Investment Strategy

Could inflation finally be peaking?

We unpack where things stand with inflation, our view, and what to do about it.

Our Top Market Takeaways for May 27, 2022

Markets in a minute

No new news is good news

The market swings continue, but this week, they have broadly brought relief. Heading into Friday, the S&P 500 was up +4% on the week as investors seemed to rally around little new news. For instance, the Federal Reserve’s latest meeting minutes (which peel back the curtain from its meeting earlier this month) just echoed its already familiar hawkish tone—officials are prepared to move ahead with multiple 50-basis-point hikes, indicating that they might have to move past “neutral” and into “restrictive” territory. Not good, not bad, just what we already knew.

What is clear is that central bankers remain committed to snuffing out inflation. And with a (likely brief) reprieve in market angst this week, we wanted to commit today’s note to digging into what is undoubtedly investors’ most oft-cited concern, our view, and what to do about it.

Inflation went much higher than we, and the Fed, expected in 2021. And despite some moderation in the latest readings, price increases are still too hot from the perspective of U.S. consumers and policymakers.

But here’s the punchline: We think inflation is now peaking, and we expect it to decelerate through the rest of this year. Our expectation is that the core measure (excluding volatile food and energy prices) will be running around 3% year-over-year by Q4 (down from more than 5% in Q1 of this year). The risk, in our view, is that Fed policy is too aggressive in aiding that along, resulting in economic growth slowing too abruptly and tipping the economy into recession.

To unpack this, it helps to break things down into three key areas: The labor market, goods versus services, and housing.

The labor market: Recent data argues against a wage-price spiral

At the start of this year, a key macro risk was one of a wage-price spiral, similar to what unfolded in the 1970s (i.e., higher wages beget more demand, which raises prices, which prompts demand for higher wages, and so on). In the second half of 2021, labor supply did not seem to be recovering, and real labor shortages were popping up in a variety of sectors, such as leisure & hospitality and healthcare. As companies increased pay to try to coax workers back into the labor force, wages were quickly accelerating (from a roughly 3.5% annualized pace prior to the pandemic to nearly 5.5% in the second half of 2021).

The labor market is still tight, to be sure, but wage-price spiral risks seem to be coming down. The working age labor force participation rate has rebounded impressively, and while not yet a trend, wage growth is showing initial signs of slowing. More participation = less scarcity of labor, and therefore less upward pressure on labor costs.

This chart shows the U.S. labor force participation rate: 16-64 years, from January 2013 until April 2022. The first data point came in at 73.1%. From there it declined to 72.4% by September 2015. Then, it rose to an all-time high of 74.4% by February 2020, before it plummeted to a trough of 71.3% on April 2020. From there until recently, it rose to 74.4%.
This chart shows the average hourly earnings (AHE) from 2015 to April 2022. The first data point came in at 1.7%. From there, it rose to 3.3% by October 2019. Then, it sharply jumped to over 6% by June 2020. AHE fell to 0.2% by October 2020 then rallied to 4.4% by January 2022. By April 2022, it fell to 4.4%.

The step down in broad wage growth from 5.5% to 4.3% has been notable, and slowing economic growth as a result of fiscal tightening and the global commodity price shock should continue this dynamic. Already, the data suggests that the U.S. economy can get to a better, less inflationary balance between labor demand and supply.

It’s all connected: The goods to services spending handoff is underway

A good chunk of the inflationary pressure over the last year has emanated from a big imbalance between goods spending and services spending. Early on in the pandemic, consumers binged on goods, while the services sector was largely shuttered. That sent goods prices soaring; but now, we’re seeing the reverse take form as reopening enables consumers to spend more on things like going out to eat, grabbing a drink or taking a much-needed vacation.

This is why renewed shutdowns in China, while notable, are unlikely to have as big of an impact on U.S. inflation this year compared to last. Consumers are not as reliant on goods as they were during the depths of the pandemic, and as a result, lockdowns are becoming less relevant for an economy increasingly refocused on services.

We’re seeing the effects of this in the retail sector, where inventories have rapidly increased relative to sales. This suggests we should see inflation continue to cool in sectors such as apparel and consumer appliances. The one caveat to this dynamic is the auto sector, where still tight inventories suggest it could take longer for inflation components such as new car prices to normalize. But given that buying a car is usually a large expenditure consumers make every few years, we’re less concerned; rather, we’re more encouraged by seeing prices cool for other goods that you might buy every day.

This chart shows retail inventory to sales ratio for vehicles & parts and total minus vehicles & parts, from January 2013 to March 2022. The first point for vehicles & parts and total minus vehicles & parts came in at 2.02 and 1.22, respectively. From there, vehicle & parts rose to 2.29 by May 2016, while total minus vehicle & parts reached a relative peak of 1.32 by January 2016. Then, both vehicle & parts and total minus vehicles & parts declined to 2.07 and 1.16, respectively, by February 2020. Here, both vehicle & parts and total minus vehicles & parts skyrocketed to all-time highs of 3.25 and 1.33 by April 2020. From there until recently, vehicles & parts has declined to 1.29, while total minus vehicles & parts declined to 1.05 before rising to 1.14.

Overall, more inventories are a healthy development, which reflects an economy that has made it over the COVID-19 hump and is seeing a normalization in spending behaviors. Companies such as Target and Walmart have seen volatility in their stock prices after indicating they may have built too much inventory (which may ultimately be a drag on their profit margins). This is painful for investors, to be sure, but in the end, reflects rebalancing that was to be expected.

Rental inflation is also likely in the process of peaking

Housing rental inflation has been red hot since the summer of 2021. But like goods inflation, it also is more likely than not to cool on a go-forward basis.

A lot of the surge can be chalked up to the shift to remote work brought on by the pandemic. For instance, shelter inflation (for which rental inflation is the largest component) is now far higher in sunbelt cities such as Tampa/Miami/Phoenix/Atlanta than in coastal cities such as New York/San Francisco/Boston/Washington, D.C. Some research has even suggested that the shift to remote work explains the majority (63%) of the national home price appreciation (and rental inflation) we have seen since the start of the pandemic.

This chart shows year-over-year shelter inflation of coastal and sunbelt cities, from March 2003 to April 2022. The first data point for coastal and sunbelt cities came in at 3.2% and 2.7%, respectively. From there, both rose to 5.2% for coastal cities, by September 2006, and 6.9% by June 2007. From there, coastal cities dropped to -0.5% by August 2010, while Sunbelt cities plunged to -2.5% by January 2010. Then, Sunbelt cities gradually rose to a peak of 5.4% by July 2017, while coastal cities peaked at 3.9% by May 2016. Here, both declined to a trough of 2.9% for sunbelt cities and 1% for coastal cities, by February 2021. From there until recently, sunbelt cities skyrocketed to 11.1%, while coastal cities rose to 2.2%.
This is important because, if correct, it also implies that as we get further away from the pandemic, rental inflation should also cool (because the growth rate of remote work will slow). Indeed, forward-looking indicators of rental inflation from Zillow and Apartment List already indicate this. 
This chart shows the month-on-month rental estimates from Apartment List and Zillow from 2017 to 2022. Apartment List began between 0% and 0.5%, then fell to -0.6% by August 2017. It rallied and held steady until February 2020 when it then fell to -1.1% by May. It rose to a high of 2.2% by September 2021 then fell to 0.5% by April. Meanwhile, Zillow followed a similar trend, beginning between 0% and 0.5%. It held steady in positive territory until February 2020 at 0.5%, it also fell to a low of -0.6% by April 2020. It rallied to a high of 1.9% by August 2021 before falling again to a more “normalized” 0.8% by April 2022.

Conclusion: The Fed and recession risks

A lot of investors feel the market still isn’t fully appreciating inflation risks, and that we’re poised for still rapid inflation and much higher bond yields.

We continue to think the greater risk is actually that the Fed tightens too aggressively in the context of inflation also normalizing, for the most part, on its own as we get further away from the pandemic. Indeed, we are at a delicate place when it comes to the Fed and the path forward. Although we do not think the United States is facing a wage-price spiral, the Fed seems to be acting “as if” it was behind the curve, tightening financial conditions abruptly and significantly as a consequence.

The challenge therefore seems to be not so much inflation coming down, but rather that real economic growth may slow too abruptly. We believe growth will continue to slow over the next year, and while the risk of recession is elevated, it is not our base case. Fed policymakers have indicated that moving aggressively now allows for flexibility to shift course later as needed. We trust that the Fed will be data dependent and ultimately responsive to the disinflationary forces we expect on a go-forward basis, but until we get fully through the expected slowdown in growth, risks will remain elevated to the economic outlook.

Investment takeaways

Bonds, bonds, bonds

Given our view for both inflation and growth to continue slowing over the next year, we think core fixed income can offer investors the right balance between risk and return. As interest rates have already risen a lot, both investment-grade credit and municipal bonds not only offer attractive yields, but also compelling potential returns in the face of uncertainty. Even if bond yields spike unexpectedly in the short term, we believe that what an investor could lose from any move higher in rates seems worth the protection this duration could provide.

Your J.P. Morgan team is here to help you navigate the current slate of challenges, and how you can position your portfolio accordingly.

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All market and economic data as of May 2022 and sourced from Bloomberg and FactSet unless otherwise stated.

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