This is not about the author’s favourite milk – naturally, that’s Earth’s own unsweetened almond milk (technically, it’s a beverage due to the political clout of dairy cows, but it will always be milk to me). The 2% is actually about the U.S. 10-year Treasury yield breaching this threshold for the first time since mid-2019. Yes, the way back before Covid. In 2019, yields were falling, the Fed had recently finished a two-year-long rate hiking cycle (8x25bp hikes in total), and the U.S. economic leading indicators were flatlining. The economy was slowing, and inflation (U.S. core CPI) was a paltry 2.0%. As a result, yields kept falling and were then crushed by the pandemic
Fast forward to today: we have a global economy that is growing at a pace well above norms. Global production bottlenecks caused by the strong resurgence of demand and issues with supply chains. And it was the Consumer Price Index (CPI) print for January that helped push the longer-term yield over 2.0%.
U.S. CPI rose 0.6% in January, roughly the same pace of inflation as December and about the average over the past year. Clearly more persistent than passing. While there is some good news, it’s mostly bad news in this month’s data. Some of the previous drivers of CPI have started to stabilize or come back down, which is good news. Plus, much of the rise can still be attributed to durable goods, which are still experiencing demand/supply mismatches. However, higher prices are now being seen across most categories – in other words, it is spreading.
None of this should be much of a surprise, though. Demand dynamics remain and supply is still struggling in certain areas (Omicron didn’t help). Inflation will likely remain a hot topic throughout 2022, if not beyond. And there are a few key questions, of which the answers will have an impact on the markets.
Path for the demand/supply imbalance? The answer to this one is pretty optimistic. As we all know, our spending patterns changed abruptly during the past few years, and supply chains/logistics are still struggling to adjust. Add in some Covid issues, and it takes even longer. But if you look a bit further up the supply chain, things have been improving. There are still shortages in chips, but given that the price has come back down, it does indicate things are improving. Global container shipping costs have come crashing back down. And manufacturing survey data does support that backlogs are easing. Just ask a friend who has purchased a new car – it may have been delayed but has likely arrived.
This is evidence that the supply chain is catching up. And, assuming the broader re-opening continues to gain traction, the shift from durable goods to service spending that has already started may accelerate. If this happens, we could very well be talking about too many goods in a year or two.
Are inflationary mindsets changing? Higher prices are manageable from an overall market/economic perspective if buyers and sellers view them as temporary or caused by the pandemic imbalances. Higher prices become an issue when people start believing the pace of price increases will continue for a much longer period of time. Do I buy that TV today? If I wait, will it be more expensive? Do I demand a higher wage, not based on my output or contribution, but given the rising cost of living? This mindset changes behaviours, and that can be economically dangerous.
Wages have started to rise. However, it's still difficult to conclude if this is from a changed mindset or yet another demand/supply imbalance caused by the pandemic. Probably more the latter for now. The economy is expanding, companies are trying to meet rising demand, profits are up, productivity is up, and companies appear willing to pay more. The chart below shows U.S. wage growth running at about 5%, the highest since the late 1990s early 2000s. Labour is in the driver’s seat at the moment. We would note that the NFIB small business survey on compensation plans, which has a history of leading wage changes, may have peaked and rolled over. The next few months may be key as this survey does wobble.
To dig a little deeper into the mindset of people – or more aptly, the people running companies – we turned to some natural language processing. Scrubbing earnings calls, research, presentations, and company filings for TSX and S&P 500 member companies, we see what is on their minds if you look for key words or synonyms. For a baseline, we used the average frequency of key words in 2019. Companies are clearly struggling with ‘cost inflation,’ which fell during the depths of the pandemic in 2020 and has been steadily rising (chart below). Labour costs have been rising as well. Most interesting has been the mention of margin pressure, a recent increase. Higher costs certainly hurt margins, but a stronger economy and rising prices help margins. Companies are mentioning margin pressure, but the mention of lower margins has not followed. Coming quarters will be crucial if this ‘talk’ translates into actual margin issues.
Will break-evens move?
We can all cite anecdotes of paying more for something that used to cost less. Gawk at headline CPI data that hasn’t been seen in a long time. But given the ambivalence shown in longer-term break-evens, the bond market continues to say this will pass. Perhaps because of the mountain of debt accumulated during this pandemic (which is disinflationary), demographics, or technology. Or it is a learned response developed during careers spent in a low inflationary world. Any previous upticks faded.
In the 1980s and early 1990s, bond traders didn’t believe the central banks could tame inflation. Any rise in the inflation data was expected to continue to rise and potentially spiral. Thirty years later, these aggregate beliefs have reversed. We learn from our personal experiences or history and form pretty strong beliefs. Perhaps we are all more Pavlovian than we thought.
At the moment, the market is saying this will pass. Inflation break-evens beyond the next year have actually been coming down over the past few months. The path of these longer-term break-evens matters much more for markets than the one-year or CPI data.
Investment Implications
We remain in our previous camp – bond yields will trend higher, but we may have already experienced most of the move. The CPI headline data will come down materially this year, reducing the quantity of ‘inflation talk.’ But inflation will remain elevated compared to the past decade. While this is our base case, the variability of scenarios is much greater today than in years past. In other words, inflation risk is now with us.
We continue to believe tilting towards value will perform better than growth in this elevated inflationary world. Real assets or other investments that can hold onto purchasing power should remain a portfolio construction consideration. We would also point out that given the TSX’s resource, infrastructure, and real estate exposure, it is one of the more ‘real’ markets available to investors.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
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