Question:  

What are the ramifications of inflation slowing down?

Answer: 

Following the recent peak inflation rate of 9.1% in June 2022, the highest in over 40 years, we’ve seen that number ease to 3% in June 2022, and inched up to 3.3% in July 2023. For comparison, according to the Federal Planning Bureau, the average inflation rate in the United States between 1914 and 2023 was 3.30%.

The anatomy of consumer spending changed during and after the pandemic. There was a 20% surge in spending on goods during a time when services were nonexistent due to shutdowns. This has reversed as evidenced by a busy travel season as seen in airports and returns to concerts and sporting events. The past two summers of “revenge” travel will begin to show signs of fatigue as spending in these areas softens. It’s unlikely that decreased spending on services when it begins to slow will be offset by greater outlays for goods. This translates into flat or downward trajectory in overall economic activity, which helps to slow inflation, which was the goal.

Consumer spending is the core of the economy equaling approximately two-thirds of economic activity. This past year, wage gains and excess cash from the pandemic supported consumption. These tailwinds are starting to fade, and with that, inflation is slowing as well. In contrast, higher gas prices and the fact that student loan payments resume on October 1st after a three-year pause, it’s reasonable to expect consumer spending to slow. 

Although consumer balance sheets are reasonably healthy, there may be signs of stress. For instance, the percent of delinquencies on credit cards, auto loans and mortgages show an uptick. With credit card balances increasing and borrowing rates at historic highs, it's likely that consumer spending may slow in the months ahead. This continues to help ease inflation yet also places a damper on economic growth including employment. A sharp rise in unemployment is certainly not expected, yet a softening trend in job openings may continue.

Does this mean that recession risk is real? Small business activity and capital expenditures are important to growth. Small business loan rates are at their highest levels since 2007 meaning activity could become subdued. Capex (capital expenditure) budgets remain at the lowest levels with only 22% of CEOs planning to increase this outlay. This translates into weaker demand for loans and slowed growth. This was the intended consequence of higher interest rates.

Inflation has slowed with the July Consumer Price Index (CPI) coming in at a lower-than-expected year-over-year rate of 3.2%. Shelter price inflation remains stubbornly high and is by far the largest contributor accounting for over 90% of the increase. 

Investor focus remains on those companies with the ability to navigate a challenging and volatile environment. Revenue growth depends on the ability to pass price increases along to consumers. The importance of strong balance sheets and manageable debt levels, in light of higher interest rates, cannot be understated. It is practical to be well-capitalized at the corporate and household levels.

Gas prices and the cost of filling up the tank are psychological thresholds for consumer spending, so higher oil prices contribute to curtailed consumer spending. It’s worth noting that as the summer driving season slows, prices at the pump tend to drop even if the overall oil price level remains high. The U.S. still has some of the lowest-cost fuel as compared to other major economies. For instance, China is at approximately $4.40, India $4.80, Spain, $7.00 and even large oil-producing countries like Canada and Mexico are both at $5.40 and Norway is $8.40 per gallon.

Several of the consequences of slowing inflation include lower loan demand and reduced capital expenditures. Loan demand is drying up, national gas prices reached a 10-month high, and airline fares are beginning to drop. Keeping an eye on revenue growth, along with household and corporate debt levels will provide indicators regarding our path forward. In July, for the first time, consumer credit card debt topped $1 trillion showing increased consumer confidence. Credit card debt only represents 6% of total deposits households have in the bank, which is the lowest level in twenty years, suggesting that consumers will be able to repay credit card debts although the Fed’s quarterly report shows delinquency rates starting to climb.

The U.S. economy appears to be more resilient than expected and is likely headed toward a soft landing with the expectation of “only” a mild recession, which is not a surprise, yet there are always wildcards on the horizon. Stay focused and plan accordingly.

Source: FactSet August 11, 2023.