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July 17, 2023 - Consumers hold the key to lower inflation.



Please note that the next weekly review will be published on August 14, 2023.

We take the opportunity to wish our readers an enjoyable and relaxing summer !!!


Inflation has been moving down primarily due to the "base effect" , i.e. the comparison of today's prices with last year's (already) high prices, as we had forecasted almost one year ago. Of course, a further significant negative contributor has been the collapse in commodity prices, energy costs and the drop of the transportation costs from the panic peak of 2021/2022. However, companies have been pushing retail prices even higher despite the fall in their input costs, earning significantly higher profit margins than historically. The consumer has been willing, up to now, to pay-up for these inflated goods and services. But there comes a point where the consumer always says "enough is enough" and this happens either because he feels "cheated-on" or most importantly, because he has reached his spending limits and must reduce spending, even in essential goods and services. The latter is what brings economic slowdown and a recession, which forces companies to lower their prices for demand to come back up again. And inflation then moves significantly down.


The June US inflation was announced lower than expected. It rose by 3.0%, which is the lowest level since March of 2021, down from 4.0% in May. The monthly pace of inflation has slowed significantly, with three of the past four months posting headline CPI increases among the lowest monthly changes since the inflation surge began in early 2021. The step down from the 0.44% monthly increase in May to 0.16% in June was led by used cars and airline tickets which fell sharply (-8%). Rents also slowed from their recent pace of increase. The producer price index (PPI) for June was announced at just 0.1% compared to last year, which is the lowest annual change in almost three years.


The US Core CPI also fell below 5.0% (at 4.8%), compared to 5.3% in May. Excluding rents the core CPI fell 0.05% in June, which is the smallest monthly change since January 2021 and a number that puts it below most months prior to the pandemic. Even with the slowing, rents continue to be the major source of inflation of the core CPI, but other data show that new tenant rents have been growing at or below their pre-pandemic pace every month since last year, suggesting CPI rents will slow further in coming months. Overall, the US inflation showed that inflation looks to be under control for now and in a clear downtrend since last year, but most likely the pace of the fall will moderate significantly in the next 2-3 months. The toughest part for inflation to move further down is now ahead of us. The 2% target of the FED looks still distant , even if we are now so much closer than last year, unless a recession forces demand and prices down.


China achieved zero inflation growth in June. China published its own data on inflation this week, showing a 0% growth, compared to 0.2% in May. The producer price index (PPI) fell by 5.4% in the same period , after having fallen 4.6% in May, showing that the cost of supplying goods is decreasing compared to last year. These data confirmed that the Chinese authorities have the privilege to be able to stimulate the economy if needed, without the fear of a run-away inflation and that companies must soon start to cut prices , as their input costs have been moving down, if they do not wish to experience a collapse in demand.


Equities rebounded strongly across the globe. The FOMO (fear of missing out) party continued after the correction of the previous week. Nasdaq added 3%, while most European indices finished about 2-3% higher. The rally was broad among all sectors, with Materials sticking out with a 5% performance. The fall in yields and the crash of the dollar helped commodities rally, pushing up also the stock prices of the companies that engage with them.


Bonds also rose (and yields fell), as the theme of the week was lower inflation. The market seems to be moving very fast from one scenario to the other. It was only two weeks ago that the market was selling off as it was pricing two more FED hikes in the next two meetings and the 2-year yield was at 5.10% again. Now it is suddenly pricing again one more hike and done with the 2-year dropping to a low of 4.65% , a whopping 50bp change in a matter of days. We cannot really trust this market, with such huge volatility and a change of mood with every piece of data. We would rather focus on maintaining positions in high quality bonds of average duration that offer very attractive income, than trade in and out of bonds and stocks to try and time the market.


The USD sold-off to the lowest levels since March 2022. The EURUSD traded as high as 1.1250, as bond yields were falling rapidly and the markets were in euphoria mood. Gold managed to capitalize on the combination of lower yields-lower dollar and rebounded around the 1950$ levels. The move was not as impressive as the move in the other two asset classes, primarily because we have entered a season which has not been friendly for the yellow metal, in terms of physical demand. The purchase of gold for the wedding season in India and China usually starts one or two months before the Xmas holidays.


The 2nd quarter reporting season started in the US with some of the major banks. JPMorgan , Wells Fargo and Citigroup posted better than expected results and raised their expectations for the full year as the rise in interest rates have helped them significantly these last few quarters. Banks have not passed the high interest rate to depositors to the extent that they have raised the interest rates on the loans to their borrowing clients, helping them boost their margins. But this is coming to an end, as more and more depositors demand higher rates and money is leaving the banks' balance sheets to go into mutual funds or move to competitor banks. It is wise to assume that we must have seen the peak of the margin for this cycle at least, which is indirectly implied in the still low valuations of the major US banks (9.5 times earnings on average).


Chart of the Week : US Inflation falls to 3%, but the move to <2% will be harder to achieve.



The easy part of the fight against inflation is over. The headline number in the US has fallen to the lowest in more than 2 years, to just 3% (blue line). The core CPI is still close to 5% (green line) however. We had noted last year that inflation is just a mathematical equation which divides consumer prices with the prices of the same month of the previous year. For inflation to be at zero, all it takes is for the prices to remain stable (albeit at today's high levels) and this comparison with a high base, it is called the "base effect". It was for these technical reasons that we had the view since the dark months of 8% and 9% inflation, that it could drop to 3% by the summer of 2023. This is now a reality. But that was the easy part. For inflation to fall from 3% to below 2% we need to start seeing prices coming down on a monthly basis and demand for goods and services to fall significantly. A recession is almost a guaranteed for inflation to drop back to the central banks' targets. The markets believe that inflation can move significantly down and stay low without a recession. The next 12 months we will have our answer to who was right.


Disclaimer

• The content of this document has been produced from publicly available information as well as from internal research and rigorous efforts have been made to verify the accuracy and reasonableness of the hypotheses used. Although unlikely, omissions or errors might however happen.

• The data included in this document are based on past performances and do not constitute an indicator or a guarantee of future performances. Performances are not constant over time and can be positive or negative.

• This document is intended for informational purposes only and should not be construed as an offer or solicitation for the purchase or sale of any financial instrument and it should not be considered as investment advice. The market valuations, views, and calculations contained herein are estimates only and are subject to change without notice. Any investment decision needs to be discussed with your advisor and cannot be based only on this document.

• This document is strictly confidential and should not be distributed further without the explicit consent of Kendra Securities House SA.

• Sources: Chart of the Week : Factset, Cover photo : Bloomberg article (Getty images)

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