- A recent inflation report showed consumer prices rose at the fastest rate in decades.
- The increase in prices were driven by a supply and demand imbalance.
- Inflation pressures should ease later this year and the markets might be overestimating the Fed.
Recently we have seen inflation readings that show consumer prices rising at the fastest annual pace since 1982. Inflation could threaten business profitability, discretionary consumer spending, and potentially derail this current economic recovery. Investors expect the Federal Reserve to raise rates to the 1.75% to 2.0% range (equivalent of seven 25 bps rate hikes) to combat inflation this year. We feel that may be too aggressive as the catalysts behind the jump in inflation (recovering demand and supply constraints) start to subside later this year.
The recent readings of inflation, such as the January Consumer Price Index, showed a 7.5% year-over-year jump. High inflation can reduce the purchasing power of consumers, especially if wage growth does not keep pace, which it has not done over the past year. Additionally, those relying on retirement income, such as pensioners, are negatively impacted. The potential result is that both could stifle consumer demand and derail this current economic recovery. Furthermore, if companies cannot pass costs onto consumers, inflation in the form of higher input costs (for example, wages, energy and raw materials) will likely hurt the current record profit margins, threatening business profitability and similarly affecting the economic recovery.
There are two primary reasons that led us into this inflation predicament. First, the combination of a strong economic recovery and a significant jump in consumer wealth from fiscal stimulus, surging home prices and strong stock market gains has led to an unprecedented demand for goods. On the other hand, a supply-chain crisis has been driven by COVID-19 disruptions and worker/equipment shortages. Thinking back to Economics 101, this combination resulted in a classic supply/demand mismatch, causing prices to rise.
Despite the headlines around the jump in inflation, we expect inflation to ease later in the year, though still remain above pre-pandemic levels. Annual inflation hovered around the Fed’s 2% target in the prior decade. On the demand front, as the economy transitions from an early cycle to mid-cycle recovery, which is usually signaled by the Fed’s first rate hike (more on that later), goods consumption should start to slow and help to reduce demand pressures on the economy. On the supply front, this reduced demand should allow companies to focus on rebuilding inventory, helping supply chains. Also, with worldwide COVID-19 cases declining and more people getting vaccinated, supply chains should further improve as workers return. We are already seeing signs of supply improvement. For instance, new auto sales, which had been hampered for nearly a year by a shortage of semiconductors, surged 20% last month. Also, just recently, the government reported a surge in U.S. imports and a massive jump in overall company inventories in the fourth quarter GDP report. Both suggest overseas production has resumed and logistics are starting to deliver fresh supply to the U.S. economy. With officials at the Port of Los Angeles recently announcing that they expect cargo normalization by the end of 2022, supply constraints should be declining rapidly.
The supply/demand imbalance has driven prices higher and inflation to levels not seen in decades. As part of their dual mandate, the Fed will attempt to combat higher inflation by raising interest rates, most likely beginning at their next scheduled meeting in March. Looking at the futures markets, investors are anticipating that the Fed will need to raise its primary interest rate tool, the Fed Funds Rate, to the 1.75% - 2.0% range by year-end. While we have noted many times throughout the past 12 months that the Fed needs to be more hawkish to combat inflation, we do feel that this current expectation may be too aggressive. Yes, the recent CPI reading was very high and we will likely get another strong reading for the month of February. However, after that, the combination of base effects, when year-over-year changes are smaller due to a high reading one year ago, and supply constraints should improve drastically.
We are in the belief that the Fed ends up being more conservative and does not raises rates to the same magnitude that the markets expect. Even with more favorable base effects and supply shortage improvement to help push inflation lower this year, so called “sticky” inflation, such as owners’ equivalent rent and food away from home, which rises faster than it declines suggests overall inflation will remain well above the Fed’s target for some time. With the labor market very tight, there is the possibility that the Fed overshoots and tightens too much. The probability of an economic soft landing is now unfortunately extremely low in our opinion.
We reiterate that in 2022, our primary investment themes are slowing economic growth, a more hawkish Fed, and an increase in market volatility. With market risks rising, we continue to anticipate more volatility in the near term. Any disruption to current expectations could be a headwind for stocks, and with stock market valuations priced to perfection, this could amplify any volatility. Still lingering stimulus, a financially healthy consumer and the eventual abatement of supply chain issues suggest limited market downside. We maintain that diversification is the key in this market.
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This report is created by Cetera Investment Management LLC.
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