We’ve taken a few weeks off from the topic of inflation in “Data”, mostly because we did not see it informing either stock or bond prices last month. Today we will revisit the subject.
First, here’s why inflation is back on our radar screen as a near-term market driver. The following chart shows US 5- and 10-year yields back to the start of 2020 with year-end levels noted in the highlight box. You can see every period of pandemic market history in this one chart: March – September’s deep recession, then October – February’s first flurry of economic optimism, and finally the March-April lull as the pandemic continued to take its toll in Europe and other parts of the world.
On the far right side we see what should be the beginning of the next move higher for interest rates – that lift from mid-April to last week. As we noted last week, crude oil prices rose 7.5 percent in April and to our thinking that move confirms the idea that inflation pressures are building.
As for where the US inflation data will go in the next 2 months with “easy” comps from April/May 2020, 3 brief points:
- The short answer is at least 2.3 – 2.7 percent (core CPI) to 3.9 – 4.5 percent (headline CPI).
- We get those estimates by increasing the March 2021 core/headline CPI numbers by 0.3 – 0.5 percent (their 3-month average increases) and then calculating the year-over year changes from April/May 2020.
- While these numbers may sound high, keep in mind that we’re already running 2.1 percent core and 3.5 percent headline CPI inflation as compared to the May 2020 reading. That’s what this chart shows (March 2020 = 100), and we’ve still got 1-2 more months to go of further inflation before we see the next US data come through.
The last piece of today’s analysis is to check in on what the market is expecting: 5- and 10-year inflation breakevens in the chart below (5’s in red, 10’s in black, data back to 2010). As you can see, 5-year inflation expectations are at 11 year highs and 10-year expectations are back to 2013 levels.
Chair Powell made some comments about these forward inflation indicators last week at his press conference that bear repeating today. See how breakevens were almost always below 2 percent (the straight black line across the graph) from 2014 onwards and how 2 percent was basically a ceiling? Powell clearly sees this as the market doubting that the Fed can actually get to its 2 percent inflation goal. He is therefore entirely comfortable that inflation breakevens are at 2.4 – 2.5 percent right now. In fact, we suspect he would like them a little higher still so that when the Fed does start raising rates they can settle down to slightly above the Fed’s 2 percent policy goal level.
Summing up (1): the US inflation narrative has been as on-again/off-again as every other investment storyline since March 2020, and we think it will get some fresh attention in May. We’re walking into the biggest CPI prints of the recovery to date, there’s plenty of anecdotal evidence that prices are rising, and crude oil is rallying.
Summing up (2): this is not necessarily bad news for US stocks, even if Treasury yields rise. To a fundamental analyst, inflation is called “pricing power” and it is very good for incremental corporate earnings. Remember that the value of a cash flow stream is “annual payment/(discount rate – growth rate)”. As long as growth rates (including pricing power) rise at least as quickly as discount rates (based on Treasuries), valuations should remain unchanged.
Summing up (3): That’s the dynamic we’re looking at right now – one where future earnings expectations rise at least as quickly as Treasury yields. We know numbers are going up for earnings (as described in Markets) – it only makes sense that the pricing power component of those revisions filters through into bond prices as well.