US inflation data shocks equities, again
In the AFR on Friday I wrote that blockbuster inflation data overnight has forced markets to converge with our expectation for 6-7 hikes from the US Federal Reserve in 2022. Annual headline inflation in the US printed at 7.5 per cent in January, the highest reading in 40 years. More worryingly, core inflation punched through 6 per cent for the first time since 1984.
On a 3-month annualised basis, core inflation is running at a 7 per cent pace. SGH Macro’s Fed watcher Tim Duy comments that “there is only one way to say this: assuming the Fed’s primary job is price stability, the Fed has arguably missed the most significant macro call since 1966”.
Rather than decelerating as the Fed had hoped, US inflation continues to accelerate, and the details suggest it is broad-based, bleeding into services as well as supply-chain disrupted goods. There is also more evidence of the burgeoning wage/price spiral that we have repeatedly warned about: Goldman Sachs says that “strong wage growth likely contributed , and we will continue to monitor this as a key inflation risk for 2022”.
The immediate price action following the data release was revealing. At first, US equities slumped about 1 per cent, but they then quickly recovered to trade up on the day. This is the post-GFC, "buy-the-dip" reflex at work. It was, however, subsequently torpedoed by Fed voter James Bullard, who jumped on the data to call for a 50 basis point hike in March and a total of 100 basis points by July. Bullard even flagged the possibility of a rare inter-meeting move prior to March. Equities promptly tanked, closing down 1.8 per cent.
SGH’s Duy is not alone in his belief that the Fed is “deeply behind the curve” (he’s calling for seven hikes this year, starting with a 50 basis point move in March). Back in December this column argued that the market pricing of rate increases for 2022 was wide of the mark and needed to adjust to a more aggressive profile. We further posited that the shift to this tougher interest rate regime would trigger significant losses across equities, fixed-rate bonds, credit, and crypto, to name a few.
While the S&P500 did indeed drop by 10 per cent in January (the Nasdaq index fell by more than 13 per cent), the buy-the-dip reflex, which is predicated on the "low-rates-for-long" paradigm, has remained unremitting: prior to last night’s 1.8 per cent drop, the S&P500 had rallied back 6 per cent from January’s low.
There is a burgeoning dichotomy between the hard inflation, wages and employment data, on the one hand, and current market pricing for interest rates on the other. This probably explains the durability of the buy-the-dip thesis relative to the alternative "sell-the-rip" narrative that is slowly starting to emerge.
At the time of writing, US markets had lifted the probability of a stunning 50 basis point hike in March, which was inconceivable only a month ago, to 85 per cent. And rates traders are now pricing in a total of 6.5 hikes in 2022, which is in the middle of our expected range. Prior to the inflation data overnight, markets had shifted to pricing in 5.5 hikes this year, which was a material increase over the circa three rate increases investors had assumed in late 2021.
Equity investors have been clinging to the hope that most of the bad news on interest rates was already in the price. After all, 5.5 hikes (now 6.5) were being assumed. Yet the real source of their optimism is likely based on the market’s benign estimate for the terminal, or final, cash rate in the US.
Whereas the Fed is telling us that their neutral, or normal, cash rate in the absence of high inflation is around 2.5 per cent, the market is only presently pricing in a terminal cash rate of just 1.9 per cent. For some reason, traders don’t think the Fed will ever even get near its neutral 2.5 per cent rate—let alone the 3 per cent plus cash rate that would be consistent with the tight monetary policy settings required to address the highest core inflation since the early 1980s.
This is the key question hanging over asset prices right now.
One obvious explanation for the market’s confidence is that the consumer price pressures are temporary and attributable to ephemeral supply-side blockages. There is clearly some truth to this. Auto price inflation is decelerating, indicating that the COVID-19 induced boost is dissipating.
Analysts like Pantheon Macroeconomics highlight that improvements in auto chip supplies out of Korea and Taiwan will allow manufacturers to ramp-up new car production again, the supply of which will put downward pressure on both new and used car prices. These categories account for about 10 per cent of the headline and core inflation index in the US and have driven a material share of the inflation gains registered thus far. Accordingly, future price declines should facilitate some mean-reversion in inflation during 2022.
On the other hand, supply-side cost pressures may be persistent because of reshoring of supply-chains from China to more expensive local markets, the quest for net zero emissions, and restraints on the availability of capital for fossil fuel industries.
The underlying drivers of inflation are also spreading as wages and labour costs climb. In the US, rental inflation is at its most elevated level since 1992 while non-shelter related services prices are increasing at the fastest pace since 2005. Goldman Sachs says this “reflects strong service price growth across personal care (up 1.2 per cent), domestic services (up 0.9 per cent), recreation (up 0.8 per cent), and hospitals (up 0.5 per cent).
So-called “super core” inflation, which strips out volatile items like food, energy, shelter, and used vehicles, is growing at an even more rapid 8 per cent annualised rate according to SGH Macro. “This acceleration in super-core confirms the story of broadening inflationary pressures as told by trimmed CPI measures,” SGH’s Duy argues.
A final hope for equity investors is the assumption that the Fed has their back. There is a very widespread belief that if shares fall by 20-30 per cent, the Fed will pause, or even reverse course. This was certainly true in 2018 when the Fed lifted its cash rate to 2.5 per cent, and equities slumped 20 per cent. The Fed initially paused and then started cutting again in 2019.
But as we have explained before, this time looks and feels very different. In 2018 the Fed was not constrained by the highest wage growth, core inflation, and consumer inflation expectations data that we have seen in decades.
If this inflation shock is indeed persistent, the only remedy will be a US recession, which is exactly what has followed most Fed hiking cycles. This will be bad news for risky assets. But it will equally bequeath attractive entry points at some future juncture...
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