The delivery of the expected inflation rise
Last week, the much-anticipated rise in inflation finally came through in the numbers. Now, we all expected a rise in inflation, for the reasons I have discussed previously, but the quantum of the rise gave investors a surprise.
US April CPI surged by 0.8% month-on-month, well above market estimates of 0.2%. The core metric, excluding volatile food and energy prices, posted a 0.9% monthly spike (estimates were for 0.3%), the largest monthly gain since 1982.
On a year-on-year basis, CPI increased from 2.6% in March to 4.2% in April, well above expectations of 3.6% year-on-year. Core inflation jumped to 3.0% year-on-year from 1.6% in March, the highest pace since 2008 and above market expectations of 2.3%.
Although the market was taken aback by the strength of the CPI numbers, we must bear in mind that it is just one data point and might be an outlier. Comments by US Federal Reserve Vice Chair Richard Clarida reflected this sentiment, he noted:
"This number was well above what I and outside forecasters expected", but that "Honestly, we need to recognize that there’s a fair amount of noise right now, and it will be prudent and appropriate to gather more evidence".
He also stated: "under my baseline outlook, these one-time increases in prices are likely to have only transitory effects on underlying inflation, and I expect inflation to return to-or perhaps run somewhat above-our 2 percent longer-run goal in 2022 and 2023".
So, the Fed is sticking to the script. Markets, however, are jittery and have begun to wonder whether the Fed is behind the curve and if the inflation genie might already have been let out of the bottle.
However, our friends at BCA research agree with the comments around “noise” in the data as the pandemic caused an unprecedented supply chain shock across multiple industries, throwing “all sorts of prices out of whack”. They argue that other measures of US inflation show that it is, in fact, well contained:
Slack in the US economy
The biggest argument against runaway inflation is that there is still plenty of slack in the US economy and that, as result, workers will not be able to negotiate higher wages. This in turn, keeps a lid on purchasing power and the ability for companies to pass through higher costs.
Some measures of wage growth, such as the Atlanta Fed Wage Tracker, also indicate little upward pressure on wages:
Keeping the economic growth strong
These factors mean that the Fed should be able to afford to keep monetary policy extremely accommodative which should, in turn, keep economic growth strong and support equity markets. Nonetheless, inflationary risks are certainly to the upside, as discussed in my last note, so we must remain vigilant.
Turning now to economic growth, I briefly mentioned last time that it is likely that economic growth in developed economies is peaking and may slow in the second half of the year. The following table shows growth expectations from a Bloomberg survey of economists:
We can see that economic growth has, according to the economists surveyed, peaked (at very high levels) and will fall over the coming 18 months.
So, what to do in portfolios?
So, what to do in portfolios? Well, the tension between potentially higher inflation but falling economic growth isn’t a good recipe for equities. On one hand, higher inflation and higher growth favour economically sensitive areas of the market which have performed very well since November of last year. One the other hand, if this bout of inflation is indeed transitory and growth falls, as expected, then this would favour more defensive areas of the market.
Regular readers can guess what is coming next. We try not to get involved in timing the outperformance of one part of the market over another. Instead, we rely on our tried and tested processes for both fund manager selection and portfolio construction. These ensure that we have managers who have been able to navigate difficult market well and that portfolios are well diversified across investment style (cyclical and defensive), size of company and industry.
Similarly, within bonds, we spend a great deal of time ensuring that the managers employed have demonstrable track records of being able to successfully navigate markets through the entire economic cycle.
For the time being, we are inclined to believe the Fed’s outlook for inflation and not to worry too much about runaway inflation in the immediate future. Nonetheless, as I have mentioned above, risks are to the upside and we are watching the data very closely indeed.
Until next time, stay well.