U.S. core Consumer Price Index (CPI) inflation was softer than consensus expectations in April, and the year-over-year rate remained stable at 2.1%. We see a couple of reasons for that, and continue to expect core CPI inflation to accelerate further (to 2.3%–2.4%) before settling back to 2.2% by year-end.
But perhaps the most interesting aspect of Thursday’s report was the market’s knee-jerk reaction to it: Equities and emerging market assets rallied in relief. This may offer further evidence of a shift we’ve observed in risk sentiment on inflation, from fears of too little inflation to concerns about too much.
Behind the numbers
Used-vehicle prices recorded the largest one-month drop since 2009 and were a big contributor to April’s weakness. However, a recent methodology change likely contributed to much of the volatility. Given that the price drop was somewhat larger than industry indicators – including the National Automobile Dealers Association’s April projection – would have predicted, we think some reversal next month is possible.
Inflation in other categories was firmer. It appears that U.S. dollar depreciation is finally boosting retail goods prices, with April’s acceleration in core retail goods (excluding vehicles and medical goods). This is consistent with the historical lags between changes in the dollar and changes to core goods prices. Household furnishings inflation was particularly firm, including for major appliances and laundry equipment (likely reflecting the impact of tariffs), and apparel was back on trend with a 0.3% rise after volatility in the first quarter (likely related to residual seasonality).
Both rents and owners’ equivalent rents remained firm despite still-high inventories of multifamily housing units in some large cities. We continue to expect a largely stable year-over-year rate of 3.3% for shelter inflation in 2018. An increase in rental vacancies will likely mute shelter inflation despite declining housing affordability arising from higher rates and generally tighter labor markets.
Shifting inflation risk sentiment
We believe 2018 may be the year that challenges preconceptions about the equity/inflation correlation, and the market’s reaction to April’s soft inflation readings seems to bear this out.
When inflation and real activity are moving in tandem, we can expect the correlation between equities and nominal bond yields to be positive. But when inflation is rising and real activity is decelerating, equity performance and nominal bond performance may both falter. This is exactly the time when we’d expect inflation-linked bonds to outperform.
These shifting correlations may have profound implications for portfolio construction. We think below-average breakeven valuations on Treasury Inflation-Protected Securities (TIPS), coupled with rising inflation risk from late-cycle fiscal stimulus, geopolitical risks and trade tensions, may argue for the importance of investment portfolio inflation hedges.
For more on our inflation forecasts for 2018, see our Cyclical Outlook: The Beginning of the End?