Rising Inflation: What Investors Need To Know
Inflation climbed higher as the consumer price index (CPI) report for the month of June furthered the recent rising trend of consumer prices and again displayed rates of change not seen in more than a decade. With more difficult comparisons versus last year’s suppressed inflationary levels and expectations of strong summertime consumer activity still ahead, it is likely inflation will remain at elevated levels for the remainder of the year as investors seek to determine whether its profile will prove transitory or more permanent in nature.
The June CPI numbers surprised to the upside, with both headline and core inflation exceeding most forecasts.
- On a monthly basis, headline CPI rose 0.9% from the previous month, as did core CPI, which excludes the more volatile food and energy components. These were well above consensus expectations of 0.5% for each. It was the highest monthly increase on the headline print since March 2011.
- On a year-over-year basis, headline CPI was 5.4%, representing the largest annualized rate of change since August 2008. Core CPI posted an annualized pace of 4.5%, its highest increase since September of 1991.
- This continued a steady upward monthly trend since March, when CPI broke above its multiyear, sub-2% trend and has not looked back since. For the past three monthly readings, headline CPI has averaged a year-over-year rate of 4.9% and core CPI 3.8%. As a basis of comparison, both headline and core CPI began the year at 1.4%.
Against this backdrop of rising prices, we believe it is important for investors to consider the following points:
Base-effects comparisons continue to skew inflation results higher. As we have mentioned in earlier commentaries, direct comparisons versus the suppressed inflation rates of last year are at least partially distorting monthly trends higher. For example, June 2020 inflation rates were quite low by historical standards at just 0.6% for headline and 1.2% for core versus previous year levels, as the economy at that time was fighting through historic economic contraction. When calculating a two-year annualized rate of inflation versus pre-virus 2019 price levels, headline CPI increased 3.0% and core 2.8%. While these rates are still higher than trend over the past decade, as well as the Federal Reserve’s long-term inflation target of 2%, they are a good bit lower than the newly reported year-over-year rates.
A select few business areas continue to account for the bulk of the CPI’s increase. As had been seen in earlier months, a disproportionate percentage of the CPI increase was driven in June by a handful of component business areas most impacted by last year’s shutdowns and this year’s re-openings. This included used car dealers and car rental companies, who last year were forced to liquidate inventories only to buy them back this year to meet demand. In numeric terms, this translated into a 45% increase among used car and truck prices and an 88% rise in the cost of rental car services. Together, these two businesses alone, which total slightly more than 4% of core CPI composition, accounted for more than 40% of the aggregate increase (2.0% of 4.5%). Other components skewing the broader index included airline fares, hotels, and lodging, which comprised just above 3% of the core index but accounted for 13% of the increase (.60% of 4.5%).
The transitory debate rages on. Following this June report, the highly spirited debate as to whether this rising trend of inflation will prove transitory and basically temporary or more permanent in nature has seen fuel added to both sides. The non-transitory camp can certainly claim numbers are numbers, and many of them are the highest since the days preceding cell phones and the internet. Those with a transitory perspective can point to improving base effects comparisons in 2022 as well as recognition that the majority of current inflation is stemming from a small and consolidated group of businesses whose price increases are unlikely to be sustainable.
Inflation reports are likely to remain hot for the next several months. The unfavorable year-over-year monthly comparisons versus last year’s extremely benign rates of inflation will continue throughout the remainder of CY 2021, improving modestly as the year progresses but not to the point of eliminating the base effects math entirely. Specifically, 2H 2020 averaged monthly year-over-year headline CPI inflation of just 1.2% and core inflation of 1.6%. So as the economy potentially closes out CY 2021 with gross domestic product (GDP) growth in the 7% range against a backdrop of widespread re-openings, short-term supplier bottlenecks, and worker shortages, it is likely these higher monthly rates will continue into the autumn and early winter months.
All considered, we remain on the transitory side of the debate and believe it is probable inflation will revert close to 2% by the early months of 2022. We maintain this perspective largely due to base effects comparisons eventually shifting in the early months of 2022 and the extremely high inflation rates of those most-sensitive business areas subsiding as the economy moves forward and beyond the early phases of widespread re-openings and pent-up consumer demand. Under such a scenario, we would view inflation as likely mitigating toward the mid-2% range for CY 2022 and to be potentially accompanied by about 4% GDP growth in that year, which we would view as a favorable environment for investors.
We see the Federal Reserve as remaining thorough and deliberate in considering any monetary policy action based on inflation. Following the June report there was immediate market speculation that the Fed might move up its timeline for tapering open market asset purchases and raising the existing 0–0.25% target range on the fed funds rate. As Chairman Powell and other Fed members continue to reiterate in public commentary — they see inflation trends as likely proving to be transitory — we believe the lagging employment recovery (still more than 6 million jobs short of the February pre-pandemic high) will help to provide a schedule by which the Fed begins tapering its $120 billion monthly bond purchases in early 2022, taking about a year to wind them down entirely and then potentially raising the fed funds rate in 2023. We view such a potential timeline as continuing to be market friendly given the current economic and corporate earnings growth environment.
Both the stock and bond markets seem unfazed by recent rising inflation. Many in the transitory camp also point to rising stock prices and falling longer-term bond yields as the market’s referendum on inflation ultimately proving to be transitory. Since the steady upshot in monthly CPI reports beginning in April and through July 13, the S&P 500® has risen more than 10% to reach record highs, and the 10-year Treasury yield has fallen from 1.78% to 1.40% after touching down on July 8 at 1.25%. While markets can certainly turn quickly, this is not the profile of trading activity nervous about runaway inflation.
In conclusion, while we believe inflation is currently the top concern of investors as we enter 2H 2021 and that future monthly reports will remain a key market focus, our judgment is one that believes a transitory path is the more likely one. The inherent characteristics keeping inflation low over the past decade, such as global supply chains, age demographics in the workforce, and technology-based distribution channels are not going away anytime soon, in our opinion. Therefore we believe these recent inflation trends are likely to normalize back toward 2% by early 2022 as the historically anomalous conditions created by the COVID-19 economic shock, ongoing recovery, and future expansion play out in the months ahead.
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