Inflation data coming out as forecast might seem boring, but it is good boring. Expectations of easing inflation are starting to be justified by the data, which means more confidence that interest rates don’t need to go up by much more. The environment for fixed income remains good as a result. But the danger is not over, and inflation will remain above recent historical levels for some time. Rate cuts from the US Federal Reserve (Fed) in 2023, in the price already, are not guaranteed by a long chalk. Still, no surprises and a boring macro world should be better for investment returns.
Challenge 1 – successful
Consumer price index (CPI) data from the US for December has kept the market rally alive. The belief that the Fed will not need to take its key policy rate above 5% is becoming unshakeable with market pricing of the peak in rates being stable since early November. It remains a positive environment for fixed income markets with annual inflation rates in the US - for both headline and core -falling convincingly. The December inflation data was the first big test for markets this year and it didn’t prove to be a problem. It came in right on expectations. No drama, no surprise, just a boring CPI print. Now the focus turns to the Fed policy meeting on 1 February. The market debate is shifting from “how many more hikes?” to “when will the Fed cut?” I guess we might have to prepare for Powell et al to hit back with “we are still hiking.”
It is interesting to look at the behaviour of inflation. There are always aggregate and idiosyncratic influences. Clearly the recovery from COVID-19 created a misalignment in global supply and demand which has pushed inflation higher everywhere, most notably in the products and commodities with the least elastic demand and supply curves. There are also micro trends which analysts pore over with every monthly release – what is happening with used car prices? Is shelter a real cause for concern? And so on. Yet, apart from the last year or so, inflation has been remarkably stable over the last two decades. Stable, with clear seasonal patterns.
First half higher
Taking inflation data from the US since the early 1990s, I calculated the average increase by month. The average monthly gain has been 0.217% for headline and 0.209% for core. The non-adjusted data reveals the seasonal patterns more clearly – monthly increases tend to be higher in the first half of the year. This is an observation that inflation-linked bond traders and investors are very much aware of in their attempts to maximise inflation carry in their strategies. Comparing the long-run averages with the outcomes for 2022 shows that most of the inflation shock came in the first few months of the year – curiously enough just ahead of and after the Russian invasion of Ukraine and the jump in global energy prices. Towards the end of the year, monthly increases in CPI were much more in line with the historical averages. Not to say inflation has normalised but when inflation reports come out close to expectations markets are relieved. Better boring than surprising.
Core prices show a slightly different seasonal pattern with humps in the annual profile coming in the first quarter (Q1) and Q3. The 2022 experience is a little more concerning with core inflation. There were inflation shocks (2022 outcomes relative to long-term averages) in most months, including December. This tells us that underlying inflationary trends remain well above the (recent) long-term performance of inflation in the US. This is what the Fed is concerned about. Unadjusted monthly average increases in core inflation in the US in Q1 have historically averaged 0.3%, 0.5% and 0.4%. The seasonally adjusted numbers are lower, but the point is that as each year begins, there is a tendency to raise prices and wages. Given the inflationary momentum that built up in 2022, the risk is that these increases will be higher than the historical average.
Year-on-year inflation rates should continue to decline but the risk is that this process could become sticky, especially at the core level. If Q1 2023 core monthly inflation numbers are just 0.1% per month higher than the historical average, the annual inflation rate will remain well above 5.0%.
Inflation is coming down, but we need to be aware of the risk that, at the core level at least, there still might be room for upside surprises. At the headline level the key risk is energy prices rising again – which could happen in the short-term if the second half of the northern hemisphere winter is colder (especially in Europe which has benefitted from unseasonably warm temperatures so far). The re-opening of China also poses a risk to global energy prices.
Short-duration remains the favoured fixed income strategy
Until we get through Q1 the Fed is likely to remain somewhat hawkish and continue to push back against the idea that rates could be cut this year. This continues to support the short-duration versus long-duration trade. It’s the same in Europe as well with the longer-end of the yield curve at risk from still negative inflation dynamics and the European Central Bank (ECB) moving towards reducing its balance sheet. The ECB will push rates higher, the decline in inflation will come after that seen in the US, and the market has not quite settled on an equilibrium trading range for German bunds and other bond markets, to the same extent it seems to have in the US.
Labour trends are important too
As well as the profile of inflation, key to any change in Fed policy is the labour market. It remains strong with the unemployment rate at 3.5%. There are some signs of slowdown – surveys from the Institute for Supply Management (ISM) have seen declines in their employment indices and the average workweek (number of hours worked) has been steadily declining in recent months. Average earnings growth is also moderating. But much of this could be that firms are asking workers to work slightly less hours and are reluctant to make big pay increases in the face of slowing demand. But they are not, overall, letting workers go. Given how tight the market is, firms may prefer to hoard labour until the economic outlook becomes clearer.
The details of the US employment situation highlight one sector that is still struggling to recover employment levels – leisure and hospitality. It is the only one major economic sector with payroll job levels below where they were in February 2020, immediately before the pandemic. People left jobs in hotels, restaurants, and bars when the economy was shut down in March 2020. They have come back but not in the same numbers. The inability to work from home, safety concerns and financial reasons may be reasons why workers have permanently left these industries. Higher wages are enticing people back – average earnings growth in the leisure and hospitality sector is above whole economy wage growth – and clearly there is demand for hotel accommodation and eating out. It would seem workers quitting this sector have contributed meaningfully to the decline in labour participation over the last couple of years. No wonder many people complain about poor service and staff shortages in restaurants and hotels these days. It’s not just a US problem either, international data show employment levels have not fully recovered. Flexible working and zero-hours contracts have made the leisure industry a less attractive place to work and certainly to build a career.
I’m not sure paying bartenders more money is necessarily the major cause of inflationary concerns. But the employment situation in leisure and hospitality highlights the structural issues in labour markets. High wage growth reflects strong demand for workers and constrained supply. Policy needs to address getting people back into the labour force to avoid excessive wage inflation going forward.
All of this suggests, despite good news in terms of the momentum of inflation, that investors must recognise the world has changed since COVID-19, and employment is different today. Some sectors are struggling with that, and this means labour markets are tight in many economies. Monetary policy must deal with the risks of inflation but the causes need to be addressed by other policies – taxation, immigration, training, and investment.
However, these are slow moving and not immediate investment themes. If inflation behaves and central banks calm down, we could be in for a boring year. Boring would be very welcome after the 2020 pandemic, the 2021 frantic recovery and the 2022 war-induced inflation surge. Boring would be good because markets are cheaper than they were last year, and yields are higher. Boring should mean better performance and gains in wealth. Let’s be boring!