Hot inflation sends chills down financial market spines

Each week, we present our featured topics in the context of the major themes listed below from Nuveen's 2022 Outlook:Nuveen's 2022 Outlook

• U.S. economy: No recession this year, although market risks persist.
• Global economy: Both headline and core inflation likely peaked in March.
• Policy watch: Fed signals aggressive tightening, but we think fewer rate hikes will be needed.
• Fixed income: Strong credit fundamentals and attractive valuations favor taking credit risk over duration risk.
• Equities: Despite further bouts of volatility ahead, equity returns should be positive for 2022 as a whole.
• Asset allocation: We’re leaning toward “risk-on” positioning. Rebalance prudently.

Quote of the week:

"Hope is being able to see that there is light despite all the darkness."  –  Harvey Milk

Inflation: None like it hot

Inflation-weary investors were right to worry about May’s U.S. Consumer Price Index (CPI) release. Led by rising food and energy costs, headline CPI leaped 1% last month (versus expectations for 0.7%) and 8.6% year over year — the largest 12-month increase since December 1981. Core CPI (+0.6% in May), which strips out food and energy costs, also topped forecasts (+0.5%), with rent, cars and airfares contributing significantly. The year-on-year change in core inflation decelerated to 6%, but that will be cold comfort for consumers, investors or policymakers.⁴

Some good news came in the form of broad-based deflation in many core goods. Television prices, for example, are falling at an accelerating rate, a sign that demand is diminishing at the same time supply chain gridlocks are easing to some degree. But the drop in TV prices was offset by last month’s increases in the cost of automobiles, both new (+1.1%) and used (+1.8%).⁵ Autos seem to be the one significant durable good for which a reversal of last year’s price hikes remains elusive.

More concerning was the climb in shelter costs — specifically rents, but also hotel room rates, as more people opted to spend their savings on vacations rather than on buying “stuff." Perhaps not surprisingly, airfares jumped 12.6% in May after increasing 10.7% and 18.6% in March and April, respectively.⁶ Much of that ticket uptick was due to higher fuel costs, but heightened demand for travel also played a major role. That demand is evident as more people hit the road with the advent of warmer weather, which likely means continued pain at the pump will be the main contributor to depressed consumer (and investor) sentiment. Lastly, while not as prominent in the headlines, services sectors have supply bottlenecks to contend with, as well — chiefly the challenge of hiring workers and, in the case of airlines, finding enough pilots and other airport personnel.

Despite the Federal Reserve’s pledge to bring inflation under control (i.e., in line with its 2% target), there’s actually little it can do to subdue food and energy costs. (More on the Fed below.) Raising interest rates can help reduce prices by stifling aggregate demand growth, but the Fed has no lever to pull for boosting supplies of food or energy, both of which have been severely diminished by the war in Ukraine. So the Fed remains focused on what it can control: the level of short-term interest rates, with the hope that hiking them will tighten financial conditions enough to dampen demand (and therefore reduce inflation) without sending the economy into a recession.

Economic data and Fed watching go hand in hand

One clear market trend in 2022 is that new economic data is instantly processed through the prism of how the Federal Reserve might react to it. In turn, of course, the Fed’s policies — both rhetorical and action-oriented — influence the economy. This cause and effect can lead to unexpected situations in which better-than-expected results — like employers adding 390,000 payrolls in May — can lead to down days for the stock market because investors fear the Fed may have to tighten further to slow the economy. (Indeed, the S&P 500 fell 1.6% on June 3, the day May’s strong jobs report was released.⁷)

It’s not that the Fed is “allergic” to good news. Rather, it wants to restore balance to sectors of the economy in which conditions deviate significantly versus long-term trends. For example, demand continues to dwarf supply in the labor and housing markets, adding to inflationary pressures that squeeze corporate profit margins, hurt consumers and threaten the economy. (Inflation in employment data comes in the form of wages that companies must pay to attract and retain workers.)

Against that backdrop, the Fed will meet on June 15 to discuss the current, and unusual, state of the U.S. economy. Here’s what we’re expecting from Chair Jerome Powell and his colleagues this week:

• Another 50 basis points (bps) rate hike to help cool inflation.
• A “dot plot” showing between 125-200 bps of further rate increases by year-end, demonstrating the Fed’s commitment to stay on the tightening track.
• Economic outlooks backing up this continued hawkish stance. In particular, we anticipate a forecast for hotter year-over-year PCE inflation than the Fed called for in March — i.e., up from 4.3% for headline and 4.1% for core (the Fed’s preferred barometer), which excludes food and energy costs.⁸

The GDP outlook for the year, however, will likely be revised down from 2.8%, given (1) the ongoing impact of the war in Ukraine, which has helped keep energy prices aloft and (2) negative GDP growth (-1.5%) in the first quarter.⁸

Inflation is sure to take center stage, especially at Powell’s post-meeting press conference. Until the Fed feels inflation is under control, and supply/demand dynamics in sectors such as housing and employment are more in line with history (that is, behaving more “normally”), equity markets may struggle to find a foothold, and interest rates may rise further.

Investors seeking an “all-clear” sign to ratchet up portfolio risk will want evidence that the Fed is steering the economy toward a “soft landing” — avoiding recession that often follows aggressive monetary tightening. While no single signal exists, we’ve assembled a checklist for a “normal” economy, one operating with annualized monthly inflation below 3% (within sight of the Fed’s 2% target):

• Job creation in the 150,000-200,000 per month range. (Over the past 12 months, the economy has averaged 545,000 new payrolls per month.⁹)
• Modest but positive real income growth, which has been negative or flat in recent months.
• A lower ratio — not necessarily 1:1 — of job openings to unemployed workers. (As of April, the ratio was 1.9.¹⁰)
• Annualized home price appreciation below 10%. (According to the most recent data from the Case-Shiller 20-City Composite Index, home prices rose 21% year over year in March.)

The key for markets this week will be how close the Fed thinks the economy is to achieving some or all of these goals, and how much more tightening it believes is needed to reach them. Hawkish Fed meetings have been sources of considerable volatility over the past year. That trend may well continue come Wednesday.