Inflation is high but could ease as the year goes on

Inflation remains a big topic among investors, and the charts below clearly show some of the reasons why, but there are also reasons to suspect inflation pressure could ease later this year.

Inflation is high . . .

A barrage of recent headlines has made it hard not to notice that reported inflation is very high (e.g. US CPI year-on-year change at 8.5%). More importantly for markets, inflation has continued to come in above expectations. The Citigroup Inflation Surprise indices (chart below) measure the degree to which inflation reports come in above or below consensus expectations. The indices for the US, Europe, Emerging Markets, and the global aggregate are all still extremely high relative to historical norms. Europe is by far the most extreme, as it is affected most directly by the war in Ukraine and the resulting impacts on energy prices and many other commodities.

Bond market in turmoil as stocks outperform

While all markets have been volatile recently, the normally “safe” Treasury bond market has been especially volatile, and is giving mixed signals. This means that even in a generally “risk off” backdrop, the normally riskier stock market (S&P 500) has outperformed long-term Treasury bonds by a historically wide margin over the last month.

The US bond market has had a rough time lately. The ICE/BofA Long-Term (10 year+) Treasury Total Return index (i.e., which includes coupon payments and price changes) has fallen 16% from its latest November 2021 peak, and is down 23% from its latest cycle peak in July 2020 (excluding the spike in March 2020). Thus bonds are clearly in a bear market by the unscientific “down 20% or more” rule of thumb. And from a volatility standpoint, bonds are at more extreme readings relative to their normal range than stocks are, based on the VIX (S&P 500 implied volatility) and the MOVE index (Treasury bond implied volatility).

Why are you not more bearish?

Client Question: There is a possible world war going on along with a seemingly never-ending pandemic, inflation is at multi-decade highs, the Fed and other central banks are tightening monetary policy, and the world may lose access to Russian oil and gas entirely soon – why aren’t you massively bearish on stocks, which everyone knows is the high-risk asset class?

Answer: While naturally reserving the right to get more cautious on stocks (we downgraded equities to neutral on Feb. 14th), there are a few reasons we are not more bearish on stocks or the broader economic outlook at the moment.

Commodity prices post record surge, near-term inflation to follow

Commodity markets have become the center of global economic and financial market attention recently, showing unprecedented volatility. Russia’s invasion of Ukraine, coming on top of the volatility caused by COVID and the subsequent policy responses, has highlighted the supply constraints now facing a wide variety of commodities.

The S&P GSCI commodity price index is a widely-watched benchmark for global commodity prices, with history back to 1970. As shown in the chart below, the rolling 3-month percent change in the GSCI index has just hit its highest reading in its 52-year history. This exceeds the moves following the OPEC oil embargo of 1973-74, the 1979 oil shock, the invasion of Kuwait in 1990, the rebound in prices in 2009 after the 2008 collapse, and the rebound in 2020 from the initial COVID-driven collapse.

Inflation expectations: markets showing more worry now, less worry later

Inflation remains a hot topic among investors, policy makers, and voters. While there is not a great deal that policy makers (fiscal or monetary) can do in the short term to control inflation (today’s announcements of coordinated releases from strategic oil reserves are mostly a signaling action), there are steps that can be taken on a longer horizon. Monetary policy has historically been the primary lever used to try to manage inflation, though it has arguably been less effective in recent years as it has run into the “zero lower bound” (ZLB) with short-term interest rates. Fiscal policy is likely a more potent lever but historically has not been used as such.

What is stagflation and is it making a comeback?

A frequent question lately has been: are we currently in, or about to enter, a period of “stagflation” like the late 1960s and 1970s as a result of COVID and policy responses? Our short answer is no: while inflation may be elevated for a while, growth is currently strong, structural inflation pressures are low, and policy is better now than in the 1970s, making any sustained stagflation conditions unlikely. Below we offer some historical context and our current views.

Inflation trend is still low

One of the biggest topics among investors recently has been inflation, particularly after the May Consumer Price Index (CPI) and Producer Price Index (PPI) reports (reflecting April data) that showed big monthly jumps in headline inflation: 0.8% for headline CPI and 0.6% for headline PPI. And the “core” rates that exclude food and energy were actually slightly higher than the headline rates in April.

Labor market improving but still shows plenty of slack

In the longer-run, a key measure of inflation pressure is the amount of labor market slack (unemployed or underemployed people), which heavily influences the ability of workers to demand higher wages.

The standard reported unemployment rate data (i.e., the U-3 measure in the US) is useful in measuring labor market slack, but has limitations due (in part) to its definitions of “unemployed” and the “labor force” in the calculation: “unemployed” people as a percentage of the “labor force”. That is, to be counted as “unemployed”, a working-age person must be considered actively looking for a job (when asked if they have sought employment in the last four weeks in the monthly household surveys done by the Bureau of Labor Statistics, BLS). If they are not currently seeking employment for any reason, they are “not in the labor force” and thus do not count in the standard unemployment rate, even if they consider themselves unemployed.

Inflation is steady on the surface, volatile underneath

Inflation expectations have been a topic of growing interest thanks to the extraordinary fiscal and monetary support in place for much of the last year, most recently the huge $1.9 trillion American Rescue Plan that is currently sending checks out to millions of Americans.

All of this new spending by the federal government, along with the economic recovery permitted by the rollout of COVID-19 vaccines, is provoking more discussion about whether demand for goods and services will outpace the economy’s ability to produce them and push prices higher.

Bond market making some noise

The bond market has clearly awoken from what appeared to be a low-volatility Fed-induced slumber for much of last year. Longer-term bond yields in the US and elsewhere have jumped to their highest levels since just before the COVID crisis hit markets early last year (blue line in first chart below). Even after this rise, though, the 10-year Treasury yield remains below even the low points of previous cycles.