The most recent inflation reading out of the US for the month of July has shown that, whereas overall Consumer Price Inflation (CPI) remains high, the speed at which price levels have risen has slowed significantly. Moreover, the month-over-month change in CPI has dipped to zero. Core prices registered a 5.9 per cent increase year-over-year last month, below the consensus estimate of 6.1 per cent. If sustained, this trend should generally be bullish for equities, bonds and the US economy.

Of course, the path to lower inflation will not be linear, but the downtrend should be maintained, given easing supply disruptions and much tighter monetary and fiscal conditions. Granted, the level of inflation remains at a 40-year high, which will continue to erode consumers’ spending power and sustain pressure on politicians and policymakers to keep policy tight. However, what matters for financial markets is not the current level, but the marginal change in future inflation expectations, because financial markets are forward looking by nature.

Some inflation sceptics point out that there is a broad category of goods and services whose prices are still accelerating. For example, food prices have spiked to new highs, while service sector and shelter inflation is also sticky. However, grain prices have been falling sharply in recent weeks, and this should lead to a significant drop in food inflation in the coming months. Moreover, while it may take a while for service inflation to come down, the concern over rental inflation should prove unfounded as the US housing market is cooling quickly.

The bottom line is that the latest CPI report should mark the beginning of a disinflationary process. Based on the premise that the current inflation problem is primarily driven by supply constraints, the outlook for the world economy and markets may not be as bleak as many have feared. In effect, supplier delivery times, order backlogs and the Institute of Supply Management (ISM) price index are all down sharply, while supplier inventories are rising in the US. In the meantime, shipping rates have fallen, and Chinese exports have been strong as well. All this suggests that supply-side inflation will continue to fall in the coming months.

The demand side of the story is more complicated because wage growth is still high and labour productivity has been weak, while the US labour force participation rate is stuck at very low levels. Nevertheless, with the Fed driving up rates aggressively, aggregate demand will likely soften enough to bring down demand while capping inflation.

To be sure, a heightened tug of war between a slowing economy and falling inflation will persist, despite the recent downtick in inflation. While falling inflation is a bullish development for both bonds and shares, a recession would entail an earnings decline, which is bearish for equities. Ultimately, we see inflation as the dominant factor in determining asset values or equity prices. This is because inflation drives interest rates, whose impact on equity prices is exponential.

The bond market reaction to the softer inflation report has also been interesting. Short-dated yields have fallen while longer dated ones have risen slightly, amounting to a modest curve steepening for the first time in a long while. By and large, the bond market interprets the preliminary drop in inflation as a pro-cyclical development because lower inflation would imply a less aggressive Fed, hence a better chance of a soft economic landing.

Finally, a peak in US inflation could mark the first step towards an eventual drop in the value of the US dollar. However, it is still too early to see a sustained drop in the dollar as all the major world economies are much too weak. Nonetheless, the dollar looks expensive, and the prospect of any additional hawkish shock from the Fed has diminished. It is only a matter of time before the Fed pauses its tightening campaign or cuts rates, but the dollar will sniff this out much earlier. In other words, the turn for the dollar may not be near as the fragile situation of the rest of the world economy should prevent a sharp fall in the greenback.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd, which is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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