Coming in Hot

The Monthly Five Author Avator

Katie Nixon, CFA, CPWA®, CIMA®

Chief Investment Officer, Northern Trust Wealth Management

May 14, 2021

Your Questions Answered

This week’s focus was squarely on inflation, with both consumer and producer price increases in the U.S. surprising to the upside. April headline and core (ex-food and energy) consumer prices (CPI) rose 4.2% and 3% year-over-year, respectively, and the Producer Price Index (PPI) gained 6.2%.

So, are we concerned about inflation? And what does it mean for financial markets and investment portfolios? Below are five insights that provide greater context around the higher-than-expected April readings, our short- and long-term view on inflation and implications for your portfolio.


Is it All About the Base?

In some ways, we should have expected this expected outcome. Much of the increase in year-over-year inflation is a function of the base effect — comparing against such significant declines last year. If we think back to a year ago in April, economies were shut down all over the world. Economic activity came to a standstill, and inflation fell as a result. Fast-forward to present time, and data over the last few weeks — both macroeconomic data, like the non-farm payroll miss last week, and commentary from company management teams indicate a growing supply-demand mismatch.

More specifically, the base effect contributed an estimated 2.4% to the headline CPI reading of 4.2%. Looking at the 2020 trends, it seems that the base effect will peak in May when year-over-year CPI in 2020 was barely positive at 0.1%. But this impact will quickly dissipate as we get past mid-year, particularly into the fourth quarter when comparisons will be far less difficult.


Supply constraints:

The impact of supply constraints was meaningful in the inflation data. We shut the economy down with a veritable light switch, but the re-opening is proving to be more challenging as we observe different patterns of supply coming back online against robust and broad-based demand. It will take some time to re-start the supply engines — recruiting, hiring and training employees and firing up assembly lines — and with suppliers of all types attempting to re-start simultaneously, it is inevitable that short-term bottlenecks will occur.

This is certainly what we are seeing now, with some additional complications within certain discreet supply chains. In particular, the global semi-conductor shortage is impacting a wide variety of industries, all of which rely on these silicon wafers to manufacture consumer electronics and automobiles, for example. We anticipate that this shortage will continue to exert downward pressure on production and upward pressure on prices for the next few quarters, but that ultimately, the bottlenecks will ease as certain exogenous events, such as weather-related disruptions to manufacturing, subside.

We also expect the labor supply constraint to ease as well, given the new, more relaxed CDC guidance for mitigation measures, along with the announcement by the head of the National Teacher’s Union, Randi Weingarten, that schools will reopen, in person, this fall. Combined with enhanced unemployment benefits expiring in September, these variables should alleviate the labor supply constraint reflected in the most recent monthly jobs report.


Why it matters?

We are going to continue to hyper-focus on inflation for the foreseeable future, because it matters: Inflation and inflation expectations impact consumer behavior, and they impact monetary policy. In the current context, inflation may also impact fiscal policy.

From a consumer perspective, we are seeing inflation concerns. The recent University of Michigan consumer confidence index fell to 82.8 from 88.3, a surprise given the economic rebound and the lifting of many COVID-19-related restrictions. Looking under the hood, a key driver of the decline was inflation expectations, which rose to 4.6% — the highest in a decade. The very concern about inflation can pull forward economic demand and actually exacerbate the inflationary trend. In addition, without commensurate wage increases, it can signal a falling standard of living.

From a monetary policy perspective, the Fed has a dual mandate: maximum employment consistent with inflation at or around the target of 2%. Although the mandate has been redefined post-COVID-19 to allow for more upside to both employment and inflation, it is unlikely that the Fed would be able to ignore sustainably higher inflation for an extended period of time. In the past, the Fed has tightened policy in order to control inflation, and this tightening of financial conditions can have negative implications for both the real economy and the capital markets as equity investors start to price in a slower economy and bond investors demand a higher inflation premium.

And last, on the fiscal front, it may prove more difficult for President Biden to garner the support needed for the two infrastructure packages on his agenda in a period of significantly rising inflation.


What will Central Banks Do?

It is important to note that the higher-than-average current inflation data is a global phenomenon. We see it in the U.S., but also across Europe and in China. And we are not seeing central bankers react to the data, and from the Fed and ECB in particular, we hear a continued call for patience.

We think it will take multiple months, and even quarters, for the Fed to have enough confidence in the outlook to change the current stance of monetary policy, with signals for a potential taper coming first and changes to the Fed funds rate coming last. The ECB will likely welcome higher inflation prints for an even longer time, given that the gap between realized and policy target inflation is even wider than in the U.S.

In short, much time remains before we return to the intended policy trend line with confidence. Central banks remain confident that they have the adequate tools to fight inflation if they are wrong in their “transitory” assessment — that they can tighten policy quickly and significantly. The overriding message is that the downside of changing policy too soon is too great to take that risk, given the toolset at play.

So far, the market agrees: Despite the “hot” inflation prints, 5- and 10-year inflation breakeven rates (the market-based expectation for inflation over the next 5 and 10 years) have fallen this week to 2.71% and 2.51%, respectively — still elevated relative to recent history but well contained in the context of the data. Also, it’s important to note that the 5-year rate is higher than the 10-year rate, again signaling that the market believes that inflation pressures will abate over time. We also see the Treasury market taking the data in stride, with an initial knee-jerk jump in rates proving short-lived.


How we think about it:

First, this is a time to be humble. We have our base case and remain confident in our longer-term outlook that the structural headwinds against perpetually higher inflation will prevail, but we are in uncharted territory with ample uncertainty and potential for more upside surprises.

As noted in last week’s The Bottom Line, your portfolio is likely already positioned well for a modest period of higher-than-average inflation. Global equities have proved positively correlated with inflation (to a point), and we are hearing from corporate management teams that they are able to either absorb the higher costs, given strong margins, or pass on marginal price increases to consumers to maintain profitability. Earnings strength will support equities, and the magnitude of the earnings growth expected this year and next can absorb some valuation contraction and still leave investors with positive returns.

Also, you likely own equites in the natural resources sector — either through an overt allocation or within your diversified index or actively-managed equity portfolio. These assets also tend to have a positive correlation to inflation, and perhaps even more importantly, have a positive correlation to unexpected rises in inflation.


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