On Friday’s Hotter-Than-Expected US Inflation Data

Ouch. Today’s CPI report showed US inflation reaccelerating to 8.6% y/y in May—notching a new 40-year high—and stocks didn’t like it.^[i] The S&P 500 dropped -2.9% in price terms on the day, extending Europe’s earlier declines.^[ii] Fast inflation and market volatility is a painful combination, especially for those trying to grow their assets over time to support living expenses. The fear of hardship is real, and we get it. So at times like this, we think it is best to breathe deep, think longer term and remember some first principles.

The precise reasons for sharp volatility are always impossible to pin down. On its face, the CPI acceleration was modest, and the 8.6% rate is but a whisker faster than March’s 8.5%. But it wouldn’t surprise us if the world’s expectations heading into today were a touch too optimistic. You see, for the past two months, the financial world’s general take on US inflation is that it is peaking. We saw it when the inflation rate hit its prior high in March—there was a lot of this is the top chatter. We saw it in April, when CPI decelerated to 8.3% y/y—then, it is finally easing was the general spirit. On both occasions, we counseled against that mentality and the follies of trying to predict such turning points in general.

Today’s market reaction is a prime example. Last month, as the world cheered April’s CPI slowdown, we cautioned:

We would love it if prices were really, truly offering American households some relief, and we do expect inflation to moderate as the year progresses. But this effort to pinpoint the start seems counterproductive to us. Markets aren’t myopic, and such inflection points will be clear only in hindsight anyway. In our view, keeping realistic expectations and a long-term perspective will be key to navigating the period ahead.

We say this because we can envision a world where April’s slight deceleration creates expectations that the worst is behind us. … We can see a risk that investors get too caught up in a the worst is over mindset and get blindsided if inflation remains stubbornly high, raising the temptation for knee-jerk portfolio moves. Four-plus months into a correction (sharp, sentiment-fueled drop of -10% to -20%), reacting to bad headlines is one of the most dangerous moves an investor can make.

Now investors are living that reality and its associated temptation. So let us reiterate our prior message: Pinpointing inflation turning points is impossible. Only now we say this not as admonishment, but as encouragement. Inflation defying popular expectations doesn’t mean the situation suddenly took a major, unforeseen turn for the worse. Rather, we think it means the crowd made a collective mental error of presuming data follow pre-set patterns and that one month’s movement surely signals a new trend. In our view, data have never worked like that. Whether we are looking at inflation, retail sales, industrial production, exports or what have you, all economic indicators are subject to monthly variability—sometimes seemingly big movements. Over time, those wiggles even out to a trend, but it is messy and only clear with several months’ hindsight.

So, we suggest not getting caught up in the short term. Instead, recognize that while data surprises can affect sentiment in a big way in the heat of the moment, sentiment itself is a short-term market force and can flip the other way on a dime. Remember that, notwithstanding daily price volatility, stocks tend to look about 3 – 30 months out, with the gap between expectations and reality the driving force. If economic data create lower expectations, then it lowers the bar for reality to clear. It takes less good news to deliver positive surprise and lift stocks over the medium and longer term.

Today, that bar looks quite low, and not just because May’s inflation report deflated investors’ nascent hopes. Yesterday, The Washington Post released a survey conducted jointly with George Mason University’s Schar School of Policy and Government, which found 66% of Americans think inflation will worsen over the next year.^[iii] That is just one survey, but when economists see stuff like this, they warn inflation expectations will become a self-fulfilling prophecy—that when people expect prices to rise, they will buy more now to lock in lower prices, and their demand will drive prices even higher. We have seen little evidence of this in reality, mind you—inflation is a monetary phenomenon, not a psychological one. But the belief reigns and it, too, contributes to the general expectations for worsening inflation to hit economic growth hard. The latest global forecasts from the World Bank and OECD, released this week, added to that “stagflation” chorus.

In our view, this fear is what is weighing on stocks. To us, it looks very detached from market fundamentals. Owning stocks means owning a share of publicly traded companies’ earnings, and profit margins have so far been resilient. Businesses’ costs are up, but they have pricing power in our growing (yes, growing) economy. From a household budgeting standpoint, this is probably bad news, because that is the very inflation that shows up in CPI and forces many people to make tough choices. But from an investment standpoint, which is how we always approach these things, it means inflation thus far hasn’t proven deleterious for earnings at a fundamental level. That is the reality we think fear is blinding people to now. As it gradually—and perhaps subconsciously—dawns on investors, we see potential for stock prices to catch up.

As for the inevitable Fed angle, we don’t give much credence to the main claims that rate hikes aren’t yet working, requiring the Fed to move fast and furious from here. As we discussed yesterday, monetary policy moves hit at a lag—anywhere from 6 to 18 months or more, depending on the methodology economists use to study this issue. Even if this inflation stemmed from excess money supply growth, it would be unrealistic to expect the incremental move in rates since March to have an effect on inflation yet. Then too, in a world where inflation stems from the “too few goods” side of the “inflation is too much money chasing too few goods and services” maxim, the only way the Fed could get it to come down is with a severe destruction in demand for that limited supply of goods. Two rate hikes totaling 0.75 percentage point—and that leave the yield curve quite positively sloped and at low levels relative to history—won’t destroy demand to that extent. (Nor would anyone even want this demand destruction, considering it would be a byproduct of a Fed-induced recession.) In our view, looking to the Fed to fix this is about as misguided as trying to predict Fed policy in general.

That is the bad news. The good news: We don’t intend any political or ideological statements by saying this, but there are still reasons to think inflation is likely to slow within the foreseeable future. The New York Fed’s latest Global Supply Chain Pressure Index showed costs and constraints in the global shipping world are easing. China’s May export data, released yesterday, show ports there are back in action as COVID restrictions ease. In the energy world, producers are responding to high prices and feared shortages of oil and natural gas. The natural gas price spike triggered by a LNG export terminal explosion earlier this week is already incentivizing more US production, which should help stabilize global markets. So, too, should ramped-up oil production in the US and OPEC’s swing producers. US oil producers have already added 100 rigs this year.^[iv] Stabilizing energy costs will benefit goods and services prices alike, as it should render the passing-on of energy costs to consumers more or less a one-time deal.

Therefore, take that deep breath. People near-universally expect inflation to be quite bad within the 3 – 30 month window stocks weigh most. That is what markets are pricing in—that fear. Even not-quite-as-bad inflation would therefore be a big relief for stocks. To us, this remains the most probable scenario over the foreseeable future.