Strategy Espresso: What happens post peak inflation?

■     Headline inflation is at peak (US) or likely to peak in the next few months (Euro area and UK) according to our economists’ forecasts. Given that high and sticky inflation has been a headwind for stocks, will peak inflation mean markets can find a trough?

■     On average, the equity market falls in the run up to inflation peaks and rallies in the months after the peak (based on 12 peaks >3% in US headline inflation back to 1951). But there is plenty of variation around the average.

■     In 2008, inflation peaked but the market fell further as recession ensued; in 2001 inflation peaked but equities fell as the tech-bubble continued to deflate.

■     In contrast, late 1974, March 1980 and October 1990 are the best examples of a strong post-inflation-peak rally. But these periods benefited from a sharp inflection in growth around the peak in inflation, falling rates and, most crucially, undemanding equity valuations.

■     European and UK equities have typically responded well as inflation has peaked. Indeed, European equities typically outperform as US inflation peaks. This may be a function of the higher beta of European indices, the UK with a lower beta (and more commodities) tends to underperform after inflation peaks.

■     If inflation does peak, who stands to benefit? Relationships with inflation are not stable over time. In recent months, cyclicals have been negatively correlated with inflation as higher prices were seen as damaging for growth so signs that inflation has peaked should be good for cyclicals, banks and consumer names.

■     But we’d be cautious of reading too much into headline inflation peaking – the uncertainty about the path of inflation is high. The downside scenarios for inflation often involve lower growth. Also, our economists remain below consensus on economic growth with the consumer being the weakest component.

■     We continue to recommend four areas in Europe – Strong balance sheets (GSSTSBAL), High & Stable margins (GSSTMARG) and companies with exposure to a structural rise in Capex and/or government investment (GSSTCAPX and GSSTFISC). We remain cautious on Consumer areas of the market and while falling inflation will be helpful, we remain of the view that discretionary spend will take a sharp dip.

Markets have fallen sharply as inflation has risen and as growth expectations have fallen. But our economists think US inflation has probably already peaked and expect European inflation to peak in the next 2-3 months (Exhibit 1). Even in the UK, where the inflation spike has been especially sharp, we think core inflation has peaked in April and headline will do so in October once the Energy price cap rises.

The impact of the rate tightening cycle, growth slowing and the falling out of the yoy numbers of some sharp rises from 2021 (autos prices for example) should all help to bring down the pace of inflation. In addition, the yoy growth of energy prices is moderating and semis supply is starting to ease. It is also notable that market implied inflation has started to moderate too (Exhibit 2).

Of course inflation is likely to stay high and we don’t expect it to moderate back to CB’s targets in the near term. Indeed, on our new numbers, Euro area inflation stays above ECB target through 2023. Also, the inflation expectations of households and corporates have risen and second round effects might prolong the inflationary problem, especially with rising wages given tight labour markets. In the UK and US there are more jobs than workers at the moment.

But overall, we think headline inflation is likely to be peaking. Could this be a catalyst to support a turn equities? We think it is probably more a necessary than sufficient condition.