Disinflation Nation: Falling Inflation Rates and Stock Market Direction

by Warren Seah

After more than two years of rising prices, the rate of inflation is falling—and fast. The consumer price index rose just 3% in June from the prior year, its smallest increase since March 2021. It’s down 6.1 percentage points in the past 12 months, marking the largest decline since 2009, when inflation had turned to deflation. The last time the rate of CPI fell from above 9% by 6.1 percentage points or more was in May 1952, when the index dropped 7.4 points to 1.9%.

Significance of the Achievement

Let’s consider how big an accomplishment this is. Yes, the overall inflation numbers remain too high. Core CPI, which removes food and energy from the equation, sits at 4.8%, well above the Fed’s target of 2%, and average hourly earnings continue to grow at a 4.4% clip.

But there’s a truism investors should fall back on: It’s the direction, not the level. And since the direction of inflation is down, the direction of the stock market is up. It really is that simple, and it’s a big part of why the stock market has raced higher in 2023.

Potential for Continued Rise

And it very well could keep rising. Bespoke Investment Group’s Paul Hickey notes that the difference between the finished-goods component of the producer price index, which goes back to the late 1940s and fell by 3.1%, and the CPI hit 6.1 percentage points in June, the widest ever. That can signify that margins are holding up or that consumer inflation will be less of a problem.

Record Gap Between Stock Market and Economy: What Does It Mean for Investors?

The relationship between the stock market and the US economy is currently experiencing a record gap, leaving investors wondering what this could mean for their portfolios. Historically, such instances have often signaled a good time to buy stocks, with the S&P 500 showing an average gain of 3.6% over the three months following these occurrences, and a significant 19% rise over the next year.

In the past, when the spread between the stock market and the economy hit a record, it was usually a sign of above-average equity returns. These instances typically occurred in the late stages of a recession or during the early stages of an economic expansion, according to financial analyst Hickey.

However, the current situation is different. Despite factors such as an inverted yield curve, declining leading indicators, and ongoing contraction in manufacturing surveys, the US economy has not yet slipped into a recession. While some experts anticipate a slowdown in the second half of the year, examples of recessions accompanied by bull markets are rare. In fact, economist John Higgins only found five such instances in history.

Each of these recessionary rallies were characterized by extremely cheap or bubble-like valuations. Given that neither scenario is present at the moment, Higgins predicts that the stock market will soon see a decline. He forecasts that this downturn will occur during the second half of 2023, before a subsequent recovery.

Another possibility is that the US has already experienced its recession and is now in a new expansion phase. Analyst Hickey supports this viewpoint based on his comparison of the Producer Price Index (PPI) to the Consumer Price Index (CPI). According to Hickey’s analysis, this metric suggests that rather than a recession looming in the near future, it is more likely that any potential downturn is already in the past.

Ultimately, only time will tell how this record gap between the stock market and the US economy will play out. Whether it leads to a recession or signals a new economic expansion, investors should stay cautious and evaluate their portfolios accordingly.

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