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Financial Industry Insights from Advisors Asset Management

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The Rise of Sticky CPI Drivers?


The Consumer Price Index (CPI) reached another 40-year high at 8.5%, slightly above consensus, with energy CPI up 11% month-on-month (relating to the war in Ukraine). Core CPI — which ignores food and energy prices — fared slightly better at 6.5%, just below consensus (albeit still another 40-year high), largely thanks to a retracement in used car prices.

There are signs that price pressures in “flexible” categories are beginning to fade, meaning “sticky” services, as well as commodities, may drive inflation for the rest of the year, leading to a moderating but above-target trajectory. Importantly, we believe markets are slightly overpricing the Fed’s hiking activity into year-end, meaning it could be time for investors to consider compelling entry points in certain areas of fixed income.

The drivers of CPI are shifting from the “flexible” to the “sticky” categories

As we continue to stress, in our view it is important to split the CPI index across three dimensions:

  1. Sticky services categories (e.g., healthcare and rents)
  2. Flexible categories (such as those impacted by supply chain disruptions)
  3. Commodity categories (food and energy-related areas)

Through this lens, the drivers of CPI look to be shifting from flexible goods to sticky services and commodities. This is best illustrated by used car prices (one of 2021’s highest performing assets) falling 3.8% in March (Table 1).

Table 1: Apart from energy, flexible inflation components are showing signs of moderating

Apart from energy, flexible inflation components are showing signs of moderatingSource: Bureau of Labor Statistics, Bloomberg, April 2022

This supports our view that decelerating flexible categories could allow inflation to moderate by the end of the year, but sticky categories will likely keep CPI meaningfully above target — perhaps around the ~4% region.

Regarding commodities, the surge in energy prices has received much attention, but notably food prices have been rising at their fastest pace in 40 years at 8.5% year-on-year (Figure 1). While the oil futures curve currently suggests the former may moderate, we expect the latter to remain elevated for some time.

Figure 1: Food inflation is running at a 40-year high

Food inflation is running at a 40-year high

Source: Bureau of Labor Statistics, Bloomberg, April 2022

The rise in food prices is partly explained by the fact (as with oil prices) that both Russia and Ukraine were collectively responsible for around one-third of the world’s wheat exports before Russia’s invasion.

This has resulted in significant disruption, compounded by the fact that it is relatively difficult for countries with strategic grain reserves (such as China) to release their inventory into global markets quickly, unlike petroleum markets (where other oil-producing nations have helped fill in the gaps).

In the U.S., we therefore believe higher food prices are a risk to the consumer, as people may need to divert funds previously available for discretionary spending. However, this may not be a headwind to GDP, as we expect savings (amassed since the start of the pandemic) to fall before spending does.

Wages and rents remain the most important long-term drivers of inflation in our view

Wages are the primary driver of sticky services costs. Notably, they have been decelerating lately on a month-on-month basis (though not yet on a year-on-year basis) as many workers have re-entered the labor force after having left during the height of the pandemic (Figure 2).

Figure 2: Rising labor participation could be starting to help cool wage growth

Rising labor participation could be starting to help cool wage growthSource: Bureau of Labor Statistics, Bloomberg, April 2022

Wages naturally feed into rents, which is our top metric to watch for clues about the persistence of inflation. Owner’s equivalent rent continued to tick up at a 0.4% monthly pace (Table 1) and is now up 4.5% year-on-year. Our analysis suggests that rents are likely to moderate in the second half of this year but could remain above pre-COVID-19 levels at least through 2023.

The key to shelter (or rental) inflation is whether the recent strength in the housing market will cool. On one hand, rising mortgage rates (in line with the Fed’s hawkish pivot) should help, but supply shortages remain a concern (Figure 3).

Figure 3: Housing completions over 10-years indicate large secular drop off in housing supply

Housing completions over 10-years indicate large secular drop off in housing supplySource: Bloomberg, April 2022

Consider that in the 2000s, the U.S. built 15.6 million homes, but just 9.1 million in the 2010s. Of course, the 2000s saw far too much building, feeding the housing bubble that burst in 2008. But, we believe the large subsequent drop overcompensated. As such, while shelter costs will potentially ease, we see them remaining relatively elevated.

The Fed will be under pressure to deliver 50 basis points (bps) hikes

Although the April 12 inflation report was not a surprise, it does underline the inflationary pressures that consumers and businesses are feeling in the real economy.

In our view, this helps to confirm a 50bps rate hike at the Fed’s next meeting in May, with a further 50bps hike in June also in the cards. If inflation does decelerate into the summer, in line with our current views, the Fed may then revert to 25bps hikes.

We currently believe the market is slightly overpricing the rate hikes for the rest of the year, but nonetheless we see 2.25% of hikes as a reasonable base case for 2022.

As such, we believe most of the pain from higher rates may already be reflected in current market pricing and investors should increasingly consider entry points for selective areas of credit (such as carefully selected low duration high yield credit) that make up our key investment picks for the rest of the year.

 

CRN: 2022-0401-9906 R

The opinions and views of this commentary are that of Insight Investment and are not necessarily that of Advisors Asset Management. 

The Consumer Price Index (CPI) is released by the Bureau of Labor Statistics as a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

Please note: any forecasts or opinions expressed herein are Insight Investment's own as of April 12, 2022 and are subject to change without notice. This information may contain, include or is based upon forward-looking statements. Past performance is not indicative of future results.


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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