US inflation to stay higher for longer

The US CPI report for April was released on Wednesday and it made for uncomfortable reading once again, with headline and annual price rises remaining close to 40-year highs. Headline prices rose by 0.3% last month, a touch more than expected, even though the annual rate of inflation eased back slightly to 8.3% from the 8.5% high reached in March. The core rate of inflation, which is closely watched since it can be a clear indicator of how sticky inflation will prove to be, also increased in April. Worryingly, core prices rose by 0.6%, larger than the 0.3% increase recorded in March. The annual rate of core prices rose by 6.2%, leaving the market disappointed, since expectations were for a drop back to 6%. When inflation is driving Fed policy and Fed policy is driving market price action and volatility it is important to get a good grip on inflation and to get under the hood of this latest CPI report.

Shelter costs remain the sticking point for US prices

According to the Bureau of Labor, who produce US CPI, increases in shelter costs, food prices, airline fares and new vehicles all caused headline prices to rise last month. Shelter costs are the largest component of the CPI index, and it saw one of the largest increases, rising by 0.5% last month. The increase in shelter costs has been consistent since inflation started to rise last year, and it still shows no sign of slowing down. The trend in US shelter costs (rent and rent equivalent costs) in the coming months will determine how quickly inflation in the US will retreat. Right now, this does not give us hope for a quick fall back in price growth. The largest increases in the core prices index included airline fares, medical care, recreation, household appliances and operations along with shelter costs. Thus, at this stage of the inflation cycle, housing, DIY and having a good time are driving up core prices.

Core prices could lead to a more aggressive Fed and a higher terminal rate

Core CPI, which does not include commodity prices, is worth watching closely because this is the inflation that the Fed, in theory, should be able to control. For example, the Fed can’t control the price of a barrel of oil because this is determined by a complex web of geopolitical forces including the war in Ukraine and Opec decisions. However, the Fed can tighten policy and thus move the demand curve to try and tame inflation. The Fed could hike interest rates to such an extent that it slams on the economic brakes, which causes house prices to fall and demand for recreation/ air travel etc to dry up. As you can imagine, this is a painful process. So, the Fed has a choice, it either brings inflation down by trying to dampen demand for goods and services, or it needs a confluence of external factors to work their magic and bring down commodity prices. The latter would be one way of taming inflation without causing a recession in the world’s largest economy, the former would be a fast-track route to a painful decline in US GDP.

Although commodity prices have fallen, for example, the 6.1% monthly drop in gasoline prices offset the increase in natural gas and electricity costs, energy prices have still risen by 30.3% over the last year, while food prices have risen by 9.1%, these are the largest increases since April 1981. It is going to take some time for commodity prices to decline, and there remains a sizeable risk that commodity prices may rise once again. Thus, a more effective way for the Fed to tame inflation is to reduce demand through aggressive rate hikes.

Treasuries: it’s too early to return to their safe-haven status

The sharp decline in risky asset prices in the last week is unsurprising in our view. Based on Wednesday’s CPI data, although from a technical perspective inflation may have peaked, inflation will be on a very gradual lower trajectory from here. The risks of a hard economic landing and a period of stagflation are now sizable as Fed watchers mull how high the real yield (when adjusted for inflation) needs to rise to tame price increases. After the April CPI report was stronger than expected, it suggests that the 10-year inflation indexed Treasury yield needs to be significantly higher than the 0.3% it currently is, before inflation and inflation expectations can meaningfully decline. It is worth noting that in November 2018 the real 10-year Treasury yield stood at more than 1.1%, so there could be a lot more upside to come, especially as inflation is coming down at a slower rate than the market expected.

Tech to stay under pressure

From a trading perspective, Wednesday’s data has sent US equity futures lower, with the S&P 500 expected to open down approximately 0.7% when US markets open. The Nasdaq is expected to open down nearly 1%, as this report suggests that rate increases may need to speed up to bring inflation back down to a more acceptable rate. It also suggests that the Fed’s terminal rate needs to be above the 3% ish mark the market currently expects. Overall, this news is not good for equities, and it suggests that it may be too early to buy the dip, particularly for the non-profitable growth companies even if their valuations look tempting (here’s looking at Peloton!). Earlier this week it looked like the bond market was starting to think about the peak in inflation and the prospect of prices falling from here. With the slowdown in price growth disappointing expectations for April, we think that bond prices could suffer/ yields move higher, as the market digests this latest CPI news.

The dollar weighs on EM prospects  

A slower decline in US prices will also support the dollar on a broad basis. Even though the dollar index is down a touch on Wednesday, we continue to think that the dollar remains king, and we could see any declines in the dollar attracting buying interest across the G10 FX space. The prospect of more dollar strength could also weigh on emerging markets, as it can cause tension in EM countries’ balance sheets, particularly if they have a lot of dollar-denominated debt, forcing their central banks to hike interest rates and triggering weaker domestic economies.

To conclude, this is not an easy trading environment. We continue to think that stock picking is better than index trading, and we would recommend buying companies that produce things that people want: airlines, energy and housing firms. These sectors’ prospects may remain supported in the short term unless/ until Fed speakers suggest that rates need to move even higher in the coming days and weeks.