With inflation among the most pressing issues weighing on the stock market over recent months, investors have been glued to the screens at nearly every instance key CPI data has been released.

Ultra-accommodative policy from central banks and governments were one of the primary drivers of inflation hitting multi-decade highs, but other factors have also played a role, including global supply chain constraints, natural disasters, lockdowns in China, tight jobs markets, and the war in Ukraine.

Australia is still believed to be in the midst of an inflation cycle that has yet to peak, but there is some hope in the US, where finally, after what seems an eternity, inflation moderated throughout July. In fact, excluding shelter, prices actually contracted for the first time since May, 2020.

Although investors should not get their hopes up just yet, with a sustained trend needing confirmation first, these are some of the reasons that inflation may have peaked already. 

Commodity Prices Are Well Off Their Highs 

Economists often look to commodity prices as a leading indicator for inflation. In other words, commodities can provide a forward view on the state of economic growth and inflation, before the broader economy shows signs.

This is because commodity markets take into account economic and systemic shocks at the drop of a hat. When the economy shows more demand for commodities, prices tend to rally. On the other hand, commodity prices will drop if the economic outlook suggests that there will be a decrease in demand. 

What more, commodity prices also move in response to macro factors or black swan' events, whether it be war, natural disasters, a pandemic, or any other factor that effectively has a sudden impact on commodity supply or demand. 

Commodity prices also flow through to the price of goods and services because businesses typically look to pass on these costs. For example, think about how rising oil prices lead to higher prices at the petrol pump. Commodities are an input within the broader economy, affecting how businesses or consumers behave in the market. 

The fact that commodity prices are now well off their highs is a positive for inflation reversing course.

Crude oil prices are now trading below US$90 per barrel, a 25% discount from when they topped US$120 amid supply constraints stemming from the war in Ukraine and sanctions against Russia.

But oil isn't the only commodity in a sharp sell-off. Iron ore prices are markedly below last year peak, and copper prices were in freefall up until just a few weeks ago, when a relief rally pared losses. 

Elsewhere, lumber prices have nosedived by around 60% in the space of just a few months, and wheat and corn prices have also recorded a sharp double-digit fall over a similar timeframe.

Consumer Spending is Looking Shaky

By increasing interest rates, central banks use the one policy tool at their disposal to put downward pressure on inflation. How does this transpire? 

Although not a primary goal associated with hiking rates, the result of a rate hike cycle typically flows through to consumer spending.  Higher rates translate into higher repayments, which means borrowers would be expected to have less disposable income. Economic theory would dictate that consumers cut back on unnecessary expenditure.

When consumers are buying less, subdued demand means that businesses are unable to push through higher costs. As we have seen with the likes of Walmart (NYSE: WMT), this can lead to a situation where a retailer is forced to discount prices in order to clear excess inventory.

Recent data out of the US suggests that consumer spending has started to plateau, which in the context of an inflationary environment, suggests underlying demand is actually well off its highs.

Although Australia does not find itself in this position, at least for now, most of the rate hikes passed by the RBA thus far have yet to be felt by borrowers - either because they were ahead of repayments, or they are still on fixed rates. In time, and with property prices expected to continue sliding, it is likely higher rates will prompt consumers to tighten their spending, a positive for reining in inflation.

Supply Chain Improvements and Lower Inflation Expectations

Based on a number of surveys with businesses, there has been a modest improvement in terms of price pressure and delivery times for a number of different industries. Freight rate costs are lower by as much as 40% between May and July, while backlogs are slowly being cleared.

This suggests some of the gremlins that have plagued supply chains over the last two years are starting to abate.

At the same time, longer-term inflation expectations have started to ease, as evidenced by consumer sentiment data from the University of Michigan. 

US consumer inflation expectations for the year ahead dropped to 6.2% in July, which was the lowest reading in five months, and more than half a percentage point off the record high of 6.8% in June. In terms of long-term inflation expectations, figures are now broadly in line, if not below the pre-pandemic average, and sitting within the Federal Reserve range of 2-3%. 

The Federal Reserve views inflation expectations as a key barometer for how businesses set prices and wages, which in turn affects actual inflation. 

Inflationary Risks

Just as we saw at the start of the year, the outlook for inflation can change suddenly. There are a number of risks that could prompt inflation to surge once again, including:

• Disruption to shipping, and higher freight costs due to geopolitical tension and/or conflict between China and Taiwan.

• Consumers turning to accumulated savings to continue spending.

• Escalating conflict in the war in Ukraine.

• A shock to US oil supply due to a natural disaster (i.e. hurricane)

• Semiconductor production outage - including Taiwan, one of the leading producers

Over the last couple months, bonds and bond yields have been repriced. Bond yields typically rise with rising interest rates. This change in the bond market suggests investors believe the Federal Reserve may not need to raise interest rates as high as once thought. 

In other words, investors are now less concerned about inflation as the market is slowly coming around to the notion that inflation may have peaked.

Of course, we won'tknow whether inflation has truly peaked until some time, but if higher bond yields are behind us, investors eyeing exposure to more defensive asset classes may wish to learn more about investing in fixed income and gold.