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 Midyear Outlook :
- U.S. economy: The growth rate has peaked but will remain high throughout 2021.
- Global economy: The economic recovery will spread to Europe and eventually Asia as more countries achieve herd immunity from COVID-19.
- Policy watch: Policy is becoming marginally less accommodative as the recovery takes hold.
- Fixed income: Even with rates subdued, credit-sensitive parts of the market should lead.
- Equities: The best opportunities may now lie outside the U.S.
- Asset allocation: Continue to allocate toward assets poised to benefit from economic reopening and recovery from the pandemic.
Quote of the week:
“It’s a very odd thing with Hollywood, where you do stand-up, you’re good at it, then they go, ‘How would you like to be a horrible actor?’ Then you say, ‘All right, that sounds good. I’ll do that.’” – Norm MacDonald
U.S. inflation is past its peak
From the spring of 2012 through early 2021, year-over-year headline Consumer Price Inflation (CPI) consistently hovered between 1% and 2.5%.4 With those sorts of numbers, investors rarely, if ever, worried about the economy running too hot. If anything, they sometimes wished for slightly higher prices, as inflation of around 2% is considered a sign of healthy economic growth.
But this year through July, CPI inflation accelerated to 5.4%, its highest year-over-year rate since 2008.5 Monthly inflation was hot during the spring and summer, largely due to (1) a broad-based unleashing of pent-up demand for many goods and services amid declining COVID-19 numbers and (2) supply chain constraints that created shortages of key manufacturing components, leading to delivery delays and order backlogs. This classic recipe for inflation — higher demand, lower supply — had investors fretting over the possibility of an overheating economy.
Those fears, for now, seem to have abated. With both demand and supply factors fading, the annual rate of CPI inflation for August, released last Tuesday, slowed to 5.3% and the monthly increase over July was just 0.3%.6 Both of these readings were slightly below forecasts. Meanwhile, core inflation, which excludes food and energy costs, slowed to 4% year over year and just 0.1% in August — its smallest monthly gain since February.7
Among the significant contributors to last month’s CPI:
- Gasoline prices rose 2.8%.8
- The closely watched “food away from home” category, which covers a broad range of eating “establishments” ranging from vending machines to full-service restaurants, increased 0.4%. But prices at fast-food restaurants jumped twice as much (+0.8%), a potential sign that higher wages for lower-paid workers were being passed on to consumers.9
- Household furnishings, including recreational goods like TVs, experienced a significant price bump, but inflation for these goods has slowed since the spring and should continue to do so absent another surge in demand, which we don’t anticipate.
In contrast, categories that tempered last month’s CPI included hotel rates (-3.3%), airline fares (-9.1%) and car rentals (-8.5%).10 While it’s difficult to pinpoint a specific reason for such steep drops, all three seemingly show the Delta variant’s “fingerprints.” They may reflect a reversal of the travel industry’s initial price hikes now that Delta has dampened people’s eagerness to travel, or perhaps companies found they raised prices too quickly coming out of the pandemic.
Prices of used vehicles — which soared earlier in the year as the production of new autos was hamstrung by a shortage of semiconductor chips — fell 1.5% in August, and we believe they’ll continue to drop over the next few months. Meanwhile, new car costs are still rising (+1.2%) but at a slower pace.11
The U.S. Treasury market initially welcomed August’s inflation data. The yield on the bellwether 10-year note, which reflects investors’ expectations for long-term growth and inflation, declined 5 basis points on the day of the report, to 1.28%.12 But stronger retail sales data later in the week helped push it higher to finish the week at 1.37%.13
The August CPI report will certainly be of interest to the Federal Reserve as it meets this week. Chair Jerome Powell has maintained that 2021’s swiftly rising prices would prove temporary, thus guiding the Fed’s patience in removing monetary stimulus. In our view, this CPI report justifies the Fed’s stance. Even so, we believe that August’s tepid 0.1% core CPI uptick understates the underlying trend in the inflation rate, because it’s been warped by large, temporary price drops in a few industries, particularly service-oriented areas such as travel and hospitality.
And speaking of the Fed, its preferred inflation barometer, the core personal consumption expenditures (PCE) price index, will be published next on October 1. In July, this index reached a fresh multi-decade peak of 3.6%, well above the Fed’s 2% target, but like the CPI report, it may show signs of slowing in August.14
Bottom line: Because the U.S. economy is expanding at well above its long-term potential growth rate and experiencing a rapid drop in unemployment in an already-tight (by some measures) labor market, above-normal rates of inflation are to be expected — just not as high as those seen recently. Against that backdrop, next year core CPI may well top pre-2020 levels of around 2%, edging up to about 2.5%.
Details emerge on potential tax law changes to fund ambitious spending plan
While inflation has been garnering most of the headlines, last Wednesday details emerged about the $3.5 trillion reconciliation bill passed by the House Ways and Means Committee, which writes tax laws.
The bill includes provisions to expand child care, paid leave, public health insurance plans, and household tax credits, in addition to a bevy of green energy incentives.
As of now, about half of the proposed spending will be financed through increased borrowing. The remainder will come from higher taxes. Among the prospective hikes: (1) raising the top individual income tax rate from 37% to 39.6% (2) boosting the top capital gains rate from 20% to 25% for those earning $400,000+ and (3) imposing a 3% surtax on individuals’ income above $5 million.
Corporations would be expected to ante up as well. The bill provides a pickup in the top corporate tax hike, to 26.5% from 21%. (The rate had been lowered to 21% as part of the 2018 Tax Cuts and Jobs Act, or TCJA). The 5.5% jump could take a bite out of corporate profit growth next year. The current consensus estimate for S&P 500 Index earnings per share in 2022 calls for around 8% growth, and it’s doubtful that anywhere near the full 5.5% hike has been factored into those forecasts.15 The possibility of higher rates for businesses may have contributed to last week’s volatility in equity markets, with the S&P 500 Index ending the week down 0.6%.16
The betting market odds have been binary on the corporate tax issue this year. The chief source of disagreement is not over what the tax rate will be raised to but whether any tax increases will pass at all. As more details emerge, and as the Senate proposes its own bill, the legislation’s specifics will start to matter if enough lawmakers appear ready to vote “yea.” This could matter to equity markets as analysts refresh their forecasts for 2022 earnings growth and ascribe a higher probability to a corporate tax rate hike. A rise in the individual tax rate on income or investment income has implications for markets as well. Specifically, a higher tax on dividends and capital gains could improve the relative attractiveness of tax-advantaged asset classes (like municipal bonds) and location strategies, such as whether to contribute more to 401(k) accounts or IRAs.
It seems clear even at this early stage that the bill currently working its way through the House lacks the votes to pass the Senate and will need to be trimmed down from its current size. We expect a slimmed down budget package — with closer to $2 trillion in new spending, lots of new borrowing and a few tax hikes — to pass in the fourth quarter along with the $1.2 billion bipartisan infrastructure bill, about half of which is funded by new spending.