Investor Spotlight: Has inflation peaked? Is it time to get involved?

This issue of Investor Spotlight is brought to you by IG, with Kyle Rodda, Market Analyst and ausbiz presenter.

US CPI data stoked a rally in equity markets, as investors positioned for a possible peak in US inflation. Is the excitement premature? If the inflation problem is 'solved', which areas of the market may outperform? In this week’s piece, we look at the drivers of the rise and potential fall in US inflation and provide three stocks in different sectors of the market that could outperform if we have indeed seen the top of US inflation.

What has been driving US inflation?

By any metric, inflation in the United States is historically high. When looking at the Consumer Price Index (CPI), US inflation hit a 40-year high of 9.1 percent in June, with the Core CPI figure (which strips out volatile items from the data) hitting 6.5% in April. While it is the subject of heated debate, the surge in prices has come from some balance of demand and supply factors. On the supply side, the pandemic and lockdowns slowed global output and stifled supply chains, while the war in Ukraine disrupted energy and food markets. On the demand side, cash hand-outs from governments, and cuts to interest rates fuelled consumption in developed economies. The imbalance between supply and demand drove too much money to chase too few goods, which pushed inflation to the levels we’ve seen over the last year.

Has US inflation peaked?

Commentators have been trying to predict the path forward for inflation since the first signs of it emerged as post-pandemic lockdowns ended. The sentiment was bolstered in the last week, however, after the US’s July CPI numbers were published and revealed that headline inflation eased to 8.5% - down from 9.1% in June and below the estimate of 8.7%. The core CPI figure held steady at 5.9% and has trended lower since the highs made in April. Confidence has also been fuelled by signs that consumer inflation expectations are falling, with the University of Michigan Inflation Expectations survey showing a drop to 5.0. This has eased fears of a so-called ‘un-anchoring’ of inflation expectations, where the belief that prices are going to rise in the future creates a vicious cycle of further price rises.

Which stocks could outperform in this market?

As we wrote about here, global investors are rotating into defensive and quality stocks as economic growth slows and financial conditions tighten. When it comes to investing in a slowing inflation environment, however, another kind of stock can also outperform - growth. Growth stocks are companies that are expected to grow their profits at a very high rate and well into the future. While often smaller companies are at the early stages of their life cycle, there are growth companies that are more mature and possess the defensive and quality characteristics investors may desire in this environment. As growth companies are expected to generate profits out into the future, investors value these stocks with a longer ‘duration’ interest rate. That means as long-term interest rates fall as inflation eases, the valuations for growth companies become more appealing, resulting in a higher share price.

Four stocks for peaking inflation

Here are four stocks on the ASX and on Wall Street that may strengthen if inflation peaks. To find a handful of stocks that fit the bill of growth, quality, and defensive, we’ve built a criteria incorporating market capitalization, cash holdings, 5Y EPS growth, and beta (or the stock’s volatility relative to the rest of the market.

So... what’s the risk here?

As always, nothing in markets is ever guaranteed. The obvious risk is that inflation has not peaked, or is only plateauing, potentially at a permanently high level. What’s also worth noting for investors is that while the easing of supply-side drivers of inflation like lower commodity prices, greater output, and easing supply-chain pressures ought to support economic activity, rising global interest rates will slow global growth. This will be a drag on financial conditions and put downward pressure on corporate profits, resulting in a potential downside risk for equity prices. Further evidence of moderating inflation is required to confirm a trend. Growth, employment, consumption, and corporate earnings data will need to be gauged to assess the economic outlook, especially as some market indicators warn of an impending US recession.

Summary

A peak in US inflation is far from confirmed. However, there are positive early signs, as supply-side pressures ease and higher global interest rates moderate demand. Being forward-looking, investment markets are discounting a growing probability that inflation will continue to fall from here, but one that will come hand in hand with a recession. Growth stocks with quality and defensive characteristics may well outperform in this environment.