Is inflation on its way to being beaten? US markets say yes

American investors are getting their mojo back, and if this rebuilding of confidence over there is sustained, it will have a positive knock-on impact over here, writes Hamish McRae

The cheerful markets are probably right; the gloomy economists are probably wrong (AP)

Too early to celebrate that inflation is being beaten? Well, yes, but that is what the markets seem to be doing.

In America, the most important share index, the S&P 500, has recouped half of its losses of the first quarter and on Friday was at a three-month high. The main driver of that was the US consumer price index coming in at “only” 8.5 per cent, down from 9.1 per cent the month before.

Maybe, the argument runs, the peak of inflation is past and interest rates will not have to rise as much as many feared. The cost of filling the car with fuel has fallen quite sharply, with the average gasoline price below $4 a gallon, the lowest since March.

In the UK, the dynamics are different, partly because of political uncertainty and partly because of the way European natural gas prices are pulling up all energy costs. Peak inflation is expected in the autumn. But the main index, the FTSE 100, is up on its level of 31 December, and actually a tiny bit higher than it was on 23 February on the eve of Russia’s invasion of Ukraine.

So what’s next? There were some wise words last week from Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management. In an interview with Bloomberg, she pointed out that while headline inflation may be past its peak, core inflation was still 6 per cent, three times the Federal Reserve’s target of 2 per cent.

History showed that the Fed funds rate would have to go up to something similar to the core inflation rate. Assuming core inflation comes down to around 4 per cent, this would mean Fed funds rising by another 1.5 per cent or 1.75 per cent. That would slow the economy. “And if the economy slows, corporate profits go down, it’s just a fact,” she said. “It’s math. And so we have not seen those earnings estimates come down yet, and that’s really what we’re waiting for.”

So how much will profits fall? Morgan Stanley reckons it will be by an average of about 10-15 per cent, far less than during the last three big recessions of 1991, 2001 and 2009, when they fell by 35-60 per cent. “That’s not too bad,” she said.

I like this because it puts two things into perspective: how high US interest rates might have to go, and the scale of the coming slowdown. Rates at around 4 per cent, and if there is a recession, it won’t be anything like as bad as the biggies of the past 30 or so years. If this is broadly right – and I think it is – that would mean that while there will be some bumps in US markets in the coming months, the shares of mainstream companies may be somewhat overvalued but not outrageously so. The cheerful markets are probably right; the gloomy economists are probably wrong.

There is something else happening, however, that is equally important. It is the way in which rising interest rates have blown away the froth in the markets. Investors want to see profits more than hopes for future growth. Companies are responding. You can see this in the way in which Uber, which has been broadly unprofitable since its origins in 2009 is now producing a positive cash flow for the first time and is forecasting a profit for the third quarter of this year.

There has also been a dramatic retreat from Spacs, special purpose acquisition companies, where a company is launched on the market simply to raise money to buy other companies. In July there were no new Spacs issues, and the values of those that were founded in the boom of a year ago have fallen sharply.

Or take another rather different measure of the way in which the markets are adjusting to a more general retreat from the heady, frothy days of a year ago: house prices. In the US in June, the only major city where prices were down year on year was San Francisco, a measure of how the wealth boom from the high-technology companies of the Bay Area has faded.

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What does all this mean from a British or European perspective? I think three things. One is that the change of US investment mood – call it a back to basics – will have less impact on this side of the Atlantic because we did not experience a heady boom on anything like the US scale.

Markets did not climb as high, so they did not have so far to fall. But if there is a reasonably solid performance in the US, some of that positivity will wash over to the UK and Europe.

The second is that the US is much less affected than continental Europe by what is happening in Ukraine, with the UK somewhere in the middle. So what happens in the US does not read directly across.

But the third and most important thing is that US markets are vastly bigger than they are in the UK or Europe. So if this rebuilding of confidence over there is sustained, it will have a positive knock-on impact over here. American investors are getting their mojo back. That is good for us too.