Thoughts on US inflation
This article is written by Julien Lafargue, Chief Market Strategist at Barclays Private Bank.
(Please note: Inflation figures quoted are sourced from the US Bureau of Labor Statistics, as at 10 June 2022.)
While inflation has become a defining topic of 2022, the May CPI print in the US was nonetheless a bit of a shocker.
The headline figure spiked 8.6% year-on-year (Y/Y), above the Street’s consensus (+8.3%) and up from +8.3% in April. Tellingly, the +8.6% represents a 40-year high in the Y/Y increase, surpassing the +8.5% from March.
Core inflation was cooler, rising +6% Y/Y, ahead of consensus (+5.9%) but down from +6.2% in April. The core peak remains +6.5% from March 2022.
As we highlighted in our recent publications, there was a risk and expectation that inflation might run hotter-than-expected in May, given the recent surge in commodity prices.
At the headline level, energy and food did drive a significant portion of the increase - fuel oil rocketed by 16.9% month-on-month (M/M). Encouragingly, core inflation is showing signs of moderation.
Against that backdrop, here are our initial takeaways from the latest data release:
1: The debate on “peak inflation” will rage on
Bulls will point to the stabilisation in the core component, as well as to the upcoming PCE release. Indeed, the US Federal Reserve’s (Fed) preferred measure of inflation has a 22% weighting to medical care prices – three times more than the CPI – and it cooled down in May.
The bulls among us will also highlight the fact that goods inflation was just 1.7% of the 8.6% CPI Y/Y increase, the lowest since September 2021, while services inflation was 3.0%, the highest in four decades. In this context, as the economic activity slows down (but does not crash), inflation could reverse quite quickly.
On the flip side, bears will argue that the peak is still in front of us and that inflation isn’t going away anytime soon. As an example, used cars prices went up M/M in May after declining for a few months. In the opinion of bears, a recession is therefore the only way out.
2: The Fed “pause” is less likely
The recent rebound in equity markets was driven in part by expectations (following a Fed official’s comments) that the Fed could pause its hiking cycle in September, after increasing interest rates by 50bp in both June and July. After this latest data release, the market is discounting another 50bp hike in September, totally dismissing the idea of a pause. Yet, three months is a long time in the context of today’s markets, and although “a pause” is increasingly less likely, it’s not impossible.
3: The immediate future will be key
While there is little doubt that the Fed will hike at the next opportunity, the market will closely watch the FOMC projections. The current dot plot shows that the Funds rate cap was around 2.8%. If this moves significantly higher, there could be further stress (and vice-versa). In light of last week’s release, it will be hard for the Fed to be even more hawkish than expected (apart from committing to 50bps increments for the rest of the year).
What it means for investors
Although the latest numbers might be considered something of a setback, it does not necessarily change the medium-term outlook. The market will see that a Fed pause is less likely and that a recession is potentially more likely, but we take some comfort from the fact that core inflation remains on a downward trend.
Headline inflation can vary significantly in the short term and there’s currently no indication that by September, we won’t be a few percentage points below current levels (in May 2021 WTI price averaged $65 but was closer to $75 in June).
The real question at this point is: what will the Fed do in September and beyond? We may get some more details soon but the reality is that a lot can happen in a short space of time.
It also seems to us that disinflationary pressures are becoming stronger every day. These include, but aren’t limited to, excess inventory in the retail space, rock-bottom consumer confidence, China’s gradual reopening, and demand destruction.
In this context, we believe that investors will be rewarded if they remain patient and do not succumb to the overly pessimistic mood prevailing at the moment. Until further clarity emerges, they should also prepare for continued volatility. Maintaining a highly diversified exposure feels appropriate.
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