Inflation Is Back: Sign of Overheating, or a Pandemic Distortion?
After being dormant for more than a decade, fast-rising inflation returned last month and, along with it, so did market volatility. The S&P 500 pulled back about 4% from the early May record high before rebounding some later in the week, with weakness concentrated in technology and high-growth stocks. The catalyst for the pullback was the release of the April Consumer Price Index (CPI) last Wednesday, which rose 4.2% from a year ago and 0.8% from March. The directional change in prices was hardly a surprise to economists and investors, but the magnitude of the increase was well above expectations. Excluding food and energy, the so-called core index rose 0.9% from March, the biggest one-month increase since 1981, and three times more than analyst estimates1. As alarming as this sounds, we believe there are unique pandemic-related factors that explain the spike in prices, with the risk of runaway inflation remaining a low probability event, in our view.
- Supply shortages and a reopening surge in demand are pushing prices higher. The current imbalances between supply and demand reflect pandemic distortions and thus are likely to prove temporary.
- We are closely watching consumer inflation expectations and wage growth to gauge whether price pressures will persist beyond this summer.
- High inflation readings over the coming months could spark volatility but won't derail the bull market, in our view. Faster economic growth and higher inflation than experienced over the last decade can benefit cyclical sectors and value-style investments, while exerting upward pressure on long-term rates.
Below we offer additional perspective on the key questions raised by last week's inflation data.
Source: Bloomberg, Bureau of Labor Statistics
The graphs shows the month-over-month change in the consumer price index, with price gains accelerating this year.
What is driving prices higher?
- Easy comparisons (base effect) – Because prices collapsed in April, May and June of last year during the height of the pandemic and lockdowns, the base from which the annual growth rate of the CPI is calculated is very depressed. Almost 1% of the 4.2% inflation rate was explained by easy comparisons2. However, this dynamic is well-understood and provides little insight on the monthly jump in prices. When comparing prices from March to April of this year, inflation rose 0.8%, which is four times the average monthly increase over the last five years.
- Supply shortages and manufacturing bottlenecks – There are widespread shortages of materials reported across manufacturing industries, limiting production and driving up prices for an array of consumer goods. Because many companies cut capacity and reduced inventories last year in anticipation of a prolonged recession that didn’t materialize, supply is now having a hard time catching up with demand. The combination of 1) the rapid rebound in demand, 2) a shift in consumer spending patterns towards goods, 3) lean inventories, and 4) COVID-19 safety protocols that created inefficiencies has resulted in shortages in materials that are used as inputs in the manufacturing process, such as lumber, copper, corn and semiconductors.
Used-car prices surged 10% in April from March, accounting for about a third of the increase in the CPI. Auto manufacturers were forced to scale back production of new cars because of the semiconductor shortage, while at the same time demand for cars exploded as consumers received multiple rounds of stimulus checks and were hesitant to use public transportation. We believe most of these bottlenecks can be resolved in the coming months, while others, like the chip shortage, could take some time but likely won't persist. Demand will eventually fall back, and supply will catch up.
- A surge in demand for services as the economy reopens – A closer look at the price trends of the various components of the CPI reveals that prices rose the most in areas that have been heavily impacted by the pandemic and are now benefiting from the reopening of the economy. As shown in the table below, airfares jumped 10% in April from March, car and truck rental prices surged 16%, hotel prices rose 8%, and admission prices to sporting events popped 10%. Most of these price adjustments reflect a return to typical spending habits as vaccinations progress, with prices for these services still below their pre-pandemic levels. The sticker shock with car rentals is related to the semiconductor shortage discussed above and the fact that car-rental companies downsized their fleet aggressively in order to survive last year. Unlike the airlines, the industry did not receive government assistance to help alleviate the cash burn.
Rents, which are the biggest component of CPI (33%) and tends to drive inflation over longer periods, remained tame, rising 0.2% from March1. Similarly, prices for other services that are less impacted by the pandemic and carry a large weight, like medical care and education, held steady.
Source: Bloomberg, Bureau of Labor Statistics, Edward Jones calculations
What to watch to gauge whether price pressures will persist?
In our view, the imbalances between supply and demand are pandemic-related and thus are likely to prove temporary. However, even though it is not our base case, we are not dismissive of the potential for inflation pressures to persist and become ingrained. Inflation expectations and wage growth will likely be the two critical tells.
- Inflation expectations – Consumer expectations for inflation, as measured by various surveys, is an important determinant of actual inflation. If consumers believe that prices will continue to rise at a fast pace, then those expectations can become a self-fulfilling prophecy. The University of Michigan inflation-expectations survey, reported last week, showed that consumers expect prices to rise by 3.1% per year over the next five-10 years, which is the fastest pace in a decade1. Prices for food and gasoline tend to heavily influence this measure, so any easing of pressures in these two areas would help make this spike temporary, as in 2011. Nevertheless, it is a trend worth monitoring.
- Wage growth – Strong wage growth also has the potential to drive long-term inflation trends higher, a dynamic that is typically seen during periods of labor-market tightness (fast-rising wages was a key variable that contributed to the double-digit inflation of the 1970s). Since labor is the largest corporate expense, employers must increase the prices they charge for the goods and services they provide in order to maintain their profitability. The current signal from wages is not a worrisome one at the moment. While wages didn't collapse during last year's brief recession like they did after the Great Financial Crisis, wage growth is still below the levels that prevailed for most of the last four years. At the same time, productivity, or output per worker, has increased, likely because of the adoption of technology, which means that the unit labor cost, or the cost to produce one unit of output, has not increased significantly.
The chart shows median wage growth for U.S. employees. Wages have held steady despite the slack in the labor market, but are still slightly below the levels that prevailed for most of the last four years.
What will the Fed do?
- Last week's inflation surprise is only one datapoint and likely changes little from the Fed's point of view. Policymakers will probably stick to their message that they won't adjust policy based on this year's inflation spike because they view these price pressures as transitory. Instead, they are laser-focused on a broad and inclusive recovery in employment, which so far is a long way from being accomplished. However, if inflation pressures persist in the fall and beyond, the argument that they are transitory will be dented, and at that point inflation could force the Fed's hand. We will stay tuned, but we think that the Fed will continue to emphasize its commitment to keeping policy loose for an extended period to support the recovery.
What are the investment implications?
- Markets have traveled a long way since the new bull market emerged a little more than a year ago, with the S&P 500 rising 78% and recording 46 all-time highs1. It is possible that higher inflation readings in the summer months could be the spark for higher volatility and a market pullback. However, given our outlook for strong economic and earnings growth, and given our assessment that the inflation story so far is all about the reopening and pandemic-related distortions, we would view any pullbacks as an opportunity to add stocks at lower prices. With the market now transitioning, in our view, from the early recovery to the midcycle phase, we recommend focusing on quality while recalibrating return expectations lower.
- Slow economic growth and very low inflation were two key characteristics of the last economic expansion that lasted more than a decade. With the labor market healing faster than in prior periods of labor-market stress, consumer balance sheets staying healthy, and the Fed being more tolerant, along with higher levels of inflation to make up for past shortfalls, the last decade's trends could partly reverse. Faster economic growth and higher inflation tend to benefit cyclical sectors, such as financials, industrials, energy and materials, which have so far led the market gains this year. We think this trend can continue, and we expect economically sensitive, value-style and international investments to perform better than they have in recent years.
- Periods of rising inflation typically overlap with periods of rising bond yields. The path of least resistance for long-term rates is higher over time, in our view, as economic growth accelerates and the slack in the labor market is eliminated. While this is not an easy environment for bondholders, we believe that bonds still provide diversification benefits, smoothing out returns during times of equity volatility. We recommend owning an appropriate allocation of investment-grade and high-yield bonds that are less sensitive to interest-rate movements, especially when earnings rise and the economy expands.
Sources: 1. Bloomberg, 2. Bureau of Labor Statistics
Weekly market stats
|Dow Jones Industrial Average||34,382||-1.1%||12.3%|
|S&P 500 Index||4,174||-1.4%||11.1%|
|10-yr Treasury Yield||1.63%||0.1%||0.7%|
Source: FactSet, 05/14/2021. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * Source: Morningstar, 4/18/2021.
The Week Ahead
Important economic data being released next week include existing home sales, and the PMI index.
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