United States
Just as we thought peak inflation had passed, CPI rebounded to another 40-year record at 8.6% year-on-year. Importantly though, we believe Core CPI did indeed peak, as it came in at 6% year-on-year, below the 6.5% high from two months ago.
“Non-core” items – food and energy – drove the surprise. In our view, it is indicative of an economic slowdown, but not yet a recession. On the “sticky” side, however, a continued march in shelter inflation is a concern.
Although a tough report for investors, we do not believe this materially changes the Fed’s hiking trajectory, meaning the hiking cycle may still be fully priced in.
A vicious cocktail of price rises
Both “flexible” and “sticky” categories saw a meaningful acceleration this month.
On the “flexible” side, used car prices rebounded 1.8% (16% year-on-year) and travel and fuel costs also surged 13% (38% year-on-year). We expect both will prove temporary, as supply chains improve and the pent-up demand for travel normalizes.
On the “sticky” side, health services rose a strong 0.4%, driven by insurance. Shelter rose 0.6%, the fastest since 1990.
Table 1: Both “flexible” and “sticky” categories accelerated this month1
| Sticky | Flexible | Non-Core | ||||||
|---|---|---|---|---|---|---|---|---|
| Health services | Owner's 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% |
Elsewhere, other flexible goods categories, such as the durable goods component, are steadily decelerating, despite the lockdowns in Chinese hubs such as Shanghai and Shenzen. However, this is being outpaced by acceleration in sticky services components such as rents (Figure 1).
Figure 1: Sticky components are accelerating faster than flexible components are slowing2
Rising shelter inflation is our largest concern
As we have continually stressed in past Instant Insights, we are most closely watching the shelter component of CPI to understand how persistent inflation will be.
The 0.6% rise in shelter inflation (largely composed of rents) is therefore a key concern for us. If high inflation is here to stay, we believe this category will be why.
On the positive side, in our recent Global Macro Research study on shelter inflation, our model indicated it will peak this summer. As such, this month’s rise is not entirely unexpected, but we believe will need to see a sustained drop in shelter inflation for CPI to start descending.
Part of our view on rents is predicated upon rising housing supply. There are a record number of homes under construction, which will inevitably get fed into the market. We are seeing signs that this is starting to loosen the market, as the vacancy rate has begun to tick up from low levels (Figure 2).
Figure 2: Housing supply conditions could finally be easing3
Nonetheless our findings still show that shelter inflation will be relatively high by year-end, potentially indicating slowing, but still above-target, inflation for some time yet.
Food and energy prices indicate economic slowdown, but not yet a recession, in our view
We believe the rise in oil prices will slow economic activity, but we do not believe it is enough to cause a recession at these levels. Consumers have built a war chest (of ~$3trn in cash holdings above the pre-pandemic trend, or ~$18trn in total4), leaving room for consumption to run.
Further, the US economy has become less sensitive to global oil price volatility over time (Figure 3). This is in part down to the overall shift from manufacturing to services and rising energy efficiency (consider for example the difference between the energy efficiency of today’s cars versus their 70s’ counterparts).
Figure 3: The US economy generates close to three times as much GDP per barrel of oil vs the 1970s5
The Fed’s hiking cycle will continue, and may still be fully priced in
Ultimately, although this report was a surprise, we do not expect this will meaningfully shift the outcome of the Fed’s meeting next week (where we expect a 50bp hike) or the subsequent meeting (where we expect another 50bp hike). We also expect further hikes at every remaining meeting this year, the magnitude being the only unanswered question.
The good news for investors is that this trajectory is already priced in by markets, including a terminal rate of ~3.25% by the middle of next year.
As such, duration exposure is potentially no longer a “dirty word,” and we believe investors may wish to consider opportunities in credit at these levels, particularly as inflation actually offers some potential upsides for corporate borrowers.
Inflation remains the primary challenge for the US economy and its policymakers. On the plus side, absent a further substantial rise in oil prices or further unexpected acceleration in rents, we believe we are currently passing the peak in headline CPI and worst of core CPI may already be behind us.
However, the underlying strength in services inflation is why it will be difficult to get inflation much below 4% into 2023.
