Broker Check
What’s The Buzz – Inflation

What’s The Buzz – Inflation

April 25, 2024

The most important Consumer Price Index (“CPI”) print in recent memory (at least until April) came in hotter than expected (again) last Wednesday which resulted in the repricing of bonds and risk assets with only oil and the dollar left unscathed. Small company stocks and long dated Treasuries got punished the most; traders have re-priced assets for few, if any, rate cuts in 2024.

CPI (year-over-year) averaged 2.7 percent since 1990, 2.2 percent during the period January 2000 through the beginning of COVID-19 (3/31/2020), averaged 2.6 percent from January 2000 through March 31, 2024. As a result, we can loosely say that CPI inflation averages 2.5 percent over the longer-term. March headline CPI rose 3.5% year-over-year vs 3.4% expected, up from 3.2% in February.March core CPI (ex-food and energy) was even higher at 3.8% (long-term average is also approximately 2.5 percent). Bloomberg reported that the core CPI gauge has risen 0.4% for three straight months: the hottest string of month-on-month price increases since early last year.

Wholesale prices (PPI) have fallen harder than CPI from the Covid era peak but have also been increasing this year as seen in the chart below. March PPI came in at 2.09% YOY growth. The market just got four consecutive inflation “beats” in a row - remember when inflation was transitory?

Rents, gasoline, and auto insurance are mostly to blame for sticky inflation and ballooning consumer credit card balances – gas prices don’t show any signs of letting up in April. Auto insurance was strikingly up 22% year-over-year for March. The inflation data suggests 23-year highs in interest rates haven’t done anything to slow labor markets and consumer spending, in other words rate increases have not significantly affected demand.

The primary culprit of the persistent CPI is an index component that no one actually pays or seems to understand called homeowners’ equivalent rent or (“OER”). In the below core CPI breakout, core services prices (seen below in yellow) are ticking up. The driver of core services is OER, which isn’t paid by anyone; it is a hypothetical metric developed by the Bureau of Labor Statistics (BLS) to estimate housing costs for people that own their home in addition to landlord surveys on what they charge renters.

Overall shelter accounted for over 60% of the total 12-month increase in core prices. Analysts at Morningstar foresee rent costs cooling in the coming months as supply and demand begin to find their equilibrium. Shown below (in green) it is clear how dominate OER has been in pushing up shelter costs since 2021. The Fed must figure out how to reduce shelter costs in order to reach their goal of 2% core inflation – market forces may do it for them.

Persistent inflation has pushed the 10-year Treasury yield to 4.63 percent, its highest since November 2023 when the Fed signaled their “pause”. The ten-year yield was as low as 3.79 percent in late December 2023. Higher yields have direct ramifications for fixed income investors: bond indices have drastically underperformed stocks as yields have trended upwards on the back of strong economic growth and consumer spending.

Risks

Fed Chairman Paul Volker had to pull the economy into recession twice in the early 80s to beat inflation. While we acknowledge the inflation of the 70s is different than the sticky inflation post-Covid, the tightrope the Fed is walking is getting skinnier. The Fed today under chairman Powell risks reigniting Covid era inflation by cutting rates too soon. If we see inflation accelerate, the Fed could hike again; on the other hand, if we see the labor market recede and help usher in a recession the Fed would certainly have to cut. We are running the risk of having to go into recession to beat inflation, much like we experienced in the 1980s – there is no indication of that happening soon.

Summary

While there are a few signs of moderate economic weakness, there has not been any strong signals of weakness or recessionary symptoms yet: stocks are rising, the consumer is strong, the dollar is strong, employment has proved resilient, credit spreads are tight, financial conditions are loose, manufacturing is expanding (slightly), commodity prices are increasing, and we have a government that’s happy to increase the deficit for transfer payments and foreign policy. Against this backdrop the Fed wants to cut, but simply can’t; the cash rate (Fed policy rate) is going to be steady for some time, maybe one cut this year in December – traders are pricing in two cuts. We don’t think the Fed will adjust monetary policy anywhere near the election this Fall, but there is a real possibility headline CPI reaches a 4% and the 10-year flirts with 5% this year if the strong consumer accelerates inflation by their spending.

We do not believe that this is the time to add duration risk to portfolios. If the odds of a Federal Reserve rate cut continue to fall, we believe that duration neutral is the appropriate stance. Higher yields have been a welcome change for income seekers, and we believe this will be a coupon clipping year – as some would say, just take the carry and be happy. Short duration is working; however, we would caution staying in T-bills or money funds long term.

On the equity side, inflation and rising yields pose a threat to the AI induced large cap growth rally. Small capitalization stocks appear cheap, but the catalyst for lift off still isn’t there, the catalyst being lower rates. Appreciation in equity prices in the short term will undoubtedly be supported by earnings growth as the higher term premia in Treasurys is putting pressure on valuation multiples.



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