Andrew Pyle
January 13, 2023
The inflation fear pendulum
Back in 2021, most people saw a much different inflation landscape developing. Massive stimulus aimed at healing the economic wounds, inflicted by the pandemic, and supply bottlenecks sparked an excess demand situation that would pull inflation from below 2% to rates three times that by the end of the year. Normally, this would have instilled panic, but it was initially passed off as something that would turn out to be as temporary as the economic recession that was its precursor. Panic did, however, start to set in as the year wore on, especially as central banks were late to the game in arresting these upward price pressures. By the middle of last year, inflation in the US had reached 9% and breached 8% in Canada. At this time, the inflation story had surpassed covid and geopolitical issues as the main sore point of businesses, households and investors.
We all know what happened next in terms of central bank reaction and financial market volatility. Towards the end of the years, however, panic over inflation had begun to subside. It remained a dominant feature in market discussions and a laser-lit target for the Fed and Bank of Canada. These central banks though did start to acknowledge the moderation in inflation and validated the market’s belief that the severity of rate hikes would begin to dissipate. The pendulum has swung so much that both bond and equity markets have adopted an almost defiant bullish tone into 2023.
The 2yr US government bond yield has fallen from a high of over 4.7% in November to just 4.15% this week. The Canadian counterpart had dropped from almost 4.30% in October to 3.65% in December, before a bounce higher into year-end. It is still a shade under 3.8%. Considering that neither central bank has signaled that it is finished with tightening, this is pretty incredible. Stocks had rallied for five straight sessions from last Thursday, despite continued concerns over economic fatigue (recession) and weaker corporate earnings results.
True, there has been supporting evidence for the pendulum swing. This week, US consumer price data for December showed a decline in the headline CPI and a 0.3% rise in Core CPI (ex food and energy prices). Both right on expectations. The headline rate of inflation dropped by six tenths of a percent to 6.5% and Core CPI (ex food and energy) inflation fell three tenths to 5.7%. This was the third CPI report in a row that delivered figures that were either in line with or weaker than expectations. Canada’s results have been a little more mixed and we will get December data next Tuesday. Suffice to say, investors are betting on a continuation of good news on the inflation front. The problem is that the market is setting itself up for disappointment should something upset this improving pattern.
Firstly, let’s recognize that almost all of the improvement in inflation has come on the back of deflation in many goods prices, like energy and used cars. Crude oil has dropped by almost 50% after peaking above $120/barrel in June of last year, however, prices appear to have stabilized above $70 and could start to trend higher. How is that possible, especially given that we are heading into recession? The short answer is that we aren’t yet in a recession and the very fact that key prices, like oil, have dropped so much means that business and consumers are getting a stimulus. Gasoline prices, which were ridiculously expensive less than a year ago, are now down to levels where no one is complaining any more. It is sort of like a negative tax.
On top of that, some people are not so happy that prices have eased as much as they have. OPEC may not like it when crude oil gets to excessively high levels, as this compels people to do silly things like switch to electric vehicles, but they don’t like the revenue hit from cheap oil either. The prevailing view has been that OPEC will likely leave production levels unchanged when it meets on February 1st and this is based on the expectation that a recovering Chinese economy will provide enough extra demand to offset weakness in the G7 and cause oil prices to rise. I think it’s premature to bet on that recovery and I wouldn’t rule out an impatience among OPEC members that lends itself to production cuts. That may not get us back to $100 oil, but possible $90 before the end of the quarter. And that is getting close to the start of the summer driving season, which could send gasoline prices to levels significantly above today’s.
The other variable, which has received less airplay of late, is services inflation. As I have mentioned in previous commentaries, prices in this area tend to be stickier than goods and can have a stronger impact on structural inflation. In other words, higher prices for services as a result in a rotation in demand from goods to services (the re-opening story), leads to higher wages in a labour market that so far is showing little indication of classical recession-style weakness. US unemployment insurance claims were trending higher in the fourth quarter, but peaked in November and have fallen back to levels seen in September. These cost increases don’t fade like the price of gasoline; hence they can feed through into subsequent supplier contracts and future wage negotiations. This is particularly worrisome for central banks and there simply hasn’t been enough time to evaluate if this is happening or not.
The above chart is one reason not to get too complacent on inflation. It is the inflation rate measured by US services less energy prices. As you can see, there has been no retreat, even in the latest report. In December, inflation in this index rose above 7% which is the highest since the early 1980s. Headline inflation, when it peaked last summer, was also back to what we saw in the first term of the Regan Administration. The difference is that a cyclical peak hasn’t been seen yet. It’s possible that we do see services inflation turn lower this half, but we won’t have another CPI report until after the Fed’s next meeting on February 1st.
Even if services inflation cools off, there is a strong argument to be made for how the base for inflation may remain higher longer. I ran some preliminary projections for inflation back last summer and thought I would adjust them now that we have a full year of data for 2022. Of course, no one knows what the month-to-month movements in consumer prices will actually be in 2023, but we can make some assumptions. We can look at moving averages over months or even years, but there has been just so much distortion to the data from the pandemic that this is kind of worthless.
Instead, I looked at how prices reacted towards the end of Fed tightening cycles. Specifically, I looked at monthly changes in the US CPI starting two hikes before the end of the cycle and lasting to just before rates were cut. This was done for the tightening periods starting in the 1990s. If you do that, the average monthly increase in the CPI comes in at just over 0.2% and it’s the same for ex food and energy. Taking this number and assuming that’s what the average monthly change will be for this year, we actually can get headline inflation down to 2.3% by June, after which it ranges between 2.2% and 2.6% in the second half of the year. Core inflation is not as well behaved and only gets to 2.5% by the end of 2023.
Bulls will argue that this scenario is sufficient for the Fed to take its foot off the brake pedal, but is that after this quarter or in the second half? Further, the assumption that we see the same average monthly price gains as in recent cycles ignores the fact that services inflation is well above any of those periods. There are eight policy meetings for the Fed and the Bank of Canada this year and markets seem to believe that we get maybe we get two more quarter-point hikes this quarter and then a pause. That would put the upper bound on the Fed funds target rate at 5% and the Bank of Canada overnight target would come in at 4.75%. If the concern over services and higher structural inflation is stronger at both central banks than what markets perceive, then we may easily see more than just two more hikes. Worse, the next Fed meeting could deliver another half-point increase and I don’t see markets being priced for that.
Ally and I don’t believe the inflation fear pendulum is going to swing back to where it was last year, but a re-focusing on the persistence of high services inflation could bring it back from the optimistic swing of the last few weeks. That is why our strategy remains the same and that is to maintain a healthy cash position in the equity portfolio and a shorter duration stance in bonds.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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