A look at inflation, interest rates and the market downturn

Pgiam/iStock via Getty Images

I just gave a webinar to 300 real estate agents on what to expect in 2023. While researching the data, we found a point of view on inflation and interest rates that guided us in our true real estate forecast. I think it has value here too.

Quick Summary

We believe the CPI surge is over and inflation and interest rates will slowly return to much lower levels by next summer. It is based on the idea that the CPI price index has experienced a “staircase function” which is now flattening out. Let me show you proof of this by showing a few slides from this presentation.

(If this sounds too basic and fundamental, I apologize, but I’ve often found ideas focusing only on the fundamentals, so please bear with me).

The CPI and the inflation rate

Chart, line chart Description automatically generated

CPI and inflation rate (Michael McDonald)

The graph above shows consumer prices in blue and the rate of change of these prices in red. The rate of change is the percentage change in prices over the last 12 months. The FED and economists do not look at the absolute level of prices, they mainly focus on its rate of change.

Notice for the past three months that the CPI hasn’t changed much. It is relatively flat. Yet, the price change over the past 12 months is 8.2%. This is because the 12 months include the previous nine months where the CPI rose dramatically. If prices remained stable for the next nine months, the year-over-year inflation rate would slowly fall to zero. This would be a perfect, real-life example of what is called a “staggered function”.

Inflation step function

Auto-generated diagram description with medium confidence

Example of a step function (Michael McDonald)

A step function is a sudden jump in price to a higher level over a short period of time. The price rise then ends as suddenly as it began. this chart shows the step function in blue and in red the rate of change of the price as it goes through the sudden start and stop. The rate of change is always slower to react since it includes the prices before and after the sudden change. We believe we are going through a step function with inflation, and I have indicated where we believe we are in the cycle. What is the proof of this?

The proof

An image containing table Description automatically generated

Components of inflation (US Bureau of Labor Statistics)

This diagram shows the different price components that make up the CPI and the percentage that each contributes to the total. Sixty-two percent of the CPI comes from 4 components – housing, food, energy and cars. Housing is the largest component at 32%, followed by food at 14%, then energy and cars at just over 7%. Let’s look at what each of these four components does.

Shelter

Chart, line chart Description automatically generated

The Housing CPI (Michael McDonald)

Housing costs are a complicated calculation that includes many factors based on current rents and the price at which a landlord could rent their property. Like the CPI index, the housing CPI shows a sudden rise in prices from January 2021. The starting point is indicated by the first yellow price marker. Since then, housing costs rose 12% in September.

It appears that this component is, however, somewhat slow to react and a little behind what is actually happening. This is because they scan and check current rents on a set number of homes every six months on a rotating basis. Other up-to-date rental metrics we’re tracking show rents have already started to flatten. However, this does not yet appear in the official housing CPI index. Regardless, we believe weak rent growth and falling house prices will flatten housing CPI growth to 2% to 3% by the middle of next year.

Chart, line chart Description automatically generated

Rent increases in LA County (Michael McDonald)

This graph shows the average rents per square foot in Los Angeles County. It clearly shows the distinct trend of slowing rents over the past four or five months. Although LA is a unique region and may not represent the entire country, we believe the pattern of slowing rental growth will occur in most areas going forward.

Used car prices

Chart, line chart Description automatically generated

Used Car Prices (Michael McDonald)

This graph plots the CPI index for used cars and shows the dramatic 57% price increase that has occurred over two years. With cars accounting for 7% of the CPI, this increase had a large effect on the overall price increase in the CPI. Since the peak in used car prices, they have been slowly receding. This now allows the CPI to fall slightly. Remember, it’s not the absolute price that’s important, but how it changes from moment to moment. Currently, used car prices, although still high, are helping to bring down the rate of inflation. By the way, this graph is the epitome of a step function.

Food prices

Chart, line chart Description automatically generated

The CPI Food Index (Michael McDonald)

The CPI food price index, which is made up of a combination of grocer and restaurant prices, shows the same long-term trend as the other CPI price indexes. There is a sudden increase in prices from January 2021. This price index, however, shows no signs of slowing down yet. Although the prices of agricultural raw materials have fallen, this has not yet been reflected at the retail level. However, the USDA predicts a slowdown in food index prices with increases of 2% to 3% in 2023.

Energy

Chart, line chart Description automatically generated

Gas Prices (Michael McDonald)

The energy CPI is mainly composed of the price of gasoline. As the graph shows, and everyone knows, there has been a significant drop of 20% in the price of gasoline over the past six months. This drop is now contributing to lower the CPI index. Unless a global event upsets this trend, we expect gasoline prices to continue to decline, or at least hold steady at these levels.

Interest rate

Chart, line chart Description automatically generated

30-year mortgage rates (Michael McDonald)

This is a chart of mortgage interest rates dating back to 1973. It is a good indicator of 10-year Treasury yield since the two are closely related. The graph shows that the long decline in rates, which began in 1982, clearly ended a few months ago. History will look back and see that a mortgage rate of 2.65% was the lowest on record.

You might like to know what we meant when we said that the sudden rise in interest rates affects housing in two ways. The first way is obvious; there are fewer qualified buyers at these high rates. But the second is less obvious. The number of people listing their homes is down 16%. Housing turnover is down. Few homeowners want to sell their current home with a low mortgage rate, then move and buy somewhere else at a much higher rate. Higher rates freeze the housing market on both sides.

This effect should subside by the middle of next year if our scenario on inflation rates and interest rates materializes. We expect mortgage rates to return to between 4.5% and 5%. Other AAA-rated rates will also decline but not return to recent all-time lows. Since interest rates are fundamental in calculating the value of stocks, the net effect of this will be lower expectations for PE ratios in the future.

Summary

We think the data strongly supports the idea that the CPI surge is over and inflation and interest rates will gradually return to lower levels by next summer. If true, I believe investor recognition will come in stages over the next three months. But the Fed will see it too and we should also see a sudden change in policy in response to that. That would be the trigger. We would be in a recession, rates would be ready to fall and equities, which always start in a recession, would be 10-15% higher.

The extreme levels of bearish sentiment we currently have suggest that stock prices will remain around current levels until this happens.

Comments are closed.