Inflation peak: Was it the Fed or the Supply Chain?

J. Paulo Silva, CFA, Senior Portfolio Manager, Senior Partner, Penn Capital Management Company, LLC
August 7, 2023

Looking back on my thoughts on inflation peaking from December 2022, they may have proved correct as the inflation number dropped to 3% annually since the last monthly report. Additionally, I addressed supply chain normalizing and how that would help to decrease prices over time. Today, supply chains are no longer a problem in most areas of the market.  Even auto production has ramped up steadily this summer, including auto companies dropping prices on some new models.  I expect that used car prices will head downward for the next 12 months as new auto sales ramp up for the remainder of the year. Although many believe that inflation has peaked, services inflation has been rather sticky. The tanker rates to ship containers have fallen back to pre-pandemic levels rapidly as global trade has weakened dramatically.  The believed inflation peak seemed to mark the bottom of the market late last year, however, the market has gained traction, including small caps, as the rate cycle finally appears to have peaked.  More importantly, the job market remains healthy, new home sales are accelerating and GDP remains very strong indicating that the market has seemingly depressed recession odds, thus pricing in a soft-landing scenario.  Adding fuel to the equity rally, China stimulus was announced as the Chinese economy remains mired in a slowdown.  There was also a significant rally in small cap banks as the deposit run that took down two marquee banks in California appears to have run its course.  Furthermore, throw AI into any earnings call for a company and that has the potential to add significant returns.  Putting these all together, you have a market running almost as fast as it did during the Covid recovery.  Large cap markets are within striking distance of their previous highs, shifting market sentiment completely.

As supply chains are normalizing, this has created some recent weakness in company results, as orders have slowed materially.  After all, companies were placing orders to satisfy extended periods of demand because lead times had expanded so dramatically.  The consequence is often higher inventories leading to slower sales, which is where they are now.  Companies are looking for an improvement in the second half of the year and stocks have reacted favorably toward recovery commentary.  Companies with global exposure are impacted the most by European and Chinese weakness in the markets.  China’s plans to initiate stimulus though have recently put a charge into some of these markets.  So much of the market movement has been predicated on the hope that earnings accelerate in a soft-landing scenario moving into the second half of the year. Pricing has helped ease some of the pain of the volume deceleration recently, but that can’t continue in the second half.

Although supply chain normalization has cooled goods inflation, services have been stubbornly high and the path to easing prices has been less evident.  An area where you thought the Federal Reserve could have been most impactful was the housing sector where higher mortgage rates would likely cool hot home prices.  Unfortunately, higher mortgage costs pushed the incremental buyers into the new housing market as individuals don’t want to give up their sub-3% mortgages.  Existing home sales are down over 20% while new home sales have surged with a lack of supply in the existing home sales market.  Even as more rental supply has come to market, we still hear apartment REITs achieving mid-single-digit rental increases annually.  Demand for travel services also remains hot this summer, as witnessed by the explosive job growth in leisure and hospitality these past few months.

Today, as the market has transitioned to a soft-landing view of the economy, equity markets have risen with great fervor.  Wall Street has forgotten that the cost of capital for every company in the market has increased dramatically to levels not seen for years.  Companies that can generate strong cash flows and are less impacted by the debt markets are typically at an advantage in this backdrop.  Also, companies with less leverage and that don’t require refinancing to pay down debt that matures are at an advantage moving forward.  This could explain why large caps have dramatically outperformed small caps in this recent market run.  The risk to the market now is worse economic news threatening the Goldilocks market.  Many areas of the market are seeing slight contraction, but most have called for rebounds as we look forward.  Consumer spending remains relatively strong throughout as job losses have not materialized in this economy.  We believe that the employment market will remain steady for the remainder of the year, but if strength doesn’t materialize in weaker sectors into year-end, we may see some job losses in 2024.  We believe that active management will become increasingly important as investors need to consider the many factors impacting the recent market move.  It will be interesting to see how the remainder of the year plays out.

The views expressed are those of Penn Capital Management Company, LLC, a boutique manager on the Spouting Rock Asset Management (“SRAM”) platform, as of August 1, 2023, and are not intended as investment advice or recommendation.  For informational purposes only.  Investments are subject to market risk, including the loss of principal.  Past performance does not guarantee future results.  There can be no assurance that any SRAM strategy or investment will achieve its objectives or avoid substantial losses. There can be no assurances that any of the trends described will continue or will not reverse.  Past events and trends do not imply, predict, or guarantee, and are not necessarily indicative of future events or results.  Investors cannot invest directly in an index.

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