U.S. inflation surges. Are transitory issues to blame?
On the latest edition of Market Week in Review, Chief Investment Strategist for North America, Paul Eitelman, and Research Analyst Laura Bardewyck discussed the steep rise in U.S. consumer prices, the inflation outlook for the rest of the year and the market's reaction to the April inflation report.
U.S. consumer prices soar amid supply-chain disruptions, bottlenecks
On 12 May, the U.S. Labour Department announced that its consumer price index (CPI) - a key gauge of inflation - jumped 4.2% during April on a year-over-year basis. Eitelman characterised the increase as quite significant, noting that on a monthly basis, the core CPI (which strips out prices from the volatile food and energy sectors) rose by 0.9%. "This month-over-month increase was the steepest in core inflation since 1981," he remarked.
So, what's behind the rapid rise? Unpacking the April CPI report further, Eitelman said that transitory issues appear to be the dominating factor. As an example, he pointed to the automobile industry, which experienced one of the sharpest rises in prices last month. "The increase in cost in both new and used cars during April was largely a result of the ongoing semiconductor chip shortage," he stated, noting that he expects the issue to fade away over time. This is because semiconductor suppliers and car manufacturers both have strong profit incentives to continue boosting supply, Eitelman explained. He added that while temporary, the issue could still take several months to resolve.
Transitory issues are also at the root of the rapid climb in airfare and hotel prices, Eitelman said, noting that both rose by roughly 10% last month. "It's important to remember that at the onset of the COVID-19 crisis, both of these sectors had absolutely no pricing power. There was simply no demand due to government-mandated lockdowns and restrictions," he remarked. Now, with the U.S. economy aggressively reopening and travel picking up, these sectors are starting to regain some pricing power - but from exceptionally low levels, Eitelman explained. This is resulting in sharp month-over-month price increases, he said.
All told, industries beset by these types of transitory issues comprise about 80% of the increase in core inflation, Eitelman said, indicating that much of the steep rise in costs should fade over the course of 2021. "Essentially, the U.S. economy is level-setting as life returns more to pre-pandemic normals," he stated.
Inflation outlook: Base effects likely to skew May data as well
In the short-term, Eitelman said that he expects a few more months of unusual inflation data, with large price increases likely to be reflected in the May numbers as well. In addition to the ongoing supply-chain bottlenecks and shortages, he stressed that base effects - the term used to describe the distortions in inflation data that occur when current numbers are compared to extremely low (or high) numbers from a year ago - are still very much present. "It's important to understand that last spring, the U.S. actually experienced deflation due to widespread lockdowns - and this spring's numbers are now being compared against those very low numbers," he explained. These base effects began artificially boosting U.S. inflation numbers in March, Eitelman said.
As a result, the U.S. Federal Reserve (the Fed)'s preferred measure of inflation - the personal consumption expenditures (PCE) price index - is likely to rise to around 3% in the short-term, Eitelman said. "Notably, that would be an increase well above the Fed's 2% target," he remarked. However, starting around the second half of 2021, and especially into the first part of 2022, Eitelman expects the inflation numbers to return to a more normal state. "By the end of this year, inflation is likely to look a lot less troublesome for both investors and the Fed," he concluded.
Does rising inflation spell bad news for growth stocks?
Pivoting to the market's reaction to the April inflation numbers, Eitelman said the immediate effect was a sharp uptick in volatility. U.S. Treasury bonds sold off in the wake of the 12 May report, he said, because inflation lessens the value of the fixed payments that bondholders receive. This, in turn, pushed up government bond yields, with the yield on the 10-year U.S. Treasury note up approximately 7 basis points as of mid-morning Pacific time on 14 May.
The volatility rippled into equity markets as well, Eitelman said, with key U.S. benchmarks selling off on the news. The selloff was especially pronounced in growth stocks, he noted, as evidenced by the tech-heavy Nasdaq Composite Index, which tumbled over 2.5% on 12 May.
"Growth stocks tend to earn their cashflows further out into the future, which makes them much more sensitive to discount-rate dynamics than value stocks," Eitelman explained. As a result, value stocks outperformed growth stocks by approximately 200 basis points the week of 10 May, he observed, continuing the trend from the start of the month.