The glide path to lower inflation
- It is important to differentiate between transitory and sticky components of inflation
- While Russia-Ukraine tensions can delay the peak in U.S. inflation due to pass-through effects of higher energy prices to energy inflation, overall inflation should still moderate lower throughout the course of 2022 and into 2023
- For investors, we believe that the Federal Reserve (Fed) will avoid introducing more uncertainty in markets as the conflict continues to unfold. As inflation continues to normalize lower, albeit at a slower pace, this will temper the Fed’s pace of normalization
Inflation has been a top-of-mind topic for central bankers and investors globally. Persistently high inflation prints have sparked a series of hawkish pivots from developed markets ex-Japan central banks since the beginning of this year. While the expectation was for inflation to moderate lower, the Russia-Ukraine conflict and the impact that it has had on commodity prices has pushed out our inflation moderation timeline. While the peak in U.S. inflation is delayed, it does not change our fundamental view that inflation should still moderate lower, especially given that the key distinction in this inflationary episode is a supply side shock that is impacting energy and core good prices, both of which are more transitory, rather than sticky, components of inflation.
Exhibit 1 and 2 illustrates this dynamic vs. history, where the gray, blue and green shading represents the transitory components while purple represents the stickier components of services inflation like shelter.
We discuss the key drivers within the transitory and sticky components of inflation and present our thoughts around their paths lower.
Transitory Components of Inflation
Oil prices have risen by about 20% since the end of January, primarily due to the Russia-Ukraine conflict and the potential to diminish supplies in an already tight oil market just as demand is recovering globally. On top of what oil spikes can do to dampen growth, there is also mounting concern on how this feeds through to other parts of inflation, especially the stickier components. Our research suggests that oil price changes tend to lead energy inflation by about one to two months. The historical sensitivities of the various components of inflation (with a 2-month lag) to oil price changes show that the pass-through to energy inflation is statistically significant. It is estimated that for a 10% increase in oil prices, we should expect to see a ~1-1.5% impact on energy inflation. The good news, however, is that there has not been a statistically significant impact of higher oil prices on core services inflation, which is stickier. While there is a statistically significant pass-through to core goods, the impact is also negligible.
Core Goods: New & Used Vehicles
New and Used vehicles are two categories within core goods that have seen a significant pick-up in inflation due to ongoing supply chain woes. While concerns have been raised around other commodities like Palladium and Neon gas due to the Russia-Ukraine conflict, we note that manufacturers have engaged in diversified sourcing and stockpiling after going through the previous supply crunch in 2014 during the annexation of Crimea. Current inventory levels are good for the next three to six months and hence, a lack of supply is not an imminent issue but of course the risk is that the conflict drags on for longer.
The Manheim U.S. Used Vehicle index which tends to lead Used Vehicles inflation by 2 months has also been declining consecutively for the past two months. This leads leads us to believe that there will be downward pressure on this transitory component that has, on its own, contributed to 1.7% of overall inflation.
Stickier Components of Inflation
The stickier part of inflation depends heavily on changes in Shelter Consumer Price Index (CPI), which accounts for roughly a third of the headline CPI basket. While the recent rise in shelter costs have not been as sharp as transitory components of inflation, the significance of shelter within the CPI index has resulted in a sizeable contribution to the rise in headline inflation. However, our analysis suggests that the peak of shelter price increase is within reach. The month-over-month (m/m) change in Zillow Rent Price Index, which leads Shelter inflation by about five months (correlation: 45%, statistically significant at 95% confidence interval (C.I.)) had been decelerating sequentially for the past six months to 0.3% m/m in January. In addition, while Shelter CPI primarily measures rent, the change in housing prices, which are reactive to current shifts in supply and demand and shows strong correlation with Shelter CPI inflation with a 15-month lead (correlation: 30%, statistically significant at 95% C.I.), have also slowed to 0.9% m/m last December from above 2.0% m/m levels mid last year. This makes sense as rental leases typically last for at least one year, meaning changes in house prices are reflected in rent prices with a lag. As a recovery in housing construction and possible tick up in foreclosures replenishes supply and a rise in mortgage rates cool demand, shelter price inflation will likely normalize.
A word on wages
Another contributor to stickier-than-expected inflation is the labor scarcity, which has led to a sharp rise in wage growth. This has fueled worries about a possible wage price spiral as the current labor participation rate still stands at 1.1% below pre-pandemic levels and there remains ~1.8 job openings per unemployed person. In our opinion, the risk of a wage price spiral is limited. First, the most recent February jobs report showed strong momentum in hiring activity, with total nonfarm payrolls increasing by 678k vs. 423k expected. Revisions added a further 92k payroll to January and February altogether. We expect tightness in the labor market to ease further as unemployment benefits and excess savings accumulated over the pandemic wears thin and workers return in seek of a pay cheque. Secondly, while there has been a positive relationship between labor cost and inflation historically, the stabilization of long-term inflation expectations in recent years has reduced the strength of the relationship. The correlation between unit labor cost growth, a measure of wage cost that accounts for productivity, and headline CPI growth was above 85% between 1980 to 1999 but has fallen significantly to 33% between 2000 to 2021. Furthermore, the pass-through from wage growth to inflation has been proven to be weaker during times of supply shocks, as we are experiencing now. Thirdly, wage growth adjusted for productivity (Unit Labor Costs) is running at 3.5% 4Q/4Q, which is manageable and has shown signs of a deceleration closer to the 10-year average levels of 2.1%.
For the above reasons that we have just covered, we believe that U.S. inflation should moderate lower throughout the course of 2022. This, alongside moderating demand, should give the Fed enough reason to pursue a more gradual path of normalization. As the Fed trudges along with a series of consistent rate hikes to get overall interest rates to a level that is commensurate with the level of activity in the economy, we continue to reiterate our positive stance on risk assets in 2022. However, the likelihood of inflation settling at a rate higher than 2% can further complicate monetary policy next year. Even with the pick-up in mortgage rates, housing demand remains strong. Pent-up demand could result in a pick-up in spending over the summer and into year end, boosting consumer spending on services that is already close to pre-pandemic levels.
Our research, which looks at all Fed rate hiking cycles going back to the 1970s, shows that risk assets tend to deliver positive returns through rate hiking cycles, barring unique macroeconomic conditions (very high inflation >12%, weak PMIs under 50, extremely aggressive Fed hiking pace of >300bps per quarter). These are not the conditions that we are experiencing today or are expecting to see for the rest of the year. With this backdrop, we prefer equities to credit and government bonds. Within equities, we advocate for a globally diversified allocation and a preference for value and cyclicals over growth and defensives. Arguably, commodities also warrant a place as an inflation hedge in multi-asset portfolios, with the demand-supply dynamics remaining favorable. Markets will also likely need to begin reflecting a higher terminal rate, closer to the Fed’s 2.5% long run projection.