In the latest Green Book, we noted that Producer Price Inflation does not usually become a challenge for the stock market until its annual rate breaks above 4.0%. The day that comment was published, the year-over-year gain in the March PPI for Finished Goods spiked to 6.0%, thanks mostly to the well-celebrated COVID-19 anniversary-effect.
The big jump in Small Caps over the last two weeks has entirely reversed the segment’s summer underperformance and has technicians feverish about another “breath thrust.” Technically, it’s impressive, but we are more intrigued by the fundamental potential for continued Small Cap (and Mid Cap) outperformance.
The Fed is hell-bent on generating inflation of 2% or higher in an over-supplied world that we think should probably be experiencing mild deflation. Their success or failure at this mission will be critical for asset allocators. For equity managers who must remain fully invested, however, the more important question might be not whether the Fed can generate higher inflation, but where.
The year-over-year headline number was in line with market expectations but the month-over-month increase missed market consensus (0.1% vs. 0.2% expected). All else being equal, there is a good chance CPI might have peaked for 2018. A stronger dollar is disinflationary while the short term impact of tariffs is higher import prices.
Headline and Core CPI figures hit estimates right on the nose in May, continuing the trend of modest but not outrageous price increases. Energy prices have boosted headline CPI while core CPI continues to be driven by services. With both of the Fed’s mandates pretty much accomplished, appreciate this rare window of time.
So, what happened to the January Barometer—the old analyst’s maxim that a market gain in January portends a gain for the full year?
The latest Core CPI number disappointed again. The divergence between inflation break-evens and the yield curve is puzzling. Given the lack of inflationary pressure and the Fed’s projected rate path, it would not surprise us to see a flatter curve without the help of fiscal stimulus in the next few months.
The CPI numbers have disappointed three months in a row. Weak commodity prices do not inspire higher inflation expectations. The global scope of inflation deceleration adds more weight to the recent soft readings. However, lower bond yields relative to nominal growth rate is inflationary and buffers the impact of weak inflation and rate hikes.
The latest CPI is weaker and the softness was sooner than we expected. More alarming is the recent broad-based deterioration in economic data. Lower inflation expectations have flattened the yield curve recently, which hurt Financial stocks. We believe inflation has likely peaked for the time being and patience is the right approach for the reflation trade at this point.
The dovish rate hike is a positive for inflation and credit. A hawkish message right now would have been quite detrimental and self-defeating in terms of realizing two more hikes later this year. We believe achieving sustained 2-3% inflation could be harder than most people expect going forward. Overall, we are encouraged by the dovish hike but we think the real test for inflation is when the base effect starts to wane.
We should emphasize that any inflation pickup is likely to be a traditional, late-cycle phenomenon stemming from rising wage growth and rebounding commodity prices. We do not expect a secular move toward significantly higher inflation rates (say, north of 3.0%-3.5%).