Each week, we present our featured topics in the context of the major themes from Nuveen’s most recent global investment outlookOpens in a new window:
- U.S. economy: Recession has become a 50/50 proposition by the end of next year.
- Global economy: High commodity prices threaten emerging markets and energy importers.
- Policy watch: Central banks are tightening but now risk going too fast, too far.
- Fixed income: Corporate credit and municipal bonds offer some recession protection and compelling value.
- Equities: Too soon to call a market bottom with recession risks looming, but U.S. growth stocks have cheapened a lot.
- Asset allocation: Plenty of opportunities for investors with a tolerance for volatility.
Quote of the week:
"Number nine, number nine, number nine, number nine…" – Revolution 9, The Beatles
Looking at inflation (from both sides now)
Last Tuesday, the day before the Bureau of Labor Statistics released the Consumer Price Index (CPI) reading for June, a fake report showing a 10.2% rise in headline inflation began circulating.
The good news is that the bogus number was wrong. The bad news is that it wasn’t all that far from the actual result of 9.1%. This level exceeded forecasts of an 8.8% jump. It also marked the highest year-over-year headline rate since November 1981. The leading culprits were price increases for energy (+41.6%) and food (+10.4%), with each hitting multi-decade peaks.5
“Core” CPI, which strips out volatile food and energy costs, was up by a lower, but still elevated, 5.9% over the past 12 months. Much of this year-over-year result was driven by an unusually large spike in rents (+0.8% in the month of June alone).6 Rent inflation is always among the most persistent, or “sticky,” of the major inflation categories, because the supply of rental properties tends to edge up relatively slowly in response to heightened demand. And rents could rise even further amid increased demand from prospective homebuyers priced out of the market by steeper mortgage rates and lofty home prices.
One segment of June’s CPI report shocked us: prices for durable goods — big-ticket items designed to last at last three years — didn’t drop. Recent spending data has shown consumers increasingly cutting their spending on large goods and opting instead for services, but that shift has not yet been reflected in goods price deflation. Aside from televisions, whose prices continued to slump, and airline fares, which retreated somewhat after surging in the spring, June’s CPI print offered little evidence that the easing demand and improving supply seen in other parts in the economy are causing prices to pause or fall.
Because the Federal Reserve now unofficially sees its job as bringing down both core and headline inflation, the recent run of dramatically rising prices will likely prompt the Fed to raise interest rates by more than it had previously planned. A hike of 75 basis points (bps) was already priced into the market before June’s report was released, but investors now see at least some chance that the Fed will hike by 100 bps when it meets on July 27. We believe the fed funds target rate could top 3.5% by the end of this year or in early 2023. That would increase the risk of a significant economic slowdown, or even a recession, sometime in the next several quarters.
While the CPI report was a most unwelcome reminder of how hot inflation has been running, forward-looking signs point to prices moderating. This is evident in market-based measures of inflation expectations such as “breakeven rates” in the Treasury Inflation-Protected Securities (TIPS) market, which have been falling sharply. According to this indicator, as of July 11, investors expect inflation to average just 3.6% over the next year — about 2% lower than they anticipated in mid-June.7
This one-year TIPS “crystal ball” is correlated with oil and gasoline prices, which have been dropping along with prices for almost all other commodities over the past month or so. Because of timing, these declines were not captured in June’s CPI release. Instead, they’ll feed through to July’s inflation data and likely cause the U.S. headline number to come in below the core reading — at least temporarily.
Why are inflation-sensitive assets like TIPS and commodities underperforming even as inflation spikes? Because they also tend to be sensitive to weaker economic growth and central bank tightening designed to bring about disinflation.
A major macro theme from our 2022 Midyear OutlookOpens in a new window is that every economic data point is being viewed through the prism of how central banks will respond to it. Last week’s market movements tell us that investors believe June’s CPI raised the chance of a U.S. recession because of the Fed’s likely decision to amp up its rate hikes and, in turn, borrowing costs.
Even in light of the distressing CPI report and increasing market concern about recession risk as reflected in TIPS breakevens and commodity prices, other data gives us reason to be optimistic that inflation will ease from here.
For starters, it’s rare for inflation to rise without an increase in wage growth. And despite a tight labor market marked by low unemployment, wage gains as measured by average hourly earnings (AHE) have been steadily decelerating this year, even as core inflation has picked up steam. Further moderation in AHE growth might persuade the Fed that at least one key threshold for disinflation is being met. This might offer Chair Jerome Powell and his colleagues a potential opportunity to slow down (or perhaps pause) its aggressive rate hikes.
Also, consumer spending is softening, as households have largely exhausted their savings built up earlier in the pandemic. That suggests to us that the demand side of the inflation equation is melting away, leaving supply shortages in areas like housing and energy as the key drivers of higher prices. Are those shortages dissipating quickly enough to bring down inflation without a recession? We think that’s a close call, but the outlook merits more optimism than the June report seems to provide.