Inflation peaked | Looking for Alpha
It would not be surprising if inflation peaked at the height of investor dismay. A year ago, I wrote an economic report warning investors of an impending spike in inflation and interest rates, which largely fell on deaf ears. The consumer price index was rising at an annual rate of 1.4% at that time, and the 10-year Treasury yield was around 1.2%. Wall Street pundits were indifferent.
Our economy is like a pot of boiling water whose top is held together by the pandemic. Suppose this peak is a combination of inflation and long-term interest rates. The steam pressure is building, some is starting to escape, as the number of new cases and hospitalizations decline rapidly, more people are vaccinated, and economic restrictions are slowly eased. The top begins to vibrate, as its edges lift off the pot in jerks. Yet the federal government is poised to turn up the heat once more with an additional $1.9 trillion in economic aid, which will bring even more pressure just as the pandemic is contained and the economy reopens. The end game is an explosion that sends that top flying, leading to a much higher rate of inflation and long-term interest rates that the market doesn’t expect. It is time to prepare portfolios for a new macroeconomic and market environment.
A year later, the consumer price index climbed at an annual rate of 7% and the 10-year Treasury yield rose to 1.9%. The investor consensus is now obsessed with inflation, whereas a year ago it was listless. The Fed now believes that inflation should be longer and faster than expected, whereas a year ago Chairman Powell was certain that a more modest increase would be transitory. Once again, I find myself in complete disagreement with the consensus.
It may be anecdotal, but I think it’s worth thinking about. I was prompted to call a top in Bitcoin (BITO) last October when the cryptocurrency was trading above $66,000, largely because Wall Street had just launched the first exchange-traded fund for retail investors at the peak of the coin’s speculative fervor. Wall Street has a knack for calling out the best in various investment themes by capitalizing on their popularity through structured investment products. Why should inflation be any different?
Amplify ETFs has just filed a prospectus for its Amplify Inflation Fighter (IWIN) ETF with the aim of actively managing a portfolio that directly or indirectly benefits from rising prices. This follows President Powell’s assertion that “the risks of inflation are still on the rise” and that “there is a risk that it will become prolonged and increase.”
This ETF would have been timely a year ago, but today it looks like something that simply capitalizes on investor fears the same way ProShares capitalized on Bitcoin euphoria at all-time highs.
Moreover, Chairman Powell does not have a great track record when it comes to forecasting inflation, as he and his cohorts at the Fed claimed until recently that any rise in inflation would be “transient”. Now, are we to believe that it will continue to increase for an extended period? I do not agree.
If we look at the relative importance of the components of the consumer price index and compare them to what has risen the most in price over the last 12 months, I think we can argue for a rate that gradually decreases from 7% throughout the year to a range closer to 3-4%.
Energy dominates all components with soaring crude oil prices over the past 12 months. Sometimes the best solution for higher energy prices is higher energy prices, because this serves as a tax for the consumer, who then spends less on other items.
Also, even if crude oil prices don’t fall, which I think is the most likely scenario, year-over-year comparisons become easier as we go further into this year. The surge started last February when prices rose from around $50 to highs of $60 and by July we were at $75 a barrel. I can see Wall Street driving prices up to $100 in the near term through speculative investment flows, but then I suspect we are seeing a significant price pullback. Anyway, comparisons get easier as we go along.
Soaring prices for new vehicles, used cars and trucks, food products and many other products purchased by consumers can be attributed to supply chain disruptions and labor shortages caused by the pandemic. The peak of the latest wave is clearly behind us in the United States with the daily average of new cases down 31% over the past two weeks. I think we are about to see the same development globally, as the percentage increase to just 14% is gradually decreasing. I expect it to drop in a few weeks.
This should ease supply chain bottlenecks and reduce pandemic-related price increases that are fueling the overall consumer price index.
Another contrarian indicator of the inflation rate and the latest wave of the pandemic is the University of Michigan consumer sentiment survey, which fell to its lowest level since November 2012, due to concerns about the two headwinds. January’s number fell to just 67.2. Sentiment is expected to hit lows commensurate with the spike in inflation and the pandemic. That’s what I see happening.
That doesn’t mean we’ll go back to the sub-2% inflation rate that most consumers are used to, as about a third of the index is based on housing costs, which show no signs of slowing any time soon. The pace at which house prices rose last year is unsustainable, but the shortage of supply should keep prices high. Rents continue to rise for the same reason. As a result, shelter costs are expected to continue to rise at over 4% this year. That’s why I see the overall rate falling in the 3-4% range this year. Still, markets are reacting to the pace of change, and that should start to move in the right direction as we approach spring. It will be a headwind that will become a tailwind for investors.