What’s Next for Inflation: A Battle Between Two Forces
Approaching the last quarter of 2022, we’re assessing a variety of short- and long-term crosscurrents for insights on where inflation is headed.
Supply-demand imbalances, which have been a key contributor to today’s high-inflation environment, are showing signs of improvement. The consumption mix between goods and services has been reverting to normal, logistics pressures have been easing, and inventories and backlogs are closer to historical levels.
Another, more idiosyncratic driver of high inflation has been the commodity-price shock from the Russia-Ukraine war. As the conflict continues, a potential natural-gas supply disruption is looming over Europe. However, global supply is starting to adjust through alternative sourcing of fossil fuels, rerouting of Russian supplies, accelerated adoption of renewables. Countries are also ramping up conservation efforts. As a result, commodity prices are now about 15% below their June 2022 peak.
Global tightening of fiscal and monetary policy should clearly accelerate the process of inflation normalization. Even though inflation has climbed to multi-decade highs, inflation expectations have not substantially dislocated, which speaks highly of continued central bank credibility.
Further out, new technology adoption accelerated by the COVID-19 crisis should continue to help ramp up productivity and production, lowering costs over the long term. Deglobalization could intensify costly trade wars, but it’s too early to tell the extent of the impact. It’s also not yet clear whether the adjustment will happen through reshoring (returning supply chains to home countries) or friend-shoring (shifting supply chains to friendly nations).
If inflation gradually decelerates over the next several quarters, it will likely prove to be a tailwind to risk assets. Below-trend economic growth should help ease supply-demand imbalances, and we’ll monitor the next round of inflation reports, which may confirm an inflection point.
Companies on Solid Ground, but See Bumps Ahead
Recent corporate reports offer some reinforcement of post-pandemic normalization themes: the consumption mix is rebalancing, inventories are catching up to sales, and employment gaps are narrowing. Yet more companies express worry over macro uncertainty.
Many firms are reporting intentions to slow new hiring, but labor markets have remained strong. US payrolls are roughly in line with pre-pandemic levels, despite real output levels rebounding to 3% above pre-COVID levels. Given high margins, companies may be willing and able to “hoard” labor.
Capital spending intentions—a leading indicator of expected business investment—suggest that investment growth is likely to slow from current levels (Display, left). Still, we observe a lack of excess across corporate investment and employment, which could indicate limited downside to activity, barring extreme policy outcomes.
Corporate profit margins remain well above pre-pandemic levels, raising concerns about margin sustainability (Display, right), though patterns vary by sector. Energy and auto profit margins, for example, are well above historical levels, but consumer cyclicals still have room to improve before they return to pre-pandemic levels. As commodity prices peak, we could see energy sector margins roll over while consumer goods margins improve. Housing is showing some cracks, but homebuilders may be willing to yield somewhat on recent price gains, given that margins are high versus history and supply remains tight.