Inflation - The Dragon Lives

When the Bureau of Labor Statistics ('BLS") reported the latest inflation data on February 14, 2023, the markets gyrated as usual. Once again, UST bears gained stature while the bulls lost ground. The oft-quoted negative sloping yield curve, which has been a harbinger of some recessions in the past, provides UST bulls with the optimism to say it's time to own treasuries. That entails all clear for the equity markets, albeit accompanied by volatility. Bears like us believe that the worse is not over and that while optimism creates wealth, goldilocks optimism craters portfolios like no other — case in point, Tiger Global in 2022.?

In our opinion, nothing in the CPI report says clear weather ahead for equity investors. On the contrary, it provided a full-steam-ahead signal to the Fed to stay the course and slay the inflationary dragon. Yes, if you don't need shelter, don't eat, and do not use energy to move, i.e., you are a reincarnate Himalayan Yogi residing in Uncle Sam's territory, inflation has been vanquished.

For others, it is unfortunate, and inflation remains sticky to boot. Figure 1 illustrates the trend in service sector inflation. At last count, the service sector represented about 77% of the U.S. GDP.?

Figure 1: Services Indlation Stays High

Even though the FED has raised overnight rates to 4.5% in twelve months, the January 23 reading on service sector inflation showed an uptick. Moreover, while interest rates have been rising, and demand in rate-sensitive sectors like housing has been flatlining, service sector inflation held steady. A tight labour market and a 3.6% unemployment rate continue to push wages higher, thereby keeping services sector inflation lofty. To keep it interesting, after a few months of downdraft in housing inflation that gave an optimistic outlook to many equity bulls, January 23 data show that housing inflation picked up again. Figure 2 shows that housing, a significant component of U.S. GDP, is seeing a revival in underlying inflation.

FIGURE 2: HOUSING INFLATION TICKING UP

After YoY declines for three months beginning September 2022, inflation again picked up pace in November 2022. It is now at its highest since early 2021. That cannot and should not give any solace to the FED. Therefore in our view, a lifeline to equity bulls of any kind is not in the offing. To those that swear by the owner's equivalent rent, the news is no better and appears to have worsened, as illustrated in Figure 3.

Figure 3 - Components of Rental Inflation

Figure 3 shows that YoY, owner-equivalent and regular rents are growing faster than overall housing inflation. With the opening of the economy, lodging away from home leapt higher, and although YoY has declined, the numbers are painfully high.?

WHAT DOES IT MEAN?

In our view, inflation is neither vanquished nor dead. The easiest component of inflation involving supply chain normalisation and consumer goods deflation is behind us. The economy is at a crossroads now because it is supply constrained. Daily shortages in autos, semiconductors and pharmaceuticals make the headlines under one pretext or another. The war in Ukraine has revived the age-old problem of Guns vs Butter. President Biden's visit to Ukraine, U.K. and Germany's intent to provide armaments, and sabre rattling by NATO all highlight impending fiscal challenges to fund an expensive and ongoing war in Europe and USA. We are witnessing the unravelling of the peace dividend of yesteryears.

For a portfolio to withstand the upcoming turmoil, exposure to rate-sensitive assets, commodities, mega-cap investment grade balance sheets, Canada, and short-duration fixed income provide succour. Private equity, venture capital, growth at any price, high-leverage real estate, variable rate debt, and bravado are best avoided.