Underlying data suggest that sizzling headline inflation will continue to cool
There is nothing the market hates more than uncertainty, and for a very long time, the US Federal Reserve mitigated investors’ fear of the unknown by answering every shock to the system with more “unprecedented and extraordinary” measures. Over time, these measures felt more like the norm than the exception.
That era is over. Inflation is the new measuring stick of macroeconomic risk and potential volatility. The market knows that the Fed must try to control inflation. What the market doesn’t know is whether the Fed will be successful.
As investors grapple with this new source of uncertainty, market expectations for inflation have been consistently below actual Consumer Price Index (CPI) data. In the chart below, the white diamonds represent the market’s forecast for inflation. The orange and blue lines represent the monthly CPI print. For most of the past year, the market thought inflation would cool, but each month it continued to run hot. Finally, in November, inflation came in below market expectations. The question now is: will the downward trend last?
As of 10/31/22. Source: Bureau of Labor Statistics, Citi, Voya Investment Management.
We believe underlying data suggest that sizzling headline inflation will continue to cool. For example, the issues that have plagued the global supply chain since the pandemic are starting to abate, which means inventories are fully stocked. From a consumer’s perspective, 2021 was a year you wanted to do your holiday shopping early to make sure you could buy what you needed before the store ran out. This year, you can wait for discounts.
Job openings are moderating, and savings rates among consumers are starting to fall. This will have knock-on effects on prices, as companies will have less wiggle room to pass on higher costs to consumers. In addition, real-time rental price indicators suggest shelter prices are also starting to cool. And while food and energy prices remain stubbornly high, industrial metals prices, generally a leading indicator, have started to come down.
Importantly, while inflation has started to cool, the volatility we’ve seen from month to month in response to the CPI print will continue until a downward trend is firmly established and the Fed pauses its rate hikes. In the meantime, for long-term investors, we believe the current environment is a very compelling entry point from a risk/return perspective. Now that yields have reset higher, bonds are positioned to protect portfolios while delivering higher income.