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Disinflation takes the spotlight: Implications for stocks and the economy

In a notable development, the rate of inflation is declining rapidly after more than two years of continuous price increases.

The CPI recorded a mere 3% rise in June compared to the previous year, marking its smallest increase since March 2021.

Over the past 12 months, it has dropped by a significant 6.1 percentage points, representing the largest decline since 2009 when inflation gave way to deflation. Notably, the last time the CPI rate fell by 6.1 percentage points or more from a level above 9% was in May 1952, when the index plummeted by 7.4 points to 1.9%.

While overall inflation figures still remain elevated, with core CPI (excluding food and energy) at 4.8%—well above the RBA’s 2% target—and average hourly earnings continuing to grow at a 4.4% rate, investors should focus on the direction rather than the level of inflation.

The downward trajectory of inflation signals positive momentum for the stock market, which has experienced a remarkable surge throughout 2023.

This trend might well continue, as Paul Hickey, co-founder of Bespoke Investment Group, points out the record-breaking 6.1 percentage point difference in June between the finished-goods component of the PPI and the CPI.

This significant gap suggests that either profit margins are holding up or consumer inflation will pose less of a concern.

Historically, such a wide gap between PPI and CPI has been an opportune time to invest in stocks. Following previous occurrences, the S&P 500 has averaged a 3.6% gain over the subsequent three months and an impressive 19% increase over the following year. Hickey writes, “Prior periods where the spread hit a record were typically followed by above-average equity returns and occurred very late in a recession or in the early stages of an expansion.”

Despite indicators such as an inverted yield curve, declining leading indicators, and ongoing contraction in manufacturing surveys, the Australian economy has yet to slide into a recession. John Higgins, chief markets economist at Capital Economics, anticipates a slowdown in the second half of the year and explores historical instances of recessions accompanied by bull markets.

Higgins identifies five examples: the end of the Civil War, slowdowns near the ends of World Wars I and II, a recession lasting from October 1926 to November 1927, and a downturn coinciding with the end of the Korean War. In each case, recessionary rallies occurred when valuations were either exceptionally low or in bubble territory.

Given that neither scenario currently applies, he expects a forthcoming decline in the stock market before a subsequent rebound.

“Our forecast is that it will take a hit amid a recession in H2 2023 before powering ahead,” he predicts.

Alternatively, another perspective is that Australia may have already experienced its recession and is now entering a new expansion phase. This view aligns with Hickey’s analysis, who favors comparing PPI to CPI. According to this metric, a recession is more likely to be in the rearview mirror rather than on the horizon.