Inflation Soars and the Market Yawns
It is not just the weather that's heating up as we enter the summer months. U.S. inflation which foreshadows the Canadian consumer price index (CPI) data this week, rose 5.0% from a year ago, and the core index, which excludes food and energy, rose 3.8%, the largest 12-month increase since 19921. Easy comparisons, as prices collapsed last year during the height of the pandemic, continue to exaggerate the yearly increases. However, prices also rose strongly on a month-over-month basis. The core index increased 0.7% in May from April, above the 0.5% expected and more than three times the average monthly increase over the last five years1.
The Bank of Canada at its policy meeting last week maintained its current pace of bond purchases while acknowledging that the average of its favored core inflation measures now exceeds its target of 2%. The bank sees CPI remaining near 3%, the upper end of its target range, through the summer but expects it to ease back later. Despite the hotter-than-expected U.S. data and the BoC commentary, government bond yields fell to their lowest levels in three months, and the TSX closed at a record high. Since the April inflation data was released last month, investor views appear to have taken a 180-degree turn, shifting from fear of runaway inflation to the belief that price pressures are transitory and will soon subside. We'd offer the following perspective on 1) the recent drivers of inflation, 2) our views of potential scenarios and our assessment of the most likely path from here, and 3) how to interpret the market reaction.
1. Reopening demand, along with supply bottlenecks, continues to push prices higher
- Like the April surge, the jump in U.S. prices in May was largely driven by a handful of categories that have been most affected by the pandemic and are now benefiting by the reopening of the economy. Car rental, airfare, food away from home (restaurants), and, to a smaller extent, hotel prices experienced sizable increases, reflecting the release of pent-up demand as consumers return to their typical spending habits. Further increases should be expected, as airfare is still below its pre-pandemic level by 12%, and hotel prices by 5%1.
- The impact of supply shortages and bottlenecks was also prevalent. Used-car prices continued to rise sharply in May, increasing 7.3% in May from April and accounting for about one-third of the overall increase in inflation1. Semiconductor shortages are still affecting new car production, but some of these supply-chain pressures are starting to ease.
- Outside of leisure and accommodation, price increases for other services that tend to be stickier, like medical care and education, were muted.
Description: The graph shows price trends for select consumer basket categories since the pandemic started. Reopening demand for services and supply shortages for goods have been driving outsized gains.
2. Transitory, enduring or something in between?
- Last week's inflation data does not provide a resolution to the great inflation debate. Below we present three possible scenarios, along with our thoughts of which one is the most likely.
- Scenario 1 – inflation transitory
So far, the surge in prices is concentrated in the pandemic-hit sectors, supporting the argument that inflation will prove to be transitory. As it pertains to goods inflation and bottlenecks, supply will catch up, and demand will eventually normalize. Such a scenario where inflation subsides back to the BoC's 2% target would be positive for both bonds and stocks. We believe this is what's currently priced in by the markets.
- Scenario 2 – inflation enduring
On the other end of the spectrum, there is a possibility that fast-rising prices become embedded in consumer expectations. Also, if wage growth accelerates, that would increase the chance of a sustained rise in inflation. Anecdotal evidence and surveys indicate that small businesses are facing labor shortages as hiring picks up. The jobs-hard-to-fill component of the NFIB small business survey released last week rose to a record high, as shown in the graph below. Many jobs in leisure and hospitality are coming back with a higher compensation structure because employers are struggling to fill positions. If elevated inflation is sustained amid rising wages, increased rents, higher commodity prices, and a falling dollar, the Fed would be forced to hike rates aggressively. Runaway inflation, similar to what occurred in the 1970s, would undoubtedly be negative for both stocks and bonds. However, we think this is a low-probability scenario.
- Scenario 3 – Spike is temporary, but inflation settles at higher levels compared with the last expansion
The most plausible scenario, in our view, is that after the upward pressure on prices from the reopening subsides later this year, inflation will settle moderately above the BoC's 2% target. Consumers have surplus savings, and by the end of the second quarter the economic slack will be eliminated. Wages are likely to accelerate, but an increase in the labor-force participation, along with productivity gains from technological adoption, could keep cost-push inflation in check. Under this scenario the BoC remains patient but starts hiking rates sometime in 2023, slightly earlier than the current committee's projections. Slightly above-target inflation is likely to be neutral for stocks, because companies with pricing power can maintain profitability levels, but it is moderately negative for bonds.
- Scenario 1 – inflation transitory
Description: The graphs shows the job openings hard-to-fill component from NFIB’s monthly jobs data. A record-high 48% of small business owners in May reported unfilled job openings.
3. Market reaction suggests some complacency is settling in
- Both the equity and bond markets shrugged off the jump in inflation, showing that investors are fully siding with central banks in their outlook that price pressures will prove transitory. The TSX made a new record high, and the 10-year Government of Canada bond yield broke below the 1.40% mark for the first time since March1.
- We agree that the bar for central banks to change their easy monetary policy is very high, even though the BoC will likely move before the Fed. Currently, the Fed's two mandates, maximum employment and price stability, are sending different signals about the economy. Policymakers are choosing to focus on a broad and inclusive employment recovery and are willing to tolerate higher inflation in order to achieve the former.
- However, we believe that markets (more so bonds) are discounting goldilocks conditions without a healthy dose of caution and skepticism. At the very least, fundamental conditions don't warrant another large drop in yields. Long-term rates are now back below the pre-pandemic 2019 level and well below market-based inflation expectations for the next 10 years1. Last time the gap between inflation expectations and yields was so large in the U.S. was back in 2013 right before the so-called "taper tantrum." Then, the Fed announced that it would be reducing the pace of its purchases of Treasury bonds, triggering a rally in yields. After being the first major central bank to taper, the BOC is expected to continue to pare back its bond purchases, as soon as next month.
- The economy is strong enough, in our view, to weather the recent inflation uptick. Increased vaccination rates, rising consumer demand, and surging corporate profits rightfully outweigh inflation concerns. But the market will likely be sensitive to the combination of elevated CPI readings and better-than-expected employment data, which we haven't got so far (both the April and May jobs reports disappointed). As employment gains pick up, bond yields are likely to resume their upward trend, with yields rising further at the long end than the short end (yield-curve steepening). A recalibration in rate and central-bank-policy expectations could trigger some volatility in stocks later in the year. We continue to think that the bull market has plenty of gas left in the tank, but we recommend investors maintain realistic expectations for returns and volatility.
Description: The graphs shows the 10-year breakeven inflation rate which is higher than 10-year nominal yields. The gap is the widest since 2013.
Angelo Kourkafas, CFA
Source: 1. FactSet
The Stock & Bond Market
|S&P 500 Index||4,247||0.4%||13.1%|
|MSCI EAFE *||2365.55||0.3%||10.2%|
|10-yr GoC Yield||1.36%||-0.1%||0.6%|
Source: Factset, 6/11/2021. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. *Source: Morningstar, 6/13/2021.
The Week Ahead
Important economic data being released this week include the consumer price index. On the US side, we'll receive producer price, retail sales, and leading economic indicator index data.
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