Deflating Inflation and the stock market

The US economy is experiencing 40-year record high inflation.  During a supply chain breakdown, the US Federal government launched a massive program to support those mostly affected by the initial COVID shutdowns and to prop up the economy in an otherwise collapsing environment.  The result was demand-pull inflation on levels not seen in decades.  The Federal Reserve has stepped in to mitigate the issues of inflation amidst an ultra-liquid environment.  Short term interest rates are heading higher and the economy and stock market are responding to the potential of far more inflation and resulting interest rate increases.

Hyper Inflation Moving Downward

But, what does bringing inflation back down to normal look like?

The answer to that lies with history where the Federal Reserve needed to step in once before and deflate inflation.

The chart above, coming in from FRED, the St. Louis Federal Reserve Economic Data website. ^[1]St. Louis Federal Reserve website. This chart shows year over year changes in inflation.

In the chart above, you can see the most recent year-over-year increases have pushed inflation upward to levels not seen since the 1970s & 1980s.  During these two periods there were both supply shocks and hyper inflation as well as stagflation.  Even then, the Federal Reserve stepped in to move inflation back down to lower levels.

If you gaze through these numbers you can see that normally we see price increases that are within a normal kind of range.  However, over the past two years, price increases on a year-over-year basis have gone upward without a move back lower.  The Fed will have to intentionally increase interest rates in order to slow demand for a period of time to lower inflation.  By doing this, increasing interest rates, this will slow demand for products and services.

But, that slowing of demand translates into a recession even if it is a mini recession.

Commodity Prices Are Already Dropping

As I have been showing in some of my videos, key commodity prices are dropping hard and fast.  The above charts are base commodities such as wheat, corn, oil, cotton, gasoline, and lumber.  All of these charts are off of there respective recent highs.  And, some of these charts are already heading toward levels just below the beginning of the 2020 COVID lockdowns.  Given the potential of this, if base commodity prices move back down to levels seen just before the supply chain meltdown, it is reasonable to conclude that we will also see prices for goods made from these products falling in lockstep.

The Race To The Bottom For Prices

A perfect example of what could happen, and that is already occurring, is the price at the pump for a gallon of gasoline.  AAA had gas prices on a national average above $5.00 just a couple of months ago.  Now, gasoline prices are dropping with a national average at roughly $4.50 per gallon.

My prediction was that gasoline would drop to a national average of about $3.50 by year’s end.  Here in Santa Fe, NM, I have seen gasoline prices at $3.67 per gallon (At COSTCO which, they seem to have a handle on how to hedge gas prices better than most others).

Two things about gasoline that have really shot the price of gasoline upward.  First, the input cost of gasoline is oil which, that price skyrocketed because of the war in Ukraine.  Second, there is simply not enough refinery capacity for demand.  But, with a lowering of demand via increasing interest rates, input costs drop, demand drops, supply catches up, and price eventually drops significantly.  We are seeing this play out.

Then, the race to the bottom occurs as companies start to lower their respective prices to entice customers to buy products.  A price war ensues, and price normalizes downward.

You will see this occur throughout the economy with food, gasoline, and clothing moving lower and lower because supplies have had a chance to catch up to demand.

More to prices than simply base commodities

With falling prices for base commodities, this will generally translate into lower prices across the board.  But, there are also input variables that have nothing to do with base commodities.  That is something that will need to be kept in mind.  Wages are the biggest that come to mind.

While we are very likely to see continued moves lower at the grocery store, packaged meals may be slower to move lower and ultimately have some form of plateau because there are more inputs than base commodity ingredients.  Labor prices are higher than what they were just two years ago.  And, wages tend to be sticky, especially in an environment where there are options to work at other firms.  But, even those options are going to dwindle.

As the unemployment rate begins its long move to what would be the very least normal, this will mean fewer alternative options for employees.  Anyone accepting a new job may do so at a lower rate.

How stocks will act in a declining inflationary environment

What will happen to the stock market?  Simple: stocks will go lower.

If prices begin to drop for products and services, this means an aggregate of lower revenue levels.  And, with lower revenues, margins will decrease.  Profits will do the same.  Stocks are currently priced for higher revenue and profit levels.  Those levels are going to move lower and stocks will move in kind.

But, this is going to be more of a long term, slow grind lower as the economy shifts and adjusts.  As more and more supplies start to build up, as inventories increase, and as base prices drop, there will be ripple effects throughout the economy.  But, this is not an event, economics is a process.  The ripple effects will take time to move throughout the economy.

This process could very well take 3, 6, 9, 12, or 18 months as prices begin to move lower and lower.  During this time, once the moves lower in prices take hold, I expect the Federal Reserve will stop its rate increasing cycles.  It is about that time that I will start to consider buying in to new stocks.  But, not before that time.

The economy will need to fully shift and adjust before I start accumulating more stocks.  Most importantly, I will want to see the consumer get back onto a solid foundation with increasing incomes and consumption amidst low inflation rates.  That is what I am awaiting.

I expect that stocks still have a long grind lower of about 5% – 10% below their most recent lows.  Afterward, I will be looking for entries, but not until I see the shifts in the consumer I am looking for.