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Is inflation set to soar this summer?

Markets stumbled earlier this week as inflation came in hotter than expected. Here’s where we stand as concerns grow.


 

Our Top Market Takeaways for May 14, 2021.

 

On investors’ minds

Inflation prints are running hot

A stumble, not a tumble. After the S&P 500 closed at an all-time high last Friday, fears around supply squeezes and inflation soured broad sentiment and pushed the index –4.0% lower by the end of Wednesday. Stocks clawed back some of their losses with gains on Thursday, but this week’s economic data prints and media headlines suggest that inflation concerns aren’t going away anytime soon.

Both the Producer Price Index (PPI) and Consumer Price Index (CPI) came in hotter than expected—the stories are similar, so we’ll focus on CPI. The core basket printed at +0.9% month-over-month and +3.0% year-over-year (far above expectations of +0.3% and +2.3%, respectively). Most of the underlying component data wasn’t actually that notable, but there were two key culprits contributing to the surprise. Used automobile prices and transportation service costs, taken together, accounted for +50 basis points of the month-over-month print.

 

On transportation costs, even with the nearly +3% month-over-month jump, prices are just starting to get back to pre-pandemic levels (the latest index reading was 324.5 versus 327.5 in February 2020). While the roundtrip ticket I just bought to visit my Indiana home might make me feel otherwise, transportation costs aren’t climbing out of control. They’re just normalizing along with the rest of our lives.

What about the used cars? More people seem to be looking to the secondhand market, at least partially because global semiconductor shortages are hampering new vehicle production (you get one guess as to what allows your new car to sense another in its blind spot, or what’s behind making it more fuel-efficient). This shines a light on one of the key sticking points of the inflation debate: supply bottlenecks.

How the bottlenecks came about and for how long they’ll be intact depends on what you’re looking at:

Semiconductors: Pretty much every end market that uses them—from smartphones to televisions, to dog washing booths—is feeling the pinch of a shortage. Global production was forced to slow down during the pandemic, and a combination of other factors has exacerbated the issue: years of outsourcing manufacturing to a small number of foundries, disruptions from Texas’s winter storms earlier this year, a factory fire in Japan, and heavy reliance on only one company in the world—ASML—for the systems that allow chips to be as small and as fast as everyone wants them to be. 

As demand boomed, the semiconductor supply chain didn’t have enough lead time to prepare. It’s not an issue that can be fixed overnight. Shifting manufacturing or expanding production capacity for semiconductors is a process measured in years, and our best guess is that it could take somewhere between six to 18 months for the supply/demand balance to normalize.

Commodities: We can’t paint the picture for all commodities with one broad brush. For many agricultural commodities, the story centers on weather-related factors (e.g., droughts in South America; winter storms in the United States) or a massive swell in demand (e.g., China asking for all the corn it can get to feed hogs and replenish supply following the pre-pandemic African Swine Fever outbreak). For lumber, it’s not so much about the trees themselves being expensive, but more about the confluence of heightened demand (think: housing boom and DIY projects—you need 2x4s!) and sawmills going offline during the pandemic. For copper, the surge in prices reflects the broad-based global recovery and is augmented by the rise of “green demand.” 

Markets are telling us that most commodities are likely to see their prices moderate by year-end as supply gets back to full steam and demand starts to cool off. Many commodities’ futures curves are in backwardation (which is just fancy jargon meaning that the supply/demand balance is tight right now, but prices are expected to be lower in the future than they are today). Copper may be the exception. It takes years to add capacity at existing mines and up to a decade to establish a new one, and incrementally increasing demand amid global decarbonization efforts could mean that elevated prices stay supported and potentially move higher in the years ahead.

Labor: With roughly 10 million fewer people employed today versus what the pre-pandemic trend would suggest, it may seem counterintuitive that businesses are having a hard time finding new employees. But last Friday’s jobs report showed that the economy added only 266,000 jobs in April versus expectations of nearly one million. The same report also showed a tick up in average hours worked, which was especially pronounced in sectors such as leisure & hospitality. This week, the JOLTS report showed us that job openings shot up by nearly 600,000 to a record high 8.1 million.

Taken together, this tells us that if anything is holding back the jobs recovery, it’s not a lack of businesses wanting to hire. It’s workers’ willingness to get back into the labor force. But as we make more progress toward herd immunity, September brings the expiration of supplemental unemployment benefits, and the new school year gets kids out of the house, it seems likely that people will go back to work. We think the risk of broad labor market scarring is minimal, and we still expect the unemployment rate to continue to fall to ~4.7% by year-end. Certain sectors may see some degree of upward wage pressure (currently, financials and leisure & hospitality are the standouts, but they account for only around 15% of the total jobs market), but there’s still much progress to be made before the Fed’s goal of maximum employment will be satisfied.

 

With a few exceptions (e.g., semiconductors and copper), it seems likely that most of the bottlenecks will clear by year-end as reopening brings more production capacity back online and the demand boom cools off. When it comes to the implications for Fed policy, it’s important to remember 1) that the labor market and housing rental prices are still the key drivers of inflation baskets they monitor (and both are still depressed); and 2) that they’re looking for a sustained inflation overshoot to bring longer-term average inflation levels around their 2% bogey. Despite the scary headlines, the market’s pricing of inflation expectations is actually consistent with that framework.

 

Our view hasn’t changed. We still think it will take a couple of years for the Fed to reach its goals of maximum employment and economic growth underpinning a healthy amount of inflation. Expect longer-term rates to rise further as the recovery carries on, and look for the Fed to convey continued patience in its messaging around tightening policy. Despite the inflation fears, the tides still look favorable for risk assets: Along with persistent easy monetary policy, abundant fiscal policy has left consumers in a place of strength, and vaccine distribution continues to move us toward economic reopening.

 

 

 

 

All market and economic data as of April 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.

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