Overall, economic data is still showing that headline inflation data should start to calm in 2H 2021.
Chief Market Strategist, Asia Pacific
Like a typhoon, we are probably in the most turbulent phase of the pick-up in inflation. The U.S. inflation data in April and May were high and came in even stronger than expected. The Consumer Price Index rose to 5% year-over-year in May, the highest since August 2008. China’s Producer Price Index (PPI) reached 9% in the same month, also the highest since September 2008. Since these numbers came in above expectations, there are concerns that inflation is starting to run away and central banks could be forced to take a more hawkish position. Last week’s Federal Open Market Committee meeting has also seen the committee’s members push forward their expectations of the next interest rate hike to 2023 from 2024.
There is both good and bad news on the inflation outlook. Commodity prices have been a key contributor to higher inflation around the world. Brent crude price jumped from USD 38 per barrel (pb) in late October 2020 to almost USD 70 pb in late February. This momentum has eased in recent months and the Organization of the Petroleum Exporting Countries is looking to gradually increase supply. Prices of industrial metals, such as copper and aluminum, have also stabilized. This should help to slow headline inflation. Given the strong correlation of China’s PPI with commodity prices, 2Q 2021 should also mark the peak of producer price inflation. In the U.S., the stimulus on consumer spending from fiscal packages should also gradually fade in coming months.
What could present central banks with a greater challenge are other supply-side constraints, such as semiconductor shortages and the production disruptions of cars and household appliances, businesses taking time to restore their full capacity and dislocation in the labor market. For example, airlines and hotels in the U.S. saw a surge in demand as lockdown restrictions were eased, but businesses need time to re-hire staff and get their services back to full strength. The interim period could see stronger demand leading to higher prices.
It can be rightfully argued that these distortions are likely to be temporary, and eventually businesses would have invested enough to bring capacity back to normal. U.S. corporate investment is rebounding at a much quicker pace than previous recessions. This would mean the Federal Reserve (Fed) and other central banks are correct to not over-react to the latest readings.
However, these temporary inflationary events are pushing consumers’ inflation expectations higher. The New York Fed’s survey of consumer expectations in May show respondents expect inflation to hit 4% in one year’s time. This is the highest reading since the current series began. This could fuel wage demand and drive wage growth higher. Even if the bond market, including inflation breakevens, does not reflect strong inflation expectations, the Fed would need to be mindful of its messaging to manage expectations.
EXHIBIT 1: MEDIAN ONE-YEAR AHEAD EXPECTED INFLATION RATE
NEW YORK FED CONSUMER EXPECTATION SURVEY
Overall, economic data is still showing that headline inflation data should start to calm in 2H 2021. Central banks are in a difficult position for several reasons. Their policy tools, including forecasts and senior officials’ comments, may help to influence inflation expectations. They are not particularly helpful in addressing supply-side constraints. Second, governments are still expected to run loose fiscal policy, and this would constrain the pace of asset purchase reduction. Third, while market attention has been on inflation risk, the COVID-19 pandemic is still here. The Delta variant is leading a pick-up in infection in Asia and Europe, which could jeopardize recovery. This would require central banks to maintain some flexibility in their policy execution.
On balance, we think the Fed would continue to socialize the idea of the tapering of quantitative easing in the second half of 2021 and begin actual tapering in early 2022. Higher policy rates may need to wait until late 2022 or even 2023. For Asian central banks, the pace of interest rate increase is also likely to be slow. This means Asian investors would need to stay invested to offset inflation’s damage to their asset’s purchasing power.
Our 2H 2021 asset allocation view is largely the same as the first six months of the year, focusing on equities and corporate credits. Despite the recent decline in U.S. Treasury (UST) yields, a combination of inflationary pressure and economic recovery should push UST yields higher. This means duration risk would be a challenge for fixed income assets. Short duration bonds with high yield would be more resilient in this scenario.
For those who are genuinely concerned about inflation staying elevated beyond 2021, commodities and real estate are two assets that can provide some protection. High inflation in recent decades are driven, at least partly, by commodity prices. For real estate, the economic recovery and low interest rates are both constructive backdrops. However, this would require more on-the-ground research and active management to understand the local dynamics influencing demand and supply in different types of property.