Andrew Pyle
February 12, 2022
US inflation or inflated concerns?
The inflation story has been chugging along for months now, making each upcoming consumer price index (CPI) report that much more anticipated and unnerving than the last. This week’s US report for January was expected to show a further rise in the annual inflation rate from the already high 7.0% pace seen in December. The gloom crew was not disappointed, as the report came in with a 7.5% read. Core inflation, which strips out food and energy, rose half a percentage point to 6.0%. It is hard to imagine that this time last year we were talking about headline and core inflation rates of only 1.4%.
The news of this week’s data focused in on how this is the worst headline rate of inflation that we have seen since 1982, even though we have been talking about this for a while. The debate between those who believe the high inflation will eventually prove to be temporary and those who think this is becoming systemic has now tilted appreciably towards the latter. We continue to remain in the former camp, even though prices are still rising at a healthy clip on a month-over-month basis. In terms of January, headline and core CPI rose by 0.6% from December – an acceleration over the pace of change in December, but not the biggest monthly moves we have seen over the past year.
If consumer prices were to continue rising each month at a similar clip to last month and do so over a protracted period, then the temporary argument would disappear. For example, if prices were to increase each month this year as the average pace seen in 2021 (just under 0.6% per month), then we would still be looking at an annual inflation rate of 7.2% by December. If we run the same analysis for core CPI, we are looking at a core inflation rate of 5.5% at the end of this year. That’s better than what was reported this week, but not by much.
Of course, most economists do not expect that this monthly pace will be maintained and there are a number of reasons. First, the pace of consumer demand and economic growth should diminish in the first half because of higher energy prices, higher borrowing costs and other brakes on activity. For Canada, this would include the trucking protests that have produced sizeable disruptions to retail and shipping. Some believe that the first quarter could end up pushing overall GDP growth slightly into the red in Q1. But let’s stick with the US story for now.
The news on the pandemic front is definitely more encouraging and job growth has started the year better than what most had projected. You would think that this should only reinforce the inflationary trends out there and, for some categories, that is true. For example, sustained re-opening and relaxation of virus mandates should generate more demand for services (dining out, travel, entertainment, etc.) and away from spending on goods.
This is an important point on two fronts. First, expenditures on services represent the lions share of US consumer spending at about two-thirds of the total. There are definitely areas in services where prices have risen at a faster clip; however, the real story from 2021 was on the goods side. The pandemic created the perfect storm as consumers looked for ways to escape their pandemic handcuffs in terms of going out and, instead, opted for buying stuff. The shutdowns and labour disruptions also created shortages of things that went into this stuff, causing costs and prices to rise.
On the durables side, we saw this in the second quarter of last year, when the CPI durables index rose by an average of 3.0% per month. From October to January, the average pace was 1.5% per month – half the pace of the initial surge, but the base effect was already in place from before the summer. Fast forward to last month and the annual inflation rate for durables stood at a whopping 18.4%. Even non-durables have exhibited stronger price advances in recent months and for good reason. Gasoline and energy make up a large part of overall non-durable spending and look at what has happened to prices there. In January, the CPI index for non-durables rose by 0.6% after two back-to-back months of 1.2% gains. This allowed the annual inflation rate to slip back below 10%, but not by much.
Even though the share of consumer spending and the CPI that goes to goods is smaller than services, there was a noticeable increase in relative expenditures on goods since the incidence of the pandemic. This led the US Bureau of Labor Statistics to increase the weights on some goods that have experienced a substantial increase in dollars spent, such as autos and technology-related equipment. In an environment where there are supply shortages and continued strong demand in these areas, then price increases will have a greater influence on the overall CPI. The opposite also holds true. If there is a shift towards services consumption in a re-opening economy and supply constraints dissipate, then a moderation in price gains for some goods items could have a greater drag effect on the overall CPI.
Still, this a big “if” and markets are short on patience. After Thursday’s report, US bond yields spiked and stocks slumped, as investors read the CPI tea leaves and saw nothing but an even stronger case for rate hikes. The 2yr yield jumped 10 basis points (0.1%) within minutes and by the close, it had tested above 1.60% to finish off just under this level. The net risen to north of 1.60% from Wednesday’s close of just above 1.36% - a move of 0.22%.
To put this into perspective, Thursday’s jump was the largest in the 2yr yield since June 5th of 2009. Back then we were still dealing with the recessionary effects of the financial crisis and there was a feeling that emergency Fed easing was going to be pulled back quick. That call turned out to be very wrong and it would be foolish to bet against the call that the Fed is about to tighten. The question is whether the market is getting too far out in front of its skis on rate hikes. We have now priced in a 50% reversal in the 2yr yield from the 2018 peak to the pandemic low just above zero and large US institutions are ramping up their forecasts for how many rate hikes we will see this year. Some now expect 7 increases (which means one for each remaining meeting).
In terms of portfolio strategy, I think we may be getting closer to a point where government bonds start to look more attractive as a hedge against a negative economic surprise. Ally and I still believe that being overweight corporates and floating rates is the best strategy, but we may need to adjust slightly. As for equities, we continue to believe that compression in multiples in growth segments, like tech, has been disproportionately affected from the jump in yields. Other areas that have been negatively impacted by inflation concerns and yields would include consumer discretionaries and real estate. The bottom line is we are still in the middle of a major distortion in producer and consumer prices and there are too many moving parts to definitely say that inflation has gotten away from us. These next two months will, however, provide a lot more clarity.
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Have a great weekend
Andrew
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