Central bankers think inflation has undershot medium term targets in recent years. They think inflation should be higher for a while to make up for that. The US Federal Reserve has been most outspoken in this regard. The overshoot is just beginning and arguably may be allowed to run for a while before monetary policy is tightened. Despite all the speculation about whether the current rise in inflation is transitory or permanent, the market is siding with the central banks. Yields are lower and that might signal another equity rotation from a fading cyclical/value trade back to growth.
Bond returns behind inflation in the US
By May, US consumer prices had risen by 2.42% so far this year. Annualised that and you get an inflation rate of close to 6%. The only broad US fixed income sector that has delivered a total return higher than the rise in consumer prices has been the high yield sector with a total index level return of just over 3.0%. Inflation linked bonds have delivered a return of 1.34% compared to the 2.42% rise in prices, driven by the increase in break-even spreads relative to nominal bonds and the inflation carry. The shorter end of the inflation bond market has done even better, with the 1-3 year sector delivering a total return of 2.82% year-to-date. Avoiding duration but being exposed to the inflation risk factor has been a good trade.
“’Ave you ‘eard about prices going up?”
It seems from the details of the inflation data that the rise in prices is still being driven largely by transitory price increases related to reopening and the inventory shortages that many industries are facing. This is substantiated by a mass of anecdotal evidence. If taxi drivers talked about dot.com stocks in 1999, they are discussing sand and cement shortages at the builders’ merchants today. I spent the week in Cornwall (pre-G7) and the zeitgeist is all about shortages of staff for bars, restaurants and hotels, a complete lack of available accommodation for the summer and house prices going through the roof. The UK is being impacted by the domestic reopening, pressure from the government to discourage foreign vacationing in 2021, and the Brexit impact on the labour market. The Bloomberg economists’ consensus for the UK Consumer Price Index (CPI) headline number for May (released on June 16th) is for a year-on-year rate of 1.8% - the highest since January 2020. It is likely to go higher putting the Bank of England in focus for an earlier exit from quantitative easing (QE) than other central banks.
The US CPI data show that monthly increases in the CPI this year have been 0.27% higher than the average monthly increases going back to 2001. Both April and May showed outsized increases in the index relative to the average for those months for the last twenty years. That’s alarming in one sense – it shows the extent to which prices have surprised on the upside – but reassuring in another sense in that this type of outsized increase is more likely to be transitory than a sign of a fundamental shift in inflation dynamics. I imagine that “frictional” inflation will continue to impact on the overall inflation rate for a few more months such that we are in for a fairly long period of above trend inflation in the US and elsewhere. What is remarkable, however, is if you look at the last twenty years and compare the actual consumer price index (and the core consumer price index) to a constructed index that increased at an annualised rate of 2%, there is not a lot of difference. Compared to a base index of 100 in May 2001, the US CPI index today stands at 151.3. If CPI had risen by 2.0% annually over that period, the index would be 148.6. The core index today stands at 148.5 relative to a 100 base in 2001. So, it is not clear the US inflation has undershot the medium term target of 2% over the last two decades. Taking that stance, one might conclude that the Fed won’t need much evidence of inflation being above “average” before it raises interest rates.
However, the Fed targets the core personal consumption deflation rather than the consumer price index. Using this data there has been an inflation undershoot of around 8% since 2001, 3.4% since 2012 and 0.7% since 2016. So, if we focus on the Fed’s preferred index of inflation then there is plenty of room for it to overshoot before there is any realistic change of tightening monetary policy. Clearly in the last two years, the gap has widened and policy has been set to raise inflationary expectations above the level inflation got to in the depths of the pandemic. This is the data to watch, it is less volatile than the CPI and it is the inflation gauge which drives the Fed’s medium term policy view. If the Fed wants to close the gap between average (say rolling 5-year) inflation and the 2% target, then it needs to allow inflation of the PCE deflator to run at close to 3% until the end of 2022.
No rate hikes
Is this the view the bond market is taking - inflation can be higher without the Fed tightening ahead of the timetable set out by the Fed itself? I think it is. Treasury 10-year yields have come down to 1.43% from a 1.77% peak at the end of March. They are still 50bps higher than at the end of last year. But there is no pressure to price in higher Fed rates. The market has less than one 25bps hike priced in before the end of 2022.
Cyclical momentum will fade
The world today characterised by strong growth driven by pent-up demand being spent and global supply being short of inventory and capacity. There are some frictional inflation pressures but this can be seen as part of the catch-up of the undershoot of inflation in recent years. The yield curve steepened in Q1 and, as I have argued here before, it did quite a lot given that the large historical yield curve steepening phases were partly/largely driven by Fed easing (this one clearly wasn’t). Growth has accelerated but from here the second derivate will ease back (US GDP growth is forecast at 9.2% in Q2, and 3.0% in Q2 next year).The steepest part of the recovery is now and soon will be behind us.
The read across to equities is that the value / cyclical outperformance might be over. Look at two value/cyclical sectors in the S&P – energy and financials. Both have outperformed the market with energy delivering a 2021 total return of 48% and financials 27.2% compared to the 13.6% for the market. The macro drivers are clear – the huge rally in oil prices and the steepening of the yield curve which boosts bank earnings. Oil prices are up because global oil demand is returning to pre-pandemic levels and supply has probably been impacted by COVID and shifting capex towards renewables. But what if there is discussion of a carbon tax at COP26? Can oil prices double again? I doubt it. For financials, if the US Treasury market is going to stay in a range or if yields move even lower, the yield curve momentum fades away. Meanwhile the longer term policy initiatives support thematic growth styles – clean economy and digital could be boosted by focus on G7, COP26 and the beginning of the spending of the NGEU funds (large bond issue coming soon).
A nuance to the narrative
I am not saying the cyclical trade is over. I do think, however, that the clear outperformance of value relative to growth could fade in a generally rising equity market. Bond performance has caught many offside in the last month or so and calling for even lower yields is challenging given the inflation backdrop. But rather than the end of year seeing a Treasury yield of more than 2%, the market might stay range bound. Inflation will be higher, the Fed will be ok with that for a while, and short duration inflation bond exposure will be an attractive strategy.
I can’t believe the Euros are about to start. The build-up has been rather different to other tournaments, but I do get a sense of excitement now that the games are about to begin. My family is split between England and Scotland so Friday 18th of June will be interesting. A leading investment bank has created a model that predicts Belgium will be the winners of the tournament. My heart is with England but my head, I think, is with France. If Boris Johnson delays the lifting of the remaining lockdown restrictions, at least we have le foot!