecessor, and current US Treasury Secretary, Janet Yellen, just a day later.

Second quarter GDP numbers have confirmed that technically, the US is in recession. The view from officials however is that the recession is not a real one, particularly with the economy creating around 400,000 jobs a month. This is hard to dispute.

The rate increase takes the Fed’s benchmark to a “neutral” rate which the central bank sees as neither stimulating nor restricting growth. This sets up the possibility of the central bank (dependent on economic data) tilting to a more gradual pace of increases going forward and dialling back to a 50bps rise in September. With the economy slowing, and inflation ‘potentially’ peaking, investors are receptive to the Fed taking ‘the middle ground’ it seems. And as we know, generally (but not always), where the Fed goes, other central banks tend to follow.

Investors are looking for the corporate sector to confirm that earnings and operational outcomes are better than feared, and better than that priced in by markets in the first half of the year.

The NZ reporting season is not set to start for a few weeks, but an interesting lead can be taken from the US earnings season which is well underway. The vast majority of releases (70%+) have been on the positive side of the ledger, but even for those that haven’t, there have been upward share moves where outlook statements have been upbeat.

A good example is Google owner Alphabet. The shares surged on the company’s result despite overall earnings and revenues falling short of expectations. Revenues at Google’s search business were robust however, allaying fears over a global ad market slowdown – Google is the world’s biggest seller of online advertising.

It was a similar story for Microsoft (held in the award-winning Devon Global Sustainability Fund) which missed earnings and revenue estimates but reported a massive jump in revenue growth for Azure and their cloud services.  Management at the software maker also issued upbeat future guidance, with revenues expected to rise 10% to around US$50 billion next quarter. The tech titan is another key bellwether, so this also provides cause for optimism around the broader economy.

Corporates are also feeling the pressure of inflation, and this has been another theme to come out of the US earnings season to date. Companies with strong pricing power are handling cost inflation better than those that don’t have it. Coca-Cola and McDonalds are two prime examples of companies that have been able to leverage their strong market positioning and mega-brands to pass rising costs down to end-consumers.

At Devon we continue to back high-quality companies that have pricing power and strong economic moats. Even if inflation has peaked, cost pressures are not going to go away overnight. Furthermore, even if an actual recession is avoided, consumer spending could continue to be under pressure, given mortgage bills (generally the biggest expense for most households) aren’t going down any time soon.

A reminder of the pain from inflation being faced by kiwi households came from Stats NZ last week. The cost of living for the average kiwi household, as measured by the household living-costs price indexes (HLPIs), increased 7.4% in the June 2022 quarter compared with a year ago. Higher prices for housing and petrol were the main contributors to the increase across all the household groups.

The HLPIs are arguably a better reflection of the cost-of-living pressures than the CPI in that they capture (rising) mortgage payments. Against this challenging backdrop, there is perhaps one ray of light. Oil prices have dropped which could ease pain at the pumps, and plenty of other places, down the track.

The forthcoming earnings season will show us which kiwi companies are dealing with inflation, and which aren’t. One segment that appears to be trucking along relatively well is logistics companies. The recent update from Mainfreight at their AGM was upbeat, with management highlighting that the company has performed very strongly in the 16 weeks since April 1. Supply-chain congestion remains something of a double-edged sword, and while freight rates have eased, these are still somewhat inflated compared to pre-Covid levels. Mainfreight shares rallied, and Freightways was higher on the read-through. Both companies are held across the Devon funds. 
Back to the original question, are we nearing peak inflation? Certainly, the high CPIs that have been clocked up recently will be hard to top mathematically, all the more so with prices of commodities such as oil coming down. Indeed, record levels of inflation may already be yesterday’s news.

A recent Bank of America monthly fund manager survey highlighted this year’s flight away from risk assets, with the investor allocation to stocks falling to levels last seen in October 2008, while cash has reached the highest levels since 2001. The poll showed that participants are concerned over the risks of a recession, along with the impact of higher inflation and interest rates this year. At the same time, the highest proportion of investors since the GFC are now picking that inflation will be lower in 2023, as will interest rates. It is quite possible however that this timeline has already crept forward.

And if this is true, then it also potentially follows that the assessment of how high interest rates will go (and how quickly), and how far the economy will sink, are also off base. This could then mean that investors flock back to stocks that have sold off this year. A rising tide may not lift all boats and the fact that interest rates are not about to fall any time soon will likely not do any favours for companies that are still on stretched valuations. But there are plenty of high-quality companies that are not in this camp. The investment team at Devon continues to seek out such names.