The Rollover Race between Growth and Inflation
David Kelly
Chief Global Strategist at J.P. Morgan Asset Management
Published Jun 27, 2022
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In times long gone by, a popular event at town fairs and school sports days was the sack race. The competitors would assemble at the starting line, each encased up to the waist in a burlap bag and gripping firmly onto its sides. At the gun, they would hop furiously in the direction of the finish line, 100 yards ahead. As a sporting contest, it lacked dramatic tension, with most of the competitors biting the dust in the first 50 yards. But it was entertaining to speculate on which brave athlete would roll over first.
U.S. financial markets are currently witnessing the equivalent of a sack race between growth and inflation. Both are going to roll over. But the sequence of which rolls over first is important. If inflation falls first, the Federal Reserve could cool its hawkish rhetoric, markets might price in fewer rate hikes, and long-term interest rates and the dollar could fall, providing relief to both the housing market and U.S. exports.
If, however, growth stumbles first, the tabloid headlines will shriek “stagflation” and Jay Powell, gritting his teeth, could don the long-discarded mantle of Paul Volker, pushing rates higher still, even at the cost of toppling the economy into recession.
So how is the race looking in the last week of June?
On the growth side, there is plenty of evidence of a slowdown, with the U.S. flash composite purchasing manager index falling from 53.6 in May to 51.2 in early June, its lowest level in 5 months and very close to its lowest level since the start of the pandemic. Consumers appear to be even gloomier than purchasing managers, with the University of Michigan’s Consumer Sentiment Index falling to its lowest reading ever.
This week’s numbers should confirm this weakness with declines expected in May durable goods orders (particularly in real terms) and in May pending home sales. Unemployment claims could also edge up from an admittedly very low current level and real consumer spending for May could come in unchanged.
Investors will also be interested in flash readings on May U.S. goods exports and wholesale and retail inventories, due out on Tuesday, and June light-vehicle sales, due on Friday. These numbers should be better, suggesting that the economy will still log solid real GDP growth in the second quarter.
Third quarter growth looks less secure. The surge in consumer spending on travel, leisure, entertainment and restaurants as pandemic effect faded has now faltered and could even reverse in the face of low consumer confidence, high prices and staff shortages. Retail sales could also post further weak numbers following a -0.3% reading for May, as low and middle-income consumers are squeezed by high gasoline prices and the lagged impact of a cutoff of federal government stimulus programs last year. A recent downward trend in housing starts and home sales could continue in the face of an almost doubling of mortgage rates since the start of the year. Trade could also worsen in the third quarter due to the twin impacts of a very high dollar and a slowing international growth, particularly in Europe.
However, growth could still remain positive in the third quarter due to three important trends.
First, auto production is gradually recovering with May U.S. light vehicle assemblies reaching their highest level since January of 2021. If the chip shortage can ease sufficiently to allow this trend to continue, light-vehicle sales could rise throughout the rest of the year, due to pent-up demand among consumers who are hesitant to buy with inventories were at super low levels.
Second, at least some parts of investment spending should continue to grow strongly as companies with healthy balance sheets try to upgrade productivity in the face of labor shortages and high energy prices encourage more domestic production.
Third, surveys conducted by both the National Federation of Independent Business and the Labor Department still show a huge surplus of job openings relative to unemployed people. Even if this surplus begins to decline, (as we expect it will), it should help keep employment growth broadly positive for months to come.
It should be noted, however, that these forces supporting the economy could weaken if consumer and business confidence remains at today’s very gloomy levels. Growth, which looks solid in the second quarter and looks shaky in the third, could roll over entirely by the fourth.
On the inflation side, the Commerce Department will release May data for the personal consumption deflators on Thursday. We expect to see headline PCE inflation of 6.5% year-over-year and core inflation of 4.8% year-over-year. Both of these would be only slightly below their peaks and still far above Federal Reserve targets.
Moreover, an early read on June inflation suggests something similar, with a spike in gasoline prices at the start of the month pushing the AAA average to above $5 per gallon. Natural gas prices also surged in early June adding to inflation for the month. Overall, we expect another hot CPI reading to be released on July 13th, with a consequent strong monthly read on June PCE being published on July 29th.
Thereafter, however, there are growing signs of a potential inflation rollover. The Bloomberg Commodity Index has now fallen by 11% since peaking on June 9th, reflecting broad price declines in crude oil, gasoline, natural gas, corn, wheat, copper and cotton. Average milk prices, which had jumped from $3.50 per gallon in May of 2021 to $4.20 per gallon by May 2022, also fell in June. According to the Hopper travel app, average prices on booked airfares have been falling in recent weeks which should reverse some of a recent extraordinary surge. Used car prices have stopped rising, according to the Manheim Used Vehicle Index, and could well fall if vehicle supplies continue to improve.
The lagged effects of higher inflation expectations, wage growth and home prices are likely to continue to add to inflation in the months ahead. However, even with this, the July CPI report, due out on August 10th, should show a much lower monthly gain in prices as should the August report, due out on September 13th.
In short, if current trends continue, there is a good chance that the Federal Reserve will have clear evidence of an inflation rollover when they meet on the 20th and 21st of September. At that point, they may well begin to express some more optimism on a reduction in inflation and some more concern about slowing growth. Unfortunately, monetary policy works with a lag, and a more dovish stance by the Federal Reserve by the fall may not be enough to prevent the U.S. economy from stumbling into recession.
It is, at best, a close call and, if inflation doesn’t roll over before growth turns negative, both the economy and financial markets are in for a tough second half of the year. However, for long-term investors, its important to recognize that, even if we can’t predict the sequencing of economic trends with great confidence, it is much easier to forecast that both growth and inflation will ease in the year ahead, allowing long-term interest rates to stabilize or fall and thus supporting both the bond and equity markets.
A wise spectator at a local sack race would probably not want to bet heavily on which of two favored contestants would win but could place a more confident wager that both contestants would hit the turf before either hit the tape.
For more of my insights, listen to my Insights Now podcast for a breakdown on big ideas, future trends and their investment implications.
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