On previous occasions we have commented that in recent years, waiting for inflation has been tantamount to the Samuel Beckett play, “Waiting for Godot.” Well, this past week Godot finally crashed the stage.
Inflation, for the most part benign and non-threatening over the past decade, has emerged from the abyss and can now be considered the market’s largest concern. On May 12, the U.S. Bureau of Labor Statistics released the Consumer Price Index (CPI) for the month of April and, no matter what category or timeframe one might choose, inflation has not tallied numbers this high in quite some time.
- April headline CPI rose by 0.8% for its fastest monthly increase since 2013. On a year-over-year basis, CPI increased by 4.2%, its hottest pace since May 2008. This was above consensus estimates of 3.6%.
- When looking at core CPI, which excludes volatile food and energy components, the monthly rise totaled 0.9%, its fastest clip since July 1981. Year-over-year, the increase on this metric was 3.0%, its highest since January 1996.
- This monthly jump has occurred after a nine-year run in which annual CPI has averaged less than 1.6% and has not seen a calendar year rise above 3% since 2012.
While markets initially reacted unfavorably to this news, few should have been too surprised, in our opinion. Expectations of April being a breakout month for inflation, given the torrid pace of current economic growth and the low comparative inflation rates of a year ago, had been mounting for weeks.
While there is no argument that inflation is back, the arguments are plentiful as to how long it might stick around.
At the heart of the debate is the concept of transitory inflation driven by the base effects of a V-shape recovery from last year’s severe first- and second-quarter contraction. Under this scenario, inflation will probably rise relatively fast, such as noticeably above the previous decade’s sub-2% pace, as the economy will grow above pre-pandemic levels, and annual inflation comparisons are prone to be distorted when calculated off their suppressed rates from this time last year. However, once economic growth normalizes and monthly inflation comparisons are based on more constant conditions, higher inflation rates are unlikely to persist.
Nonetheless, given the rapidly changing environment even temporary inflation still might create, we believe investors may want to take the following into account:
The blistering short-term pace of the current V-shape recovery needs to be considered. Gross Domestic Product (GDP) increased by an annualized rate of 6.4% (advanced estimate) in 1Q21 and the Atlanta Fed is currently tracking 2Q21 in the double digits. As a result, CY 2021 GDP growth could challenge or even exceed 8%. Clearly, this is not a sustainable rate of growth, though, while it is occurring, inflation rates seem destined to rise to multiyear highs.
We believe base effects are driving much of the current inflationary rise and likely creating a transient profile. April’s 4.2% year-over-year CPI rate is, in large part, the result of comparing it to April 2020 when inflation was abnormally low at just 0.3%. Hence the transient inflation argument is essentially a mathematical one. As last year’s low inflation rates of 2Q20 fade into the rearview mirror, so will this year’s higher differentials. That said, we are now staring into at least two more months of these higher base effects comparisons, as the months of May and June 2020 posted year-over-year CPI gains of just 0.1% and 0.6%, respectively, before they rose above 1% in 2H20. So, we certainly could see monthly CPI move even higher as we progress into the summer.
The Federal Reserve has solidly placed itself in the camp of higher inflation rates being transitory. Chairman Jay Powell and fellow Fed members have several times in recent weeks voiced their judgment that the expected inflationary rise is being caused by base effects related to the strong economic recovery and therefore are not expected to warrant specific monetary action as such. Refraining from policy action is further supported by the Fed’s “Statement of Longer-Run Goals and Monetary Policy Strategy,” announced in August 2020, stating its intentions to achieve inflation targets “over time.” Keeping this in mind, any subtle changes in perspective at the Fed could still garner market reactions, and in this regard much attention will soon focus on the upcoming June meeting.
Longer-term interest rates could still move higher in response. Higher inflation trends, even simply on a transient basis, are likely in our opinion to contribute to the rise of longer-term interest rates already reacting to stronger than expected economic growth. Therefore, we would not be surprised to see the 10-year Treasury yield challenge or exceed 2% by year end.
Higher inflation reports in the months ahead could induce more market volatility. Given the strong stock market performance since March of last year, we would not be surprised to see this inflationary pickup help provide fodder for a potential market correction in the months ahead. As we have said in previous commentaries, the likelihood of a stock correction was high even before these inflation numbers were released, based, in our opinion, on simple profit-taking and past market history. However, should such a correction occur, perhaps at a level of about 10% from the recent early May record highs, we would likely view that as a strong buying opportunity for investors. We are maintaining our year-end 2021 price target on the S&P 500 of 4,500.
In conclusion, we believe investors should recognize inflation is now the market’s highest concern, yet we also believe the argument for its transitory profile to be a rational one and therefore downside volatility created in the markets could provide advantageous opportunities for investors. That said, higher monthly CPI and other inflationary readings are likely to continue into the latter parts of the year and should be monitored closely for any potential longer-term impacts, particularly as economic growth further accelerates.
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