We have been writing about the rise in cost pressures due to improving economic activity and ongoing supply constraints. This has become a mainstream concern and something that can have major implications on asset class returns. Predicting how long these inflationary pressures will last is not possible, but we can monitor some market-based indicators to see what investors are thinking and how the situation is progressing.
Last week, there were a series of inflation indicators released and all of them showed signs of continued acceleration. In the Consumer Price Index (CPI) report, headline CPI increased 0.8% month-over-month (m/m), the most since June 2009. The core measures (excluding food and energy) increased 0.90%, the most since September 1981. The year-over-year (y/y) gain for headline CPI was the highest since September 2008 and January 1996 for core.
The Producer Price Index (PPI) increased 6.2% y/y, the most since the data started in 2010. The core measure increased 4.2%, also the highest in the data series. There were increases across the input stages, suggesting that inflation could persist.
The Reuters/University of Michigan Consumer Sentiment Index declined m/m and the biggest contributor was inflation expectations. The one-year expectation increased to 4.56%, the highest since August 2008, and the five-year increased to 3.1%, the highest since March 2011.
The NFIB Small Business Optimism Index noted that a record net 36% of companies expect to raise prices.
These updates suggest inflation could continue to be an issue and could start to impact behavior, making supply shortages worse and slowing down economic activity. This could have a large impact on asset classes that would require altering portfolio positioning. There are market-based signals we monitor to help determine when the probabilities are high enough to suggest this could occur.
If inflation is expected to be a persistent problem, then longer-term inflation measures should start to increase. Currently, short-term inflation expectations are higher than long-term. This can be seen in the inflation breakeven curve (a market measure of expected inflation) and inflation swap rates. The shorter-term maturities have higher expected inflation rates than longer-term maturities.
Monetary policy would likely have to adapt to the expectation of persistently higher inflation and the FOMC would need to raise interest rates, or at least consider doing so. If this were to occur, then short-term interest rates would start to increase. One-year Treasury yields have been declining for over a year and the pace of the decline has accelerated since the month of March.
Equity industries, like Utilities, tend to outperform in rising inflation, falling growth periods because they have pricing power through regulation. Energy companies also outperform because the price of their product increases. Materials companies tend to lag as demand for their product declines as companies pull back orders since they cannot pass on the higher costs. Financials also lag because the yield curve tends to flatten as shorter-term rates increase. Right now, two of the three best performing industries over the last 1-3-month periods have been Financials and Materials, while Utilities have lagged.
Credit spreads tend to widen in rising inflation, falling growth periods as margins and cash flow decline and credit risk increases. High yield option adjusted spreads (OAS) have increased modestly in the last few weeks and are still near the lowest level since 2018 and 2007. The same is true for the CCC-rated part of high yield, which is the most sensitive to changes in credit risk.
Persistently rising inflation and falling growth are a major headwind to credit risk and are important factors to monitor. Currently, this does not appear to the be the base case for the market and a normalization in supply chains should alleviate the current rising price pressures. There is a risk that these conditions do not change or behavior changes cause supply shortages to accelerate. We will continue to track these market indicators for signs that we need to revisit our outlook and positioning.
Vice President, Research and Strategy
Boyd Watterson Asset Management, LLC
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.