You have probably heard the phrase buy the rumor sell the news. Well, the rumor for a while now has been inflation, and the news is that we are seeing very strong inflationary pressures. At least that is what many pundits say. So far however, the market is not selling the inflation news.
Markets as we know are forward looking mechanisms, and mostly do not price what is happening today but what might happen in the future. Now, the Fed’s favorite inflation metric is the PCE, or Personal Consumption Expenditures Index. As the chart below depicts, PCE probably peeked some while ago.
Coupled with the fact that 10- year yields also peeked several months ago (chart below), the Fed might be right in shrugging off the inflation talk, and calling inflationary pressures transitory.
Now I am not smart enough to be able to predict if inflation is transitory, if the Fed is right, or if those who worry about inflation are right. However, the market seems not to worry, and we do have indications that inflation may have peeked several months ago.
If this proves to be correct, then the market is correct in not panicking, and the Fed will also be proved correct with its transitory theory. Either way, if we assume the market is the be the best indicator of what is going on – in the sense that we are not seeing panic selling because of inflation fears — then chances are that inflation, is not a risk to the market overall.
The Fed last week basically told us what most of us suspected.
First, the Fed was optimistic about economic growth, while anticipating higher inflation, while stressing that COVID is still a risk.
The Fed will continue to purchase $120B of assets each month until, and I quote, “substantial further progress has been made toward the Committee’s maximum employment and price stability goals”. At the same time, is has not given the market when tapering will begin.
The Fed is also insisting higher inflation is transitory and is mostly due to supply chain “bottlenecks”.
Finally, the Fed shed some light on when it might raise interest rates or takeoff. This expectation is now set towards the end of 2023.
Overall, the bond market does not seem to worry about inflation, siding with the Central Bank. Please note it now seems yields peeked several months ago.
Also note that even assuming rates do rise towards the end of 2023, that is a very long way in the future to be able to position any portfolio. However, it might be a headwind.
The dollar initially rallied, but it has since given back most of its gains. As a sidenote, I personally do not consider the Fed statements dollar positive.
Overall, the Fed is still very accommodative, and does not want to surprise markets, giving a heads up of its intention’s way in advance. This is very market positive, because it provides participants time to digest and price everything in advance.
The bottom line is that the Fed continues to be supportive of both the economy and markets, but please note that now we have two headwinds. First at some point the markets will be concerned about interest rates if they rise, and second, inflation concerns are on everyone’s mind. If we add to these the valuation landscape, investors need to be extra cautious looking ahead.
May CPI in China came in about 1.3%, below the average estimate of 1.6%. This was mostly due to weak pork prices. Please note the CPI Index in China is heavily geared towards food. The producer price index on the other hand rose by a whopping 9% Y/Y, mainly driven by oil, metals and chemicals.
Chinese PPI is a function of higher commodity prices, not due to internal factors. This means inflation is not exported outwards. So, what happens in China in CPI or PPI terms, stays in China. In other words, don’t expect China to be an exporter of inflation as many have suggested. Please note that for the last 30 years or so, China is a deflation exporter, not an inflation exporter.
Last Thursday headline CPI in the US rose 5% Y/Y, the fastest pace since 2008. Used car and truck prices were partially to blame, posting an almost 30% rise Y/Y.
It is the norm for economies to experience pent up demand when coming out of a recession. However, this time around we also have supply chain disruptions due to the pandemic, but also supply chain disruptions because of politics.
But a rise in commodity prices due to supply shortages and disruptions has always been temporary. This is the main reason why Central Banks insist inflation will be transitory.
But the question is, what does the market have to say about all the inflation talk? The market is taking the inflation talk with a big yawn. We have not seen a correction in equities, nor a huge rally in bonds. In fact, when US CPI figures was published last Thursday, the 10-year US bond rallied and yields fell below 1.5%, after rising to almost 1.75% several months ago.
So insofar as the market, the message from the bond market is that it is siding with the Fed, and so far, it is not worried about persistent rising inflation expectations.
Finally let us not forget that even if inflation persists for the next several quarters, the reasons why inflation has been low for a long time have not changed. And the two main reasons are demographics and technology innovation.