Good inflation news comes with caveats

Bottom line up top:

• A welcome step in the downhill climb from peak in?ation. Last Thursday’s release of U.S. Consumer Price Index data for October was the inflation report financial markets have been waiting for. Year- over-year headline CPI came in softer than expected at 7.7%, down from September’s 8.2%, driven by a broad decline in goods prices. Core CPI, which excludes volatile food and energy prices, rose 6.3%, versus 6.7% in September. While these levels are still high by historical standards, the significant downshift rekindled hopes that a soft landing for the economy may yet be possible in 2023.
• Base effects kicking in at last. The so-called “base effects” of inflation may finally be doing their part to bring down year-over-year CPI, as lower readings begin to roll off the 12-month calculation, replaced by higher readings that result in a more favorable comparison. For example, a forward path of a constant +0.50% monthly change in prices — elevated compared to history but in line with the average monthly increase over the past two years — would result in a year-over-year CPI print of about 5% by the end of June 2023 (Figure 1).

• Don’t expect services inflation to decelerate quickly. While goods inflation came in at -0.5% in October, services inflation was +0.4%, driven by shelter (rent) costs at +0.8%. It will take some time for CPI shelter inflation to come down, even though some private measures of new rents are entering disinflationary territory. Figure 2 shows the Zillow Rent Index beginning to decline year over year, while CPI shelter is still accelerating. Also contributing to the “stickiness” of services inflation is a still-tight labor market, with 6% median year-over-year wage growth helping fuel the continued post-Covid consumer shift from goods to services spending.

• Energy prices remain a wildcard. Since June, an approximately 20% drop in prices for energy commodities, measured by the Bloomberg Commodity Index, has made energy a detractor from monthly CPI over the past three months, after being the inflation bogeyman for the majority of 2022. Gasoline prices — a particularly volatile subcomponent of energy CPI — ticked up in October after three consecutive monthly declines (Figure 3). Looking ahead, the World Bank expects energy prices to fall 11% in 2023, driven mainly by weaker demand amid slowing global growth and continued lockdowns in China. We agree with this view, but acknowledge the difficulty of predicting the potentially dramatic impact of policy, geopolitical and supply dynamics on energy prices.

Portfolio considerations:

One data point does not make a trend, and the U.S. Federal Reserve is unlikely to reverse course based on October’s CPI print. It was only two weeks ago when Fed Chair Jerome Powell conveyed that rates are likely to remain “higher for longer,” even if the pace of rate increases begins to moderate in the coming months.

That said, our base case calls for a continued deceleration of inflation for the remainder of 2022 and the first half of 2023, driven first by goods and energy prices, and eventually by services. But given energy’s potential to have an unpredictable and outsized impact on the trajectory of CPI, we caution against removing inflation protection from portfolios or positioning for a Fed pivot until further data indicate that it would be prudent to do so.

In the meantime, infrastructure remains our preferred method for inflation protection, as essential projects tied to the power grid can benefit from higher energy prices with less volatility than direct ownership of energy commodities, paying streams of income along the way. Farmland investments are also attractive because they tend to hold their value in real terms, and provide income stability thanks to their longer-term leases.