Asset Allocation Strategy
20 November 2023
US Inflation Coming down from the Peak
US Inflation: Downside Surprise Drives Bond and Equity Rally

Despite calls for structurally higher inflation, the US headline consumer price index (CPI) appears to be falling as fast as it went up. This should provide support for both fixed interest and equity markets over the coming year.

October’s headline US CPI print was flat (0.0%) month-on-month (MoM) versus the consensus estimate for 0.1%. On a yearly basis, headline inflation has now fallen from a peak of 9.1% in June 2022 to 3.2% at the end of October. Energy prices lead the downswing in headline CPI, with gasoline prices dropping nearly 5%.

The closely watched “core CPI” reading came in at 0.2% MoM, which was also below the consensus estimate of 0.3%. On a yearly basis, it dropped from 4.1% to 4.0% - the lowest since September 2021.

Figure 1: US Inflation is now well down from its peak
Figure 2: Most categories have normalised
Figure 3: The path to lower core inflation has been bumpy month to month but the trend is clear

Housing Largely Responsible for Lingering Core Inflation

Looking at the contributions to core CPI, core goods inflation has now been negative for the past 5 months, currently sitting at 0% year-on-year (YoY). It appears the only “sticky” inflation left is coming from services and, more specifically, from the housing (shelter) sub-component. 

Rents continued to rise last month, and although the pace of the increase slowed considerably from September, housing was still the largest factor in the monthly increase in the core CPI. “Shelter” increased 0.3% in October, after rising 0.6% the previous month. The shelter index has increased 6.7% over the last year, accounting for over 70% of the total increase in core CPI.

Importantly, we expect the shelter component to ease considerably over the coming year as slower rental growth, which is currently observable in more timely indicators, finds its way into the US CPI calculation. The US Bureau of Statistics uses a complicated procedure to estimate rents, based on surveying panels (control groups) of households at an interval of six months and asking them about the rent they are actually paying. This causes changes in measured rents to lag behind changes in rents negotiated in the marketplace, as does the fact rents are normally only renegotiated once a year. Changes in “owners’ equivalent rent” are estimated using changes in measured actual rents and lag in the same way. 

According to web-based real estate platform Zillow, the rent on new leases in September was up 3.0% YoY, but up just 0.8% at an annual rate over the past six months. We expect this very slow rent growth to continue, reflecting plenty of new multi-family supply coming on the market, the fact rents are still high relative to income, a squeeze on consumer budgets from the renewal of student loan payments, slower job growth and relatively sluggish US demographics. If this is correct, shelter inflation, which peaked at 8.1% YoY in early 2023, should fall from the current 6.7% YoY rate to under 3% by the end of 2024, dragging core CPI lower.

Outside of housing inflation, the so called “super core” service component (which the Fed seems to have put outsized weight on) slowed from a 61-basis point (bps) increase in September to just 22 bps in October. So, general services inflation does not appear to be a problem.

Figure 4: Core goods inflation has dropped to zero year on year
Figure 5: Core Services is still elevated but...
Figure 6: Shelter is the key reason services inflation remains elevated
Figure 7: Core CPI (ex shelter) is already back to 2%

Encouraging Trends but November Print Will Likely Edge Up

Looking forward, continued declines in retail gasoline prices in November will likely lead to another moderate headline CPI increase next month. However, a pick-up in used vehicles prices and less deflation from hotel prices will likely see a bounce in core inflation in the November print. The past 12 months have shown that the trend improvement in inflation will not be a straight line. 

6- to 12-month Outlook for US Inflation Appears Encouraging

While November CPI may pick up somewhat, this month’s downside inflation surprise continues the established decline in inflation that has been playing out this year and is consistent with our medium-term view that inflation will slow faster than either the Fed or the market expects. We expect 12-month core CPI inflation to trend down significantly through next year amid increasing goods supply, the lagged pass-through of slower rent increases into CPI rents, and a general easing in the economy. While 12-month core CPI is still running at 4%, 12-month core CPI excluding shelter is down to 2%, very close to its pre-pandemic average. This means shelter is really the only thing keeping core inflation above target, and, as discussed, trends in market rents point to a rapid deceleration in shelter inflation over the next 6-12 months.


Market’s Lock in a Fed Peak

The softer-than-anticipated CPI inflation release prompted investors to both firm up their view of no further hikes and bring forward Fed rate cut expectations. The market is now giving a zero probability to further hikes and roughly 25% odds to a rate cut in March. The market has fully priced in 2 rate cuts by July. A total of 100 bps of cuts are priced into 2024.

Figure 8: The market is now pricing 4 Fed cuts by the end of 2024

At the long end of the curve, the US 10-year bond yield fell by almost 20 bps to ~4.5% in response to the downside inflation surprise, reaching its lowest level since late September.

While resilient US labour market data may prevent bond yields from falling much further during the next few months, a likely peak in the Fed Funds rate suggests US bond yields have likely peaked for the cycle. On a 12-month investment horizon, bond yields are more likely to fall further than return to recent highs. Beyond the sharp moves in interest rate markets, the S&P 500 posted a large daily gain of 1.9%, while the AU$ rebounded back to the 65c level as the US$ weakened.

Figure 9: The easing in bond yields on softer growth and inflation data has buoyed equities once again

Lower Inflation to Support Bonds and Equities

Overall, the decline in inflation is supportive for our relatively constructive fixed interest and global equity market view, and provides support to Australian equities (and bonds) despite our own stickier inflation situation and higher-for-longer cash rate expectations.

US macro data will likely continue its recent softer tone in the coming weeks/months, which should be good news for equities and bonds after the run of stronger-than-expected data. Positioning remains favourable for more gains with Institutional investors yet to aggressively chase the recent bounce, although that may well change heading into year-end. 

Crucially for markets over the next 6 to 12 months, progress towards 2% inflation should be substantial in the months ahead. This should go a long way to calming any residual fears of sticky US inflation. If the US economy can stay on this path of decelerating inflation while avoiding a recession, the outlook should be positive for US equities and fixed income. There is, of course, a risk the US economy could fade into recession, or get hit by another shock in the months ahead. However, the good news for investors is that, after an extremely volatile ride in recent years, US inflation looks set to reach its 2% destination ahead of expectations.

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Written by

David Cassidy, Head of Investment Strategy

David is one of Australia’s leading investment strategists.

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