We are skeptical that we will see U.S. inflation sustain above 2% anytime soon.
As the recovery continues and the U.S. economy digests another deluge of fiscal stimulus, many investors are worried about inflation. However, in our view, the earliest we see inflation rising above 2% on a sustained basis is H2 2023 – and this is assuming we don’t hit another negative shock along the way.
While we do expect some firming of inflation, particularly in the service sector in the coming months, it is important to put this into context. In 2020, services inflation collapsed (think the cost of an airline ticket or a haircut), while the cost of goods rose. As the pandemic subsides, we ultimately expect the gap between services and goods inflation to normalize. Goods inflation should cool as global manufacturing production ramps up given low inventories in the sector, and services inflation should firm as the resumption of services activity allows companies to regain pricing power. The improvement in services inflation is likely to cause a temporary overshoot of the Fed’s 2% inflation objective. But once supply catches up to demand beginning in the second half of this year and going into 2022, inflation will likely be driven more by its fundamental factors.
As such, any problem with consumer inflation is more likely, in our view, to come from cyclical items, namely those more tied to the business cycle.
To explain the cyclical components, we use a model that consists of two main variables, namely the degree of slack in the labor market, as well as inflation coming from the housing sector. This model explains 87% of the variation in core cyclical consumer price inflation since 1985. Therefore, these two areas deserve most of our attention when assessing inflation pressures. In short, we don’t think there is going to be much upward pressure on inflation from either the labor or housing market. Additionally, we don’t think the backdrop will change much in the coming years. It is important to emphasize that inflation generated from the labor market and housing comes from the level of activity in these sectors, not from the growth rate.
On the labor market, we expect the unemployment rate to continue its rapid descent, and will likely now fall below 5% by the end of this year, given recent upward revisions to fiscal stimulus expectations. That said, the unemployment rate was 3.5% prior to COVID, and core consumer inflation was struggling to hit 2%. The path from where unemployment ends this year to it eventually falling below 3.5% will be measured in years after 2021.
On housing, the conversation is trickier. Yes, the home purchase market has been booming as a result of low mortgage rates and accelerated migration trends from COVID. However, for consumer inflation, a booming home purchase market isn’t a driving force. Housing inflation in the consumer price basket comes from housing rental rates, not from home prices, since paying rent is a consumption item that reoccurs whereas buying a home is treated as a one-time investment. The rental market is currently still deflating, which is acting as a headwind to overall consumer inflation, despite the pickup in home prices. This is important, as rental inflation carries an 18.5% weight in the core PCE inflation basket (and nearly a 40% weight in core CPI). Our expectation for rental inflation is that it will recover, but the recovery will be slower than in other components of services, due to the multifamily market being somewhat oversupplied on a fundamental basis (even absent COVID), particularly in densely populated metros.
Global context is important
And the global angle is important here – we are not seeing many signs of strong underlying inflationary pressure on a global scale. Because of China’s “first-in, first-out” Covid-19 dynamic, its economic recovery is further along than the rest of the world, and as such we can take clues from China on how the path of inflation might play out globally. Interestingly, China’s core CPI inflation was 0% year-on-year in February, after contracting by 0.3% year-on-year in January (see chart below). As China re-opened last year, some services, such as tourism, saw a brief pop in prices. Nonetheless, once supply normalized, prices settled back down.
China’s lack of inflation can largely be explained by the different stimulus policies enacted compared to the rest of the world. China’s stimulus was more short-lived and directed at the supply side; that is - supply increased while demand stayed subdued. Since China is the world’s largest exporter, this is important on a global level. Increased production and goods supply in China can continue to suppress prices even as demand increases. Indeed, we are already seeing U.S. import prices fall across consumer goods. Furthermore, this is evident across Asia as we see current account surpluses (which at a basic level highlights the gap between supply and demand) increase over last year. Granted, as the global industrial cycle ramps up, commodity prices have rebounded (as suggested by PPI inflation) – but the rebound is more cyclical, and does not tend to filter through to underlying consumer price inflation in a meaningful way. So all in all, the lack of strong underlying inflation in China will help to moderate global realized inflation, in our view.
Although we are skeptical that we will see sustained consumer price inflation at above 2% any time soon, we do expect to see more evidence of ‘inflation’ in asset prices. In the U.S. equity market, we continue to like cyclical segments such as Commodities, Financials, Industrials, & Homebuilding sectors. The recent market pullback also presents some opportunities to revisit certain growth stocks. We are also less convinced that there is value in traditional inflation hedges, such as TIPs or inflation-swaps. Given that the global backdrop still remains largely reflationary rather than inflationary, we continue to favor China, Hong Kong, Korea and India equities, which have a mix of cyclical and structural opportunities.
All market and economic data as of March 8, 2021 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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