An unexpectedly high US inflation reading has sent shockwaves through financial markets. In this multi-asset & macro interview we step back and explore the deeper implications for financial markets.
Investors are now on edge because of what the recent inflation spike might mean for monetary policy. However, our multi-asset & macro team are less concerned, viewing the rise as temporary and believe a lone blockbuster inflation reading shouldn’t warrant a change in asset allocation. Fabio Faltoni (FF), multi-asset & macro investment director, interviews David Nowakowski (DN), senior investment strategist, to find out more.
FF: Were the latest inflation numbers really that large?
DN: Yes, relative to history, the move was big. The April Consumer Price Index figure was much stronger than had been expected, at 0.8 per cent on a month-on-month basis (versus 0.2 per cent expected), which in turn sent the year-on-year rate to 4.2 per cent. This is the highest it has been since September 2008.
Core inflation didn’t provide any respite either, with the 0.9 per cent monthly increase being the fastest pace of core price rises since September 1981, sending the annual number up to three per cent (the highest since January 1996).1
FF: What were the main factors behind the increase in prices?
DN: In a word: “re-opening”. Strong demand across multiple sectors, as well as post-pandemic supply chain disruptions, helped push prices to record highs.
Strong demand, as well as post-pandemic supply chain disruptions, helped push prices to record highs
In particular, the biggest increases were in used vehicles (affected by the global semiconductor shortage’s limiting auto production) and service sectors being disproportionately impacted by shutdowns (including lodging and airfare) – now that they are re-opening, hotels and airlines have been able to raise prices by ten per cent. Energy and housing didn’t actually add much – although they might rise in future months.
FF: What was the market reaction?
DN: Bond yields, which had retraced in April after rising significantly over the course of the first quarter, renewed their move higher. The inflation news also added further fuel to the sell-off in equity markets, especially tech stocks which have shown to be inversely correlated to bond yields and concerns about economic overheating risks.
Bond yields renewed their move higher
However, European banking stocks advanced to a post-pandemic high as sovereign bond yields in Europe hit fresh two-year highs. Inflation breakevens, a measure of inflation expectations, also inched higher, with the 10yr US breakeven touching 2.5 per cent – levels not seen in nine years.
FF: The market reaction seems to suggest investors are continuing to position for a change in the inflation regime. However, Federal Reserve communications imply "transitory" factors are at play. What is your take?
DN: Understandably, investors are now on edge as to what this might mean for monetary policy. However, the Federal Reserve (Fed) officials we heard from after the inflation release predictably downplayed the report and repeated their mantra that any rises in inflation would prove temporary. For instance, Vice Chair Richard Clarida said that even though he was surprised by the reading, he expected “inflation to return to – or perhaps run somewhat above – our two percent longer-run goal in 2022 and 2023”, with this outcome being “entirely consistent” with the Fed’s new framework.
In our House View2 published last month, we highlighted the potential for a variety of factors, such as energy prices, affecting the annual comparison for both headline and core measures of inflation over the course of 2021, pushing measured inflation temporarily above target in most major economies. This is partly what we saw happen with this reading. The next few months will also show high annual comparisons, and (probably) monthly as re-opening continues. This won’t happen next year, and so it should be transitory in that sense.
Much like the Fed officials, we think annual inflation rates should start edging lower as we move through the third quarter of 2021 and the economic extreme of lockdown is no longer included in the calculation.
Just how temporary that proves to be will depend on the pace of recovery. In the US, we expect the output gap to turn positive by the end of 2021, with the euro zone to follow around a year later. That could put moderate upward pressure on underlying inflation in 2022 and beyond – and while we see a risk that could be too high for comfort, we don’t see runaway inflation happening either.
Assuming inflation is moderate – CPI in the high two per cent or even low three per cent range, with PCE prices rising around 2.5 per cent for a while – it would be welcomed by central banks as it shouldn’t result in second-round effects like rapidly rising wages and de-anchored expectations.
FF: What would change your view?
DN: As mentioned above, it all depends on the extent to which spare capacity is eroded. Certain sectors are feeling constraints and passing on input price increases, but others still have slack. To this end, we are monitoring job reports closely.
The weak US hiring report reinforces the Fed's view that employment is far from ‘full potential’
The surprisingly weak US hiring report released in the first week of May reinforces the Fed's view that employment is far from ‘full potential’. Based on the criteria laid out by Chair Jerome Powell (and echoed by other Fed officials), it would take more than just a strong May jobs report to shift their view. Sizable upward revisions to March and especially April, as well as a few more months of lower unemployment would be necessary get the Fed and our team to materially reassess the current expectations.
It is important to remember that the Fed’s new framework means that they do not want inflation to be transitory – they want to see “moderately above” target inflation for a sustainable period.
FF: In that case, what are your expectations on asset purchase tapering and the potential for interest rate hikes in the US?
DN: We expect tapering announcements from the Fed before the end of the year and for it to take about 12 months to complete. That should set the stage for lift-off – the first hike – and gradual interest rate hikes after that. There is some potential for repricing since a pace of two hikes per year, as implied by Eurodollar futures and swaps, is too small (if the Fed does actually get to the first hike, of course).
FF: Since your macro outlook has not changed, would it be fair to assume that your view on risk assets hasn’t either?
DN: That is correct. We are supportive of risk assets, with a preference for equities over credit. Even though equity returns should slow from here, we expect them to remain positive as real rate pressures on valuations are balanced by a bright outlook for earnings – which was confirmed in the latest reporting season.
Strong policy support and strengthening global trade should be favourable
From a regional perspective, we are slightly underweight emerging markets, while are somewhat more overweight the US and UK markets, where domestic growth differentials, strong policy support and strengthening global trade should be favourable. From a sector perspective, we expect “high growth” stocks to underperform and “value” and “cyclical” stocks to continue their recent outperformance.
FF: What about duration?
DN: Government bond yields have risen in recent months, reflecting the brighter economic outlook and increased fiscal support, particularly in the US where the infrastructure bills are expected to be passed in the second half of the year in some form. That means more growth and more bond supply, though some taxes might be added to the mix.
There remains a limit as to how far yields can rise in the near term
Even after this latest treasury sell-off, we think that longer-term bond yields can rise further; yes, the US 10-year is over 100 basis points higher than its trough in August 2020 – but a lot has changed since then, and we shouldn’t expect the US or global economy to return to its pre-pandemic state. With most central banks set to keep policy rates at the effective lower bound for some time, there remains a limit as to how far yields can rise in the near term. That said, we are approaching interest rate hiking cycles in several G10 markets; as such, we are modestly underweight duration.