Sharp recent declines in commodity prices bode well for the Fed's inflation fight and stocks

Published Thu, Jun 23 20222:41 PM EDT

Earlier Thursday, we called attention to the three primary market overhangs: China's Covid lockdowns, Russia's invasion of Ukraine and the Federal Reserve's fight to quell decades-high inflation in the United States. Unfortunately, we can't provide too much insight into the minds of presidents Xi Jinping or Vladimir Putin. But we can delve a bit deeper into the price pressures gripping the American economy, turning to actual data in an attempt to draw some investable conclusions. To do this, we want to look beyond the monthly updates we are all too familiar with at this point, the consumer price index (CPI) and personal consumption expenditures (PCE). Those are crucial readings for every investor to be mindful of. However, by the time they are released, they are outdated and they only give us a window into consumer spending. The producer price index (PPI), while also backward looking, gives us a reading on wholesale prices. But that's also delayed. What we want to look at here are some of the trends we are seeing in the commodity market and use that as proxy for input costs at the earliest stages of the supply chain. After all, the price of coffee beans is going to ultimately dictate the price of your cup of coffee at Starbucks . The cost of corn will dictate the cost of animal feed at farms and ultimately the price of a burger at Shake Shack . Of course, the price of oil will determine the cost to get anything and everything from the factory to your front door or your local store. Overall, the Refinitiv/CoreCommodity CRB index , which tracks a basket of 19 commodities, indicates that raw material costs have already peaked. Some of the bigger declines from recent highs can be seen by looking at futures trading in cotton, wheat and corn, silver and copper, as well as U.S. crude oil and natural gas. While this certainly does not represent the entirety of the commodity universe, it does serve to show the magnitude of the rollover we have seen in prices in only a few weeks' time, with the exception of wheat and silver which started their declines a bit earlier. Given that these declines for the most part took place in June, the current month, they are not yet reflected in any released government economic data. While there is a lag between declining input costs dynamics and the prices consumers ultimately pay, this exercise does offer some insight into the back half of 2022. It also indicates that producers should start seeming some relief on the input cost side of things, or at the very least a cessation of rising costs, which might start moving the needle at the wholesale level. Of course, any data showing easing or even peaking price pressure would be welcome news to investors and at the Fed, which is waging a war on inflation with ever tightening monetary policy that risks tipping the entire economy into a recession. Many market observers think the Fed should have been hiking interest rates much earlier in the cycle with bigger moves to wring the excesses out of the economy, a view we must concede even as we continue to believe in Fed Chairman Jerome Powell's ability to win this fight. In addition to the potential for lower inflationary readings in the second half of the year, it could also point to some upside for corporate margins. Remember, the price hikes have already gone through and while a pullback in commodity prices can indicate that there will be no further hikes going forward, it doesn't mean costs are coming down. That's because price hikes tend to be very sticky. So, if input costs come down quicker than expected and selling prices hold at current levels, profit margins stand to benefit and serve to support stock prices. In the end, while we hesitate to make a call that inflation has peaked, we believe the price action we are seeing in commodities serves to support the view we shared earlier this week about dispiriting nature of this year's stock market. Jim Cramer wrote that to bail out now and broadly sell stocks, with so much pain already endured and commodities finally starting to roll over, would be foolish. While there can certainly be some more downside in stocks before we see the true market bottom, we believe the price action in so many crucial commodity inputs points to a very favorable risk/reward, which is why we are ready to bring cash levels even lower as opportunities present themselves and continue our rotation into higher quality stocks. 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Doug Langley clears the combine harvester's head from weed before he starts harvesting, during the wheat harvest in Shelbyville, Kentucky, June 29, 2021.

Amira Karaoud | Reuters