Should investors worry about inflation? Is the upcoming spike temporary, a longlasting trend leading to central banks hiking rates or are bond yields ultimately overreacting?
At the most basic level, inflation is generated in two ways. When the unemployment rate is lower than its ‘natural’ rate, labour shortages can occur. If companies increase wages to attract workers, this pushes production costs higher. If they raise prices too, cost-push inflation occurs. When unemployment is low and wages are rising, demand for goods and services increases too, and consumers are willing to pay more – especially if supply is slow to adjust. The result is higher prices due to demand-pull inflation.
The inverse relationship between the unemployment rate and core inflation – known as the Phillips curve – is unstable over time. Expectations of higher inflation can become a self-fulfilling prophecy and perpetuate any inflation rise, and vice versa. As it turns out, central banks’ credibility as inflation fighters has ‘flattened’ this relationship. In the 1960s and 1970s, a given level of unemployment rate tended to correspond to a higher inflation rate than today – a trend that’s possibly been reinforced by a prolonged period of low inflation (figure 1).
We think US consumer price inflation is set to accelerate to more than 3% year-on-year in the second quarter. However, we expect it to fall back to just above 2% or so 12 months later. This is because much of the rise is due to the comparison with the pandemic-induced fall in prices this time last year. Figure 2 shows an example where the month-on-month inflation rate is a small number every month except in January of year Y when, owing to a one-off event such as a lockdown, it falls to -1%. Inflation calculated in year-on-year terms then slows down for one year until the deflationary effect drops out of the year-on-year comparison and, all else being equal, it goes back to the pre-shock year-on-year inflation rate in January Y+1. An inflationary shock has the opposite effect.
Of course, things are rarely all else being equal in the real world. Oil prices have risen since – and we now project a further pickup to USD 75 per barrel at year-end. But, unless one assumes everincreasing oil prices, this effect too, at some point, drops out of the year-on-year comparison. We build a model that takes drivers like these into account but, crucially, also projects the core inflation rate based on a gradual improvement in the unemployment rate and wage growth, anchored consumer inflation expectations and a moderate feedthrough of producer prices. This model suggests that underlying inflation should pick up too, but slowly, and range between the current rate of 1.5% and about 2% over the next year – still below the Fed target (figure 3).
While our model performs well in terms of projecting overall inflation trends and their seasonal patterns, calibrating these forecasts month after month is harder. It’s possible that the pass-through of past dollar weakness and higher oil prices is more rapid than expected. However, the dollar has strengthened recently and we believe that the biggest jump in oil prices is behind us (figure 5) – although stronger demand on the back of reopening and supply restrictions implemented by OPEC+ are still likely to drive oil prices somewhat higher from here. More uncertain is the impact of a shortage in processing capacity at ports, as well as limited availability of shipping containers. This has led to a surge in shipping costs from China to the US and Europe (figure 6). If sustained, these higher costs may partially be passed on to consumers. We bias our forecasts upwards to account for these price pressures – and for the impact of weather on food prices – but this calibration exercise is imprecise.
How much these lagged and temporary effects feed through and, ultimately, impact producer and consumer prices remains to be seen. For now, it looks as if producers are willing and able to absorb these costs via margin compression – at least in part. China’s producer prices, which are important for global supply chains, have risen, but their pace of increase is now merely in line with the longterm average. US producer prices have picked up too, although the current rate is well below past peaks (figure 7). Importantly, whether any current or future pipeline price pressure eventually translates into a faster pace of consumer price increases depends on whether firms believe the consumer is able to withstand a higher bill. From this perspective, even though it’s getting better across all measures, we think the headline unemployment rate underestimates the degree of slack in the economy. Accounting for ‘underemployment’, joblessness is much higher – which should mitigate any upward pressure (figure 8).
To be clear, it’s not impossible that overstimulation manages to turbocharge demand and deanchor inflation expectations, and that supply bottlenecks turn out to be more structural in nature. More realistically, though, we think the upcoming inflation spike will likely be followed by positive, but moderate inflation trends – at least until the labour market tightens more visibly and/or pipeline price pressures rise to a greater extent. We won’t likely get back to the very low-inflation, very lowyield environment seen during the pandemic. However, we won’t be in a strongly inflationary environment either. While we do forecast rising inflation and bond yields over the medium term, we see this happening in the context of stronger growth. Historical equity and credit performance has been better when rates are rising rather than falling, especially when rates are rising along with inflation expectations.
The picture we’re painting here is one where growth recovers strongly, inflation picks up but more moderately in this early phase of the cycle than historically (apart from a near-term spike), and the major central banks don’t hike rates for the next two or three years. Market pricing of nearly three Fed rate hikes through 2023 seems too hawkish to us. We expect one. In essence, this means:
Rising but historically low US yields. We now expect US 10-year yields to range between 1.75% and 2% in the fourth quarter of 2021 – perhaps ending higher than that in the final part of the quarter – and rising gradually as the cycle progresses. Eventually, central bank tightening should become a more realistic scenario. We think the Fed won’t push back if inflation overshoots slightly (since it changed to flexible average inflation targeting last year) and yields pick up mainly because of faster growth, but we think the Fed would want to continue to keep government funding costs affordable. We expect an announcement on tapering (scaling back the size/pace of asset purchases) at the end of this year, to start in early 2022. We don’t see any rate hike until 2023.
Steeper yield curves. Front-end rates should remain anchored and long-end rates increase further, but not that rapidly. That said, we don’t believe that, even when we’re through the temporary rise in inflation that we envisage from next month (March data and, more strongly, in Q2), we’ll return to inflation rates and bond yields as low as those seen during most of the pandemic. We see steeper curves as signs of normalisation but, just like with the level of yields, there’s probably a limit to how much and how rapidly they can steepen. However, should the yield rise be too fast – say, higher than between 2% and 2.5% at year-end – we’d expect the Fed to skew its purchases towards the long end of the curve, in an attempt to push yields down.
European inflation/yield outlook more subdued. There’s more scope for inflation/yield normalisation in the US than Europe, as growth prospects, vaccine trends and fiscal policy all look more favourable in the former than the latter. The European Central Bank has recently announced that it would step up the pace of bond purchases to mitigate any unwarranted rate rise. It should revisit its inflation aim from “below, but close to, 2% over the medium term” to symmetric around 2%, similar to what the Fed did last year. This means that it will let inflation rise (a high-class problem for now) above target for some time before it begins hiking rates.
Stronger US dollar. We no longer expect the US dollar to weaken to 1.25 versus the euro. We now see the current level of around 1.20 as a likely turning point and project gradual dollar strength from here. Our new target is 1.17 at year-end and 1.15 at the end of 2022. This is because we now see stronger growth and higher inflation in the US relative to the euro area, and more scope for rising Treasury yields versus Bund yields. In turn, this is because of extra fiscal stimulus in the US and faster vaccine rollouts, versus a slow implementation of the EU recovery fund and a lagging inoculation programme in the euro area.
Higher oil prices for a while longer. We also see higher oil prices than previously, ending the year at USD 75 per barrel, but with only modest upside from there. As economies open up and mobility restrictions are lifted, there’s potential for oil demand to grow to well over 1 million barrels per day month-on-month for several months in a row over the summer period. Additionally, with OPEC+ continuing to target a tight market, supply restrictions may put some pressure on prices. That said, our macro outlook wouldn’t be consistent with much higher prices at short horizons, say, above USD 80 per barrel.
Some emerging markets to struggle. The pace of increase in US 10-year yields is two to three times the ‘pain threshold’ of 20 to 30 bps per month beyond which emerging market (EM) assets typically struggle. Comparing EMs across many dimensions, our scorecards suggest that Asia has the strongest fundamentals – but it’s also the EM region where equity valuations look more challenging, although this may partly reflect structural shifts towards higher growth sectors – while Latin America shows a range of vulnerabilities. Exporters of commodities, at this stage, benefit from rising commodity prices.
Cyclicality to stay well supported. When the cycle turns from recession to pickup, and eventually expansion – when things move from weak and getting weaker to weak and getting better, and eventually strong – what tends to happen is that assets geared to accelerating growth outperform, including cyclical stocks, sectors and investment styles. Core rates typically underperform. Long-duration, growth stocks such as tech may be impacted by a somewhat higher discount factor – and, briefly, they have been – though this is just one factor to consider and the horizon that matters here is a longer one.
Daniele Antonucci Chief Economist & Macro Strategist
Tom Kremer Senior Fund Manager
Bill Street Group Chief Investment Officer