Coming in Hot

Nearly everyone, including the Federal Reserve, is probably tired of hearing about inflation, but let’s talk about it anyway. It does look like the consumer price index (or CPI) peaked in March. That is the good news. The bad news is that it did not show the kind of deceleration that investors were hoping for with headline inflation falling from 8.5% to 8.3% (versus consensus expectations of 8.1%). We doubt that the April consumer price index has created the case for a substantial stock market rally from here, but it may have helped to calm things down a bit with the S&P 500 rising about 3.3% and the NASDAQ up 5.4% in the two days following the report. Perhaps more importantly, the MOVE index, a measure of bond market volatility, has been falling since the start of May (see figure 1). For additional insights on why we believe the forward returns on U.S. Treasuries have improved, please see our, “CIO Strategy Bulletin | Understanding Markets and Inflation.”

This chart shows the U.S. Bond Market Volatility (or MOVE) Index versus the percent of Nominal U.S. 10-Year Treasury Yield from 2020 to 2022 year-to-date.

When it comes to inflation, the CPI is still showing some unusual distortions that should normalize over time. The category with the highest month-on-month rise was unsurprisingly airfares, which jumped 18.6% in April, as travel has surged with covid restrictions being removed throughout most of the country. The category with the second highest prices was eggs. With food inflation at a record high, it is not surprising to see a food category near the top (see figure 2), but it may have less to do with supply chain issues and more to do with the current strain of bird flu that is lowering the chicken population (less chickens, less eggs). While those trends shouldn’t last, the downside is that shelter prices were up 0.6% during the month and that trend may remain in place for several more months as the shelter prices component of the CPI lags national home prices by about a year (see figure 3).

This line chart shows Select Consumer Price Index Categories (Month-on-Month Percent Change). Data shown indicates Airline Fare at 18.6%, Eggs at 10.3%, Meats, Poultry, Fish and Eggs at 1.4%, Fuels and Utilities at 1.2%, New Vehicles at 1.1%, Pets, Pet Products, and Services at 0.9%, Food at 0.9%, Shelter at 0.5%, Cigarettes at 0.5%, All Items at 0.3%, College Tuition and Fees at 0.2%, Prescription Drugs at 0.0%, Used Cars and Trucks at -0.4%, Apparel at -0.8%, and Gasoline at -6.1%.

This line chart shows National Home Prices versus the Consumer Price Index of Owner’s Equivalent Rent in percent year-over-year from 2000 to 2020.

Fortunately, we are entering a period of easy inflation comparisons with the consumer price index having risen by over 0.8% in April, May, and June of 2021. That means we should see headline inflation continue to fall for at least the next three months with inflation potentially nearing 6.5% by year-end and 3.5% by the end of 2023. Still above the Fed’s 2% target but headed in the right direction.

Will Falling Inflation Change the Fed’s Trajectory?

Probably not immediately. Fed Chair Powell said last Thursday that, “the one thing we really cannot do is fail to restore price stability...the economy doesn’t work for anybody without price stability.”¹ Given the Fed’s current rhetoric, it seems almost assured that the Fed will raise interest rates by 50-basis-points for at least the next two meetings (June and July). Beyond that, we could see a pause or perhaps a move towards 25-basis-point rate hikes. The September FOMC meeting may prove to be a critical meeting with its results potentially determining whether the Fed will be able to pull off an optimistic “soft landing” for the U.S. economy.

While all eyes are on inflation right now, it may be the state of the labor market that proves more important come year-end with weekly initial jobless claims an official component of the leading economic indicators index. Currently, just 1 out of 1,000 working age people are filing claims for unemployment insurance (see figure 4). However, initial jobless claims tend to bottom about 13 months before the onset of recession with the longest lead time being 22 months (see figure 5). If we assume that claims bottomed on March 19th 2022 at 166,000 (see figure 6), then the most likely timing for a recession would be April 2023 to January 2024.

This line chart shows the Number of Working Age People Filing for Unemployment Insurance from 1968 to 2023 year-to-date.

This line chart shows U.S. Initial Jobless Claims versus Periods of U.S. Recession from 1958 to 2023 year-to-date.

This line chart shows the U.S. Initial Jobless Claims in thousands from June 1, 2021 to June 1, 2022 year-to-date.

In the past eight recessions, initial jobless claims rose by about 57,000 off their bottom before the U.S. economy entered a recession (the highest climb before entering a recession was 105,000 claims in 1979). If we use that range, then initial jobless claims between 223,000 and 271,000 might imply we are nearing a recession. Right now, weekly claims are at 203,000. This is just one metric to watch, but we think it’s probably a good one to keep an eye on. If something is going to give the Fed some pause, it will most likely be job losses (see figure 7).

This line chart shows the U.S. Effective Federal Funds Rate versus the Unemployment Rate from 1955 to 2025 year-to-date.

Our Tactical Asset Allocation Remains Defensive

Our global equity overweight is largely in commodity hedges like natural resources, oil field services, and other defensive equities like dividend growers. We also believe that investors may wish to consider adding long-duration Treasuries (such as the 30-year U.S. Treasury) with yields likely to peak in 2022. We think that this type of defensive portfolio tilt will remain appropriate until growth fears fade. For additional portfolio insights, please see our Quadrant | The Late, Late, Late Fed Show.

What Should U.S. Investors Watch in the Week Ahead?

In the week ahead, investors will receive the April retail sales report which will provide a fresh look at the consumer with the consensus calling for sales to rise by 1.0% in April. Also on the economic calendar are U.S. industrial production and housing starts. Aside from retail sales, we suspect the big event of the week may be a Wall Street Journal interview with Fed Chair Powell on Tuesday.

¹ https://www.marketplace.org/2022/05/12/fed-chair-jerome-powell-controlling-inflation-will-include-some-pain/

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