United States
Headline inflation set yet another 40-year record, breaching 9%, more than the expected 8.8%. It may be of little comfort, but Core CPI did decline for the second straight month (as we projected last month) but remains high at 5.9%.
Energy CPI was once again the largest culprit, but the main story for us is the continuing surge in “sticky” inflation. We believe credit investors need to stick to companies with strong pricing power and ensure adequate compensation for risk.
Sticky inflation is an even larger concern now
The “flexible” energy CPI category was up 7.5% month-on-month from 3.9% last month, accelerating more than any other main category.
“Sticky” CPI indicators (chiefly healthcare and shelter) accelerated to their fastest levels yet this cycle and are showing no signs of slowing down (Table 1). This is far more of a concern for us.
Table 1: Energy may command the headlines, but sticky inflation’s rise is the real story1
| Sticky | Flexible | Non-Core | ||||||
|---|---|---|---|---|---|---|---|---|
| Health services | Owners' Equivalent Rent | Education and Commuication | Airfare | Used Cars | Apparel | Food | Energy | |
| 12 month Average | 0.3% | 0.4% | 0.1% | 2.7% | 1.8% | 0.4% | 0.7% | 2.3% |
| Feb-22 | 0.1% | 0.4% | 0.1% | 5.2% | -0.2% | 0.7% | 1.0% | 3.5% |
| Mar-22 | 0.6% | 0.4% | -0.1% | 10.7% | -3.8% | 0.6% | 1.0% | 11.0% |
| Apr-22 | 0.5% | 0.5% | 0.2% | 18.6% | -0.4% | -0.8% | 0.9% | -2.7% |
| May-22 | 0.4% | 0.6% | 0.2% | 12.6% | 1.8% | 0.7% | 1.2% | 3.9% |
| Jun-22 | 0.7% | 0.7% | 0.2% | -1.83% | 1.6% | 0.8% | 1.0% | 7.5% |
Easing commodity markets imply energy CPI will ease
Commodity prices have retreated over the last few weeks, with the Goldman Sachs S&P Commodity Index down 20% from its June high and back to levels before Russia invaded Ukraine.
This has helped US gasoline prices fall almost every day for the last month (Figure 1), which has not been fully captured in this CPI report but should be next month.
Figure 1: Gasoline prices have started to reverse course as commodity strength has eased2
Further, declines in wheat, natural gas, lumber, and concrete markets also bode well for a potential easing in “flexible” CPI categories.
Sticky inflation is surging – and this will be a persistent threat
Inflation in core services is running above 5% year-on-year. The 3- and 6- month annualized rates are even faster, suggesting things are getting worse (Figure 2).
Figure 2: “Sticky” services inflation categories are accelerating at a concerning pace3
We expect more pain yet from health insurance inflation, which we expect to peak at ~20%.
Even more of a concern is shelter inflation, an area we have covered in depth, given its much larger weight in the CPI index. We believe that it would take months of slowing home price appreciation and disposable income for this category to cool.
Peak CPI should be close, but target CPI is not
It will be mathematically difficult for CPI to reach the Fed’s 2% target anytime soon.
Even if monthly CPI was zero for the next 18-months, it would still take until Spring next year to bring annualized CPI to 2%, and we would still be above 5% at year-end (Figure 3). Getting even to 3% will realistically take ~12 months in our view.
Figure 3: Mathematically, it will be tough for CPI to fall to target anytime soon4
The Fed’s hiking cycle will likely be even steeper
The FOMC meets later this month, and we expect markets will price in another 75bp hike, consistent with last month’s “dot plot”. The recent employment report offers further incentive for the Fed to push ahead.
This would take the upper bound of the Fed Funds Rate to 2.5%, in line with the central bank’s estimate of the long-term “neutral” rate. As such, the Fed may then prefer to hike in smaller increments for the rest of the year, particularly if we do finally see peak CPI set in.
However, we believe investors should be prepared for the Fed to hike more than the market is currently pricing in, meaning further volatility feels inevitable.
In credit, we think companies with strong pricing power and liquid balance sheets may offer the most compelling opportunities for diligent investors. Further, although we often focus on the negatives of inflation, there are some upsides of inflation worth considering for credit investors.
