The stock market is gearing up for a strong recovery in the 2nd half as 'transitory' inflation begins to cool, Fundstrat says

• The stock market is poised for a strong second-half recovery as inflation proves to be transitory, according to Fundstrat's Tom Lee.
• Lee highlighted falling commodity prices and a decline in home sales as reasons why recent inflation is more temporary than structural.
• "Can inflation accelerate if inflation expectations and inflation leading indicators are tanking?" Fundstrat's Tom Lee asked.

Concerns of elevated inflation will likely abate over the coming months as surging prices prove to be more transitory than structural, according to Fundstrat's Tom Lee.

That means the stock market is poised for a strong second half recovery, as lower inflation will give the Federal Reserve breathing room in its current interest rate hike cycle, Lee argued in a Wednesday note.

Inflation readings have been hitting records month-after-month, surging to a 40-year high in May. But since then, oil prices have fallen considerably, home prices are getting cut at a rapid pace, and an inventory glut among retailers is leading to steep discounts, Lee highlighted.

"Can inflation accelerate if inflation expectations and inflation leading indicators are tanking?" Lee asked.

Specifically, Lee pointed to the more than 20% decline in oil and other energy commodities over the past two weeks. WTI Crude fell as much as 10% on Tuesday alone. Lee added that a potential cease fire between Russia and Ukraine would put further pressure on energy prices.

Meanwhile, other commodities like lumber, copper, and cotton have plunged more than 20% in recent weeks.

Also helping ease the pressure of inflation is a surge in mortgage rates, which has led to a swift reduction in home sales prices, as well as a surge in now homes up for sale.

Finally, putting downward pressure on prices is the retail inventory glut, which has seen some retail liquidators take products off the hands of major chain retailers even before the products hit their shelves, highlighting the urgency to offload these items. That's leading to big discounts for certain goods like apparel and appliances at off-price retailers.

All of the above has led to a marked drop in the 5-year inflation breakeven futures, which has dropped from nearly 3% in April to about 2% today, hitting lower levels than seen in 2018. Additionally, Fed rate hike expectations into year-end have tanked, erasing 48 basis points of expected rate hikes.

"If a 'disinflation' trend is underway now, this argues inflation was indeed 'transitory," Lee said.

And if inflation is indeed transitory, the stock market should stage a quick recovery, as it gives room for the Fed to stage a quick pivot to a more dovish stance. Boosting Lee's view is the fact that mega-cap tech stocks and Chinese stocks have been relative outperformers in recent weeks.

"The relative strength of these two indices, in our view, are counter arguments to a 'recession starting' in the US. And moreover, we think this coupled with improving inflation risks, support better equity returns in the second half of 2022," Lee concluded.