A Lot Rides on Peak Inflation

We came into this year with expectations that while slowing, growth would continue at an above trend pace. That remains the case, but inflation is leaning heavily on the outlook. The inflation roar we’re seeing is exacerbated by war in Ukraine and by China’s zero-Covid policy involving lockdowns, which is weighing on Chinese growth and the global supply chain.

M&A activity is robust, as are corporate investment and capex. In the U.S., we are back to pre-pandemic savings rates. There is well in excess of $2 trillion in savings on personal balance sheets because of pandemic-driven government stimulus. That’s a positive as it relates to both economic normalization and consumption in the face of higher prices.

Economic growth is likely to fall as central banks tighten.

That said, the slowdown induced by central bank tightening is just starting. Be patient when adding risk to portfolios. Valuations have declined materially but the price paid for high earnings growth is still elevated.

A bottom for equities is likely to coincide with a peak in inflation, since that will signify how much central banks have to tighten. A lot of Wall Street research claims that inflation is peaking now, and a recent IMF report came to similar conclusions – the IMF sees U.S. inflation peaking around current levels. Even so, we don’t think we’re there yet.

Inflation has already blown past the IMF forecast for Europe, and there’s evidence of a wage-price spiral in the U.S. in low wage industries; U.S. labor markets are still at their tightest levels in the post-war era; and supply chain pressures which spiked last year have yet to abate (some of which is due to the China lockdowns). On top of all that, rising food and energy prices are now feeding into airlines, restaurant and lodging prices. Bottom line: there’s a lot riding on when inflation peaks. Even if that happens now (which we doubt), the Fed has a ways to go before it can stop tightening.

Economic growth is likely to fall as central banks tighten. Leading indicators point to a decline in manufacturing activity this fall, and the lean inventory positions of a year ago are gone as rising inventory levels in the U.S. have now converged with falling sales. Large declines in manufacturing and bloated inventory conditions usually result in large earnings declines. For anyone looking to add risk to portfolios this year, more bad news is now in the price for equities (the S&P selloff of 18% from its peak is ~70% of the average selloff during the prior 11 recessions), but still we think you can be patient.

Rick Barragan is the Managing Director, Los Angeles Market Manager, for J.P. Morgan Private Bank.
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