The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveen's 2021 Q2 Outlook
- U.S. economy: A strong economic backdrop bodes well for U.S. economic growth.
- Global economy: Should also surge as large developed countries sprint into the post-pandemic world.
- Policy watch: No Federal Reserve interest-rate hikes until at least 2023.
- Fixed income: Take more risk in credit-sensitive parts of the market.
- Equities: Bullish on cyclicals but looking for opportunities again in growth.
- Asset allocation: Consider benefits of active management amid idiosyncratic opportunities.
Quote of the week:
“Invest in inflation. It’s the only thing going up.” — Will Rogers
What’s driving higher-than-expected inflation?
Another month, another stronger-than-forecast inflation reading.
In April, the Consumer Price Index (CPI) jumped 4.2% year over year — up sharply from March’s 2.6% rise and its biggest 12-month increase since September 2008.3
We weren’t surprised by this “inflated” result, which was distorted by the very low energy prices that prevailed in April 2020. That month, the West Texas Intermediate (WTI) crude oil benchmark never closed above $29/barrel, a victim of the pandemic-driven recession. Fast-forwarding to April 2021, though, WTI consistently traded at more than double its year-ago price, hitting a peak of $65.4 Also contributing to the surge in April CPI: a number of other industries that were effectively closed a year ago have begun to raise prices since reopening over the past few months.
For April alone, CPI rose 0.8% from an already high 0.6% in March and well above forecasts for 0.2%. Meanwhile, core CPI, which excludes volatile food and energy prices, climbed 0.9% — its largest one-month increase since 1982.5 Notably, for all the recent focus on prices at the pump, energy costs weren’t a driver of higher inflation in the month of April.
So what fueled April’s CPI gains? Broadly speaking, inflation occurs when demand for goods and services outstrips supply. That happened in April as (1) people continued their “return to normalcy” amid COVID-19’s declining threat and (2) consumers flexed additional purchasing power courtesy of the $1,400 American Rescue Plan Act (ARPA) stimulus checks that began hitting mailboxes in mid-March.
- Used car prices soared 10%, accounting for more than one-third of the total inflation rate. This upswing is attributable to massive demand for preowned vehicles as a global microchip shortage continued to hinder the production of new cars. Meanwhile, auto insurance premiums (+2.5%) kept climbing as Americans began hitting the road again — leading to more accidents — and insurers eliminated last year’s discounts.6
- Airline fares (+10.2%) and hotel rates (+8.8%) increased sharply, reflecting unleashed pent-up demand for travel and leisure services.6
- Tickets to sporting events rose 10% even in the face of increasing supply as capacity restrictions in many stadiums were eased.6
- In what was already a supply-constrained environment for many products, furniture (+2.1%) and “recreation commodities” such as televisions and audio equipment (+1.2%) both edged up as people continue to deploy some of their ARPA checks to purchase expensive home goods.6
Looking ahead, monthly price increases may stay high into the summer, although they likely won’t reach April’s level. For the most part, industries that are still reopening, such as travel & leisure and others in the service sector, have yet to raise prices back to their pre-pandemic peaks. At the same time, greater supply in those parts of the economy (e.g., more available stadium seats, a pickup in scheduled airline flights) may ease price pressure.
As far as consumers go, we believe substantial jumps in prices of larger goods are likely to cease as people shift their consumption more to services over the summer. Most importantly, the items that tend to make up the largest shares of household consumption — like shelter, health care and education — are exhibiting few, if any, signs of inflationary pressures. In our view, broad-based inflation (as opposed to reflation, or the restoration of depressed prices to normal levels) shouldn’t materialize unless and until the labor market tightens further even after transitory supply constraints like the virus fade and supplemental unemployment benefits expire.
Moreover, household balance sheets remain in excellent shape. April’s retail sales report (released this past Friday and showing spending unchanged from March’s 10.7% burst) confirms that the ARPA’s fiscal aid checks are still supporting consumer spending.7 Personal incomes have surged and seem set to climb further, providing a potential buffer against a moderate one-off increase in inflation. As we see it, the psychological effects of higher prices in one industry or another are unlikely to spread to the broader economy as long as consumers don’t feel like their incomes and savings are being eroded away. That hasn’t happened yet, and we doubt it will anytime soon.
Markets did not overreact to the data this week, but investors still don’t quite seem convinced that the Fed will be able to resist pressure to tighten policy in response to this higher-than-expected inflation bump—even if it’s transitory. However, we still do not expect the Fed to make any policy shifts in reaction to inflation this summer.
What’s (not) up with the 10-year U.S. Treasury yield?
The U.S. economy got off to a strong start in the first quarter. Amid upbeat data, the bellwether 10-year Treasury yield jumped from 0.93% on January 1 to 1.74% on March 31.8 At the time, it looked like rising interest rates naturally reflected improved fundamentals as the economy’s rebound proceeded apace. A series of stellar March data releases (job creation, retail sales and housing, among others) only reinforced that expectation.
Yet instead of moving even higher in line with the strengthening economy, the 10-year yield has actually trended a bit lower, from 1.69% on April 1 to 1.63% on May 14. 8
To understand why, consider these crosscurrents:
- Rising inflation expectations. Investors believe inflation is going to heat up, and they’re acting accordingly by flocking to Treasury Inflation Protected Securities (TIPS). These U.S. government-backed bonds are designed to offer protection against rising prices by adjusting their face value according to the CPI. TIPS are only one of a handful of taxable fixed income asset classes to post a positive return for the year to date, and they’re up 1% thus far in May.9 All else being equal, heightened fears of sharply rising inflation should push up the 10-year yield.
- Economic data reports are unlikely to consistently (and dramatically) beat expectations. Unlike the first quarter, when actual results repeatedly left forecasts in the dust, economists have generally done a better job at estimating second-quarter data. Consequently, the Citi U.S. Economic Surprise Index, which gauges the extent to which data releases diverge from consensus forecasts, began to fall at around the same time the 10-year hit its most recent high of 1.73%.10 In general, fewer positive surprises in economic data should remove a factor that had been driving up long-term rates.Taken together, these two opposing forces have essentially offset each other, inhibiting the 10-year yield’s potential rise.Meanwhile, other factors can help explain the loss in upward momentum for the 10-year yield:
- The passage of the ARPA. Markets had just over two months between the start of the new Congress and the passage of the ARPA to process what an additional $1.9 trillion in fiscal stimulus might do for the U.S. economy. The bill, once it seemed likely to pass, became its own “positive surprise” for markets. And the effect on rates could be priced in prior to its signing given the relatively small number of changes made to it between proposal and passage.
- The Fed plans to remain dovish. Although the outlook for Fed policy is more accurately reflected in shorter-term Treasuries such as the 2-year note, the 10-year also reacts to the Fed’s outlook on the economy and direction of interest rates. And for now, the Fed says it will stand pat on rates through at least 2023.
- Increased demand from outside the U.S. Asian institutions, which tend to begin their fiscal year on April 1, have remained willing buyers of U.S. Treasuries. This demonstrates both their desire to rebalance portfolios given the first quarter’s dramatic equity outperformance versus fixed income and reduced hedging costs, which makes U.S. debt more attractive.