We have a new CPI print today which sent markets into a week-ending nosedive. 8.6% for May puts inflation for consumers near where it was in 1981 before the Volcker Fed cranked rates to an eye-watering 17+%. For as painful as rate increases are right now we have light years to travel before anything even remotely resembling the 80’s, nostalgia for Soviet conflict and striped shirts notwithstanding. This chart from the US Bureau of Labor Statistics compares CPI in total against two of the three components that seem ripe for a nasty mean reversion, the third being energy which we covered in the last chart and commentary. Shelter has broken out, rising to 5.5% which exceeds the lusty moments before the housing market imploded with the Financial Crisis. We have been pointing out repeatedly that there are two major moving parts driving increases in shelter — the speculative fervor over single family housing fueled by low rates, urban migration and non-human (e.g. investment fund) buyers, and the inevitable upward correction in rentals after ending pandemic moratoria on rent, rent increases and evictions. It seems likely that the single family bubble is nearing its bursting point especially as the Fed acts, but rent will continue to grind higher as the economy digests the rental disruptions of the pandemic.
New vehicles on the other hand appear perched on the precipice. Supply chain disruptions, particularly for microchips, have tightened supply and handed dealers tremendous pricing power even while makers have largely kept their price increases steady (but have been able to slow or suspend aggressive promotional programs). The rate of increase peaked at 13.2% in April and posted 12.6% for May. Other than playing demand catch-up after the market for new vehicles crashed in the depths of the Financial Crisis, the 12-month change over the last 20 years has stayed in a band of +/- 2%, and most of the time close to zero. There will come a moment when makers catch up and inventory will be abundant (and auto loan and lease rates will be higher), and the market may well punish the dealers for exploiting the situation, potentially severely. [Chart courtesy US BLS, CPI All Items, Shelter and New Vehicles, May 2002 to May 2022]
The market, in our view, is trying to come to grips with a less accommodative yet still supportive monetary and fiscal policy environment. Federal Reserve policy is dominant at this moment, since it appears fiscal policy progress has stalled until the mid-term elections and perhaps beyond. The Fed is unlikely to turn away from its recent pivot towards being less “dovish”, which in light of recent inflationary trends is still is a far cry from an aggressively “hawkish” stance.
This will be our last chart before Labor Day. The US Federal Reserve’s preferred measure of inflation, the YoY rate of change in the Personal Consumption Expenditure Index (PCE), has been exceeding its 2% target rate since April making investors concerned that we may be approaching a monetary tightening cycle. That fear was escalated by this week’s release of the Fed’s July 28-29th meeting minutes that indicated they may begin to wind down the current $120 billion monthly asset purchases by the end of this year or the beginning of 2022. The Fed has expressed its view that current inflation trends are transitory and are likely due to temporary factors such as supply chain bottlenecks and a strong rebound in demand from last year’s lull in consumption. As of June 30th, the current annual rate of the PCE was 3.54%, well above the Fed’s target, but in June 2020 the reading was 1.13%. Since the Fall of 2008 during the Financial Crisis, the PCE has been stubbornly below 2%, averaging 1.59%. Over that period of nearly 13 years, the PCE has been over 2% only in Q1 2012 and for most of 2018. Inflation has been undershooting for a long period leaving aggregate price levels far below the Fed’s ideal. This suggests to us that the Fed will likely tolerate inflation until the PCE normalizes.
Equity markets around the globe were on edge as February came to a close. The technology-laden NASDAQ fell nearly 7% from an all-time high on February 12th. The weakness in equity prices came despite very accommodative comments from US Federal Reserve Chairman Jerome Powell during his scheduled two-day Congressional testimony last week. Equity markets became unnerved as government bond yields began to rise at an accelerated pace in the US, Eurozone and particularly the UK. Benchmark interest rates have been rising since the beginning of this year and US interest rates have been climbing since last Summer signaling expectations of improving economic conditions in the months ahead. As long as the rate environment increases gradually, gains can continue in equity markets. But, as we witnessed over the past few weeks, a steep ascent in market interest rates will have an expected adverse impact on risk assets. [chart courtesy Bloomberg LP (c) 2021]
A positive development has surfaced within the US fixed income market — Investment Grade Corporate Credit spreads have narrowed relative to the 10-year US Treasury yield, yet still remain wide by historical measures. There may be some opportunity in that sector of the bond market. Even with that backdrop, oil price volatility unnerved many observers as the near-term WTI contract (for May 2020 delivery) priced with a negative sign Monday closing at a bizarre -$37.63. It has since recovered to about $17. Ongoing anemic demand combined with a lack of available storage to create a moment where there was no immediate bid for oil. From an equity market standpoint, the impact was limited though as the major integrated energy companies continued to rebound along with the overall stock market. Importantly, the sector currently stands at only 2.9% of the S&P 500 while 10 years ago it represented nearly three times that share of the index.
We are optimistic about US capital markets, but the health crisis will continue to generate grim news and adversely impact the labor market and the overall economy. This week’s first-time unemployment claims brought the running total to 26.5 million American jobs, essentially wiping out all job gains since the Great Recession. The US is far from out of the woods, but the market is handicapping a positive outcome in the long term.