Inflation is Here. Will it Stay for Dinner?

Third quarter earnings season kicked off in earnest last week with several of the big banks reporting. The first six of the banks to report beat expectations with adjusted earnings-per-share (EPS) besting expectations by an average of 17%. Revenues beat expectations by about 2.7%. Interestingly, Financials slightly underperformed the broader market last week, but that likely reflects the 10-year Treasury yield coming down from 1.61%% at the start of the week to 1.51% by last Thursday. It’s a bit weird to see both stocks and bonds rallying at the same time, but this is likely due to technology stocks’ sensitivity to interest rates. When yields come down, technology shares have been rallying and that brings up the headline index. Last week, Technology shares rallied 2.6% while Financials gained 1.2%.

U.S. retail sales came in stronger-than-expected in September. The headline index jumped 0.7% (vs. a consensus expectation of -0.2%). Sales in August were also revised upward to a 0.9% gain. While the delta variant and supply-chain issues have likely caused consumer spending to come down significantly from its 12% annualized pace in the second quarter, the report showed that demand for goods remains resilient.

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The debate rages on with surging energy prices adding literal fuel to the fire that inflation may prove to be more persistent than initially hoped for. As a result, financial markets have pulled forward their expected timing for the first Fed rate hike from December 2022 to September 2022. There is no denying that inflation is here with the Consumer Price Index (CPI) now 5.4% higher year-on-year as too much demand chases too few goods. This is not a surprising dynamic given the large swaths of the global economy were literally shutdown and then reopened, but the key question for investors is just how long this higher rate of inflation will last. To our knowledge, literally no one has a fully functioning crystal ball, but we will still try to project what may happen moving forward based on the current information available.

The short answer is that we think elevated inflation will stay for dinner but may not be a permanent house guest. In terms of inflation data, last week’s data releases were sort of a mixed bag. The Consumer Price Index (CPI) came in hotter-than-expected – rising 0.4% month-on-month and the year-on-year rate ticking up slightly from 5.3% to 5.4%. Core CPI, which excludes the volatile food and energy categories, stayed elevated at 4.0%. While some pandemic distortions like the spike in used car prices are starting to normalize, coming down from up 45% year-on-year in June to up 24% year-on-year in September, those declines are being at least partially offset by rising home prices. Owner’s equivalent rent of their primary residence (OER), which is the CPI’s version of home prices, has been climbing over the past few months with prices climbing from about 2.0% higher year-on-year in March to 2.9% higher year-on-year in September. This may not sound like a major rise, but the OER component of the CPI carries about a 22% weight in the CPI – making it an extremely important component. It is also one of the stickier components with prices usually rising or falling over a lengthy period instead of the rapid up and downs often seen in energy prices (see figures 1 and 2).

This line chart shows consumer price index owner’s equivalent rent of their primary residence year over year percent change from 1986 to September 2021.

This line chart shows consumer price index of gasoline, year-over-year percent change from 1986 to September 2021.

Importantly, the OER component of the CPI is not the same as traditional home prices measures with the Consumer Expenditure Survey asking consumers who own their primary residence: “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” As such, it is not going to reflect the 21% rise in national home prices over the past year as measured by the Case-Shiller Index. It will, however, likely follow the same pattern with the Case-Shiller Index leading the OER component by about one year (see figure 3). While it is not hard to imagine a scenario where inflation falls back into a range of maybe 2.0%-3.0% by late 2022 with consumer prices excluding food, energy, and shelter prices already falling steadily since mid-June, it is possible that inflation will continue to overshoot the Fed’s 2.0% target well into 2022 (see figure 4-5).

This line chart shows the Case-Shiller national home price index versus the consumer price index owner's equivalent rent of primary residence, year over year percent change from 2000 to September 2021.

This line chart shows consumer price index excluding food, energy and shelter, year over year percent change from 2000 to September 2021.

ISMInstitute for Supply Management manufacturing (20% weight) and services (80% weight) versus core inflation metrics year-over-year with an 18-month lag, from 1998 to September 2021. Inflation metrics are likely to stay elevated heading into 2022.

This more persistent inflation narrative has caused investors to price in a slightly more aggressive Fed with lift-off (or the first rate hike) being pulled forward from December 2022 up to September 2022. This led some investors to question whether the U.S. is headed towards a stagflation-like scenario where the Fed needs to act fast in order to squash inflation which could in turn lead to slower economic growth. The term “stagflation” is clearly not the right term to use as it is often used to describe a period of rising inflation and rising unemployment. Unemployment is clearly in decline and economic growth is likely to remain above trend in the year ahead once supply chain issues ease and supply and demand reach a new, likely above-trend, equilibrium.

There Are Plenty of Signs that Demand Remains Solid

Although the Wall Street Journal Economic Survey’s consensus forecast for third quarter 2021 real gross domestic product (GDP) has been revised down to an annualized rate of just 3.1%, the consensus also expects growth to rebound in the fourth quarter with a better 4.8% annualized print as activity picks back up. For full year 2021, the consensus envisions 5.2% real GDP growth on a 4Q/4Q basis and a still above-trend 3.6% real GDP growth rate for 2022. The consensus sees inflation dropping from a rate of about 5.3% at year-end 2021 to a rate of about 2.6% by the end of 2022. This type of scenario is far from what would typically be called stagflation or stagnation. We tend to agree with these forecasts with numerous data supporting this resilient demand thesis. Just 4.0% of small businesses are saying that their number one problem is poor sales, September retail sales came in above market expectations, the U.S. labor market has 2.8 million more jobs available than the number of unemployed, jobless claims dropped below 300,00 last week for the first time since early March 2020, CEO confidence remains elevated and suggests a strong earnings outlook, and Citi’s economic surprise index had been trending upward since early September.

With the Fed likely close to a year away from its first rate hike and six rate hikes away from where the fed funds rate stood at the start of 2020 (see figure 6), we think that the economy likely still has a lengthy runway ahead of it. Importantly, neither the yield curve nor leading economic indicators suggest that a U.S. recession is approaching (see figures 7-8). Instead, we are likely seeing a normalization of the U.S. economy as the worst of the global COVID-19 pandemic appears to be fading. As such, investors should expect both monetary and fiscal policy to normalize as the patient prepares to finally leave the hospital and stand on their own. While investors are unlikely to see a repeat of the strong returns between 2019 and 2021, equity investors will likely still be rewarded for taking on risk in the year or two ahead as the economy transitions into a more traditional mid-cycle phase (see figure 9).

This line chart shows the federal funds rate hikes between 2012 and September 2021.

This bar chart shows the U.S. yield curve (10-Year minus 2-Year) & length of time between Inversion and recession from 1958 to September 2021.

This line chart shows the leading economic indicators Index year-over-year percent change versus periods of US recession from 1960 to September 2021.

This bar chart shows the S&P 500 annual total returns in percent for 2019, 2020 and 2021 year to date.

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