March Inflation Through Markets’ Eyes

Editors’ Note: MarketMinder is nonpartisan, favoring no politician nor any political party. We assess developments and policy prescriptions solely for their potential market or economic impact (or lack thereof).

US inflation hit another 40-plus year high in March, this time with the Consumer Price Index (CPI) rate clocking in at 8.5% y/y.^[i] In a rather novel twist, most of the coverage parsed the underlying details in search of signs prices are peaking—and hit on encouraging nuggets like the deceleration in month-over-month core CPI, which excludes food and energy. While we think the nascent sentiment shift is noteworthy, the overall exercise seems largely beside the point. For stocks, the question remains: Is elevated inflation a big enough negative to knock the economy into recession? We don’t think so.

Not that fast inflation is good—it isn’t. For households keeping to strict budgets, it is cold comfort that prices outside food and energy rose just 0.3% m/m compared to headline CPI’s 1.2% jump.^[ii] Inflation has become increasingly political, too, turbocharging the emotional response (and leading to some rather unusual “solutions,” which we will discuss momentarily). There are hardships and difficulties all around, and we don’t dismiss that. But stocks don’t move on whether any development is good or bad in a vacuum. Rather: Is the totality of the economic—and corporate earnings—picture likely to develop better or worse than expected over the next 3 – 30 months? Whether inflation is a big enough negative to offset all the positive forces is what really counts, in our view.

To assess this, we think it is most helpful to come at it from two angles: households’ point of view and businesses’. Spiking food and energy prices are widely seen as a headwind for the former, as they constrain family budgets. Yet spending on food and energy is still spending—it counts positively in GDP. Higher prices may limit spending on discretionary goods and services, but as we wrote a few weeks back, the effect historically hasn’t been as big as you might think. For one, food and energy were just 7.1% and 2.3% of total consumer spending, respectively, in 2019 (before lockdowns crashed oil prices).^[iii] The extent to which households will have to make adjustments will depend on whether and how much their disposable incomes rise alongside the prices of their daily essentials. So far, wages and salaries are keeping a decently close pace, which should help limit the impact. The Atlanta Fed’s wage tracker, which charts individuals’ compensation, showed median wage growth at 6.0% y/y over the past three months.^[iv]

We offer that stat as an economic offset because—and we say this without political bias—the White House’s latest reported plan to help tame gas prices probably won’t do much. In the time-honored tradition of “doing something” about something frustrating voters in a midterm election year, the Environmental Protection Agency has agreed to allow sales of gasoline with a higher ethanol count during the summer months. Typically, the summer blend has lower ethanol since the alcohol-based fuel generates more emissions than typical refined petroleum—an effort to keep the smog at bay during America’s traditional Road Trip season. But the White House has decided allowing more ethanol (and emissions) is an acceptable tradeoff if it can ease folks’ pain at the pump.

In our view, there is a tiny little problem with this: Ethanol derives from corn, and corn prices also spiked as Vladimir Putin invaded Ukraine. As we wrote last week, Ukraine is a top global exporter of wheat and cooking oil. With the invasion wiping out most of its shipments, demand for alternate grains and oils is spiking, sending corn prices through the roof. And unlike oil prices, corn hasn’t un-spiked since the invasion—it is trading at a high plateau. While Russian crude oil has still found its way to the market, easing the immediate supply concerns, there is no such luck for Ukrainian wheat and sunflower oil, which could extend supply constraints through this year’s crop season at least. So while Brent crude oil prices are now just 18.9% higher than they were six months ago, corn is up 46.2%.^[v] Therefore, we fail to see how adding more ethanol will be a material benefit.

On the business side, we think the divide between headline and core CPI is more relevant. The latter rose a milder 6.5% y/y, with much of the rise coming from goods.^[vi] Core services (meaning, services excluding energy services) rose 4.7% y/y.^[vii] That means most businesses aren’t having to raise prices through the roof, which limits the risk of alienating their customers. It may also mean that many of these businesses are able to absorb their own rising costs without having to pass them on fully to customers—one of the benefits of having big profit margins, which companies up and down the S&P 500 have these days. Those with the ability to limit their price increases should gain market share, which can be a big long-term earnings boost if new customers stick around. That is a possibility we haven’t seen discussed much, making it an area where reality looks ripe to exceed dismal expectations.

Businesses’ ability to continue generating earnings in inflationary environments is why stocks often do better than other asset classes at keeping pace with (and even exceeding) consumer prices. While consumer prices rose 8.5% in the 12 months through March, the MSCI World Index returned 10.1% over the same period—that includes this year’s early correction (sharp, sentiment-fueled decline of -10% to -20%).^[viii] The S&P 500, perhaps more relevant when discussing US-specific inflation measures, rose 15.6%.^[ix] Hence, while inflation accelerated, stocks proved a pretty good inflation hedge. Of course, we are in a correction now, but in time, we suspect rebounding stocks will cushion investors against rising prices about as well or better than any other similarly liquid asset class out there.

America’s economy seems to be growing on an inflation-adjusted basis over the last year even though prices rose 8.5%. GDP isn’t synonymous with the economy, but as a rough gauge of output, real GDP rose 6.7%, 3.3% and 6.9% annualized, sequentially, in 2021’s final three calendar quarters. Q1 2022 data aren’t out yet, but monthly numbers held up pretty well. We already have a lot of evidence the economy can withstand fast price rises. In our view, the benefits from global reopening—which is well underway pretty much everywhere outside China—should help offset price-related headwinds, too.

Again, we know inflation is painful. We hate it too. But tuning down these emotions is key to navigating markets over time. Humans hate inflation, but stocks don’t.