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 26, 2022.
Markets in a minute
No new news is good news
The market swings continue, but this week, have broadly brought relief. Heading into Thursday, the S&P 500 was up +2% on the week as investors seemed to rally around no new news. For instance, the Fed’s latest meeting minutes (which peel back the curtain from their meeting earlier this month) just echoed their already-familiar hawkish tone — officials are prepared to move ahead with multiple 50bps 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 vs. 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.
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 like 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.
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 that 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 like Tampa/Miami/Phoenix/Atlanta than in coastal cities like NYC/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 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.
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 U.S. 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 dis-inflationary 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.
Bonds, bonds, bonds
Given our view for both inflation and growth to continue slowing over the next year, we think that 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 that 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.