Inflation is starting to 'drop like a rock' leading to deflation in certain areas of the economy, Fundstrat says

• Inflation is starting to 'drop like a rock' rather than a feather, according to Fundstrat's Tom Lee.
• Lee observed outright deflation in some areas of the economy, suggesting that inflation is less sticky than perceived.
• Stock market investors are looking for a cool down in inflation as it would allow the Fed to ease its rate hike trajectory.

Inflation is starting to "drop like a rock" rather than a feather, leading to outright deflation in some areas of the economy, Fundstrat's Tom Lee said in a Wednesday note.

A slowdown in rising inflation would be welcome news to investors given that the stock market has sold off 5% since Fed Chair Jerome Powell's hawkish speech at Jackson Hole last week.

Powell reiterated the Fed's resolve to tame inflation by being aggressive with interest rate hikes and a reduction to its $9 trillion balance sheet. The market currently expects another outsized 75 basis point rate hike from the Fed at its FOMC meeting in late September.

If inflation cools and is less "sticky" than most expect, it could change the Fed's current interest rate hike trajectory, ultimately leading to a faster pivot towards a pause in rate hikes. That would be a boon for risk assets, which have been stymied in recent months by fast rising interest rates.

And according to Lee, inflation is quickly cooling.

"42% of CPI components are declining from recent highs = deflation," Lee said, adding that five of the nine US regions saw outright deflation in July on a month-over-month basis.

"These 5 regions represent 49% of GDP. In East North Central, CPI annualized is -3.96%, outright DEFLATION," Lee said.

Additionally, leading inflation indicators like used auto prices, airfares, and real estate "suggest many other components of CPI could start falling outright," according to Lee.

"There are many counterpoints to suggest inflation could fall faster than consensus expects. This, in turn, would change the path of Fed policy. Arguably, the inflation swaps markets are already reflecting this, hence, the lower levels of implied inflation," Lee explained.

Digging into the actual components, Lee highlighted that commodity prices like gasoline, lumber, and wheat are falling like a rock, as are electronics, meats like chicken and beef, and clothing.

At the same time, used cars and vehicles, airfares, and durable goods are "starting to fall like a rock," and history has shown that rent and housing costs will "fall like a rock" soon, according to the note.

Analyzing the previous 40 years of rent data for New York City and San Francisco, Lee found that "when owners equivalent rent falls, it falls like a rock...rents could fall a lot faster than many expect."

With the view that inflation is quickly falling, Lee reiterated his call for a second half rally in the stock market that could ultimately drive the S&P 500 to new highs by year-end. "Bottom line. We see second half rally thesis intact," Lee concluded.