Whether or not U.S. inflation will turn out to be “transitory” as the Fed has asserted on many occasions, the reality is the official consumer and producer inflation data continue to march higher, and the anecdotal inflation evidence is now widespread.
The Consumer Price Index (CPI) surged 6.2 percent in October compared to a year ago, the highest level since 1990. The CPI jumped almost a full percentage point on a month-over-month basis, the biggest such increase since 2008. This consumer data came on top of a 12.5 percent surge in producer prices in October versus a year ago, the highest level since 1980 when inflation was raging in America.
Consumer inflation surpassed the previous peak
U.S. Consumer Price Indexes (CPI) in year-over-year percentage change
Source - RBC Wealth Management, Bloomberg; monthly data through 10/31/21
But the curious phenomenon is that the U.S. equity market has largely ignored high and rising inflation so far this year. At the same time the CPI surged from 1.4 percent to 6.2 percent from January to October, the S&P 500 rallied 22.6 percent, seemingly unfazed. What explains this positive equity market performance in the midst of difficult inflation trends? And will the market be able to continue to cope with inflation if it persists?
More than meets the eye
We think there are many reasons the market hasn’t been bothered by high and rising inflation thus far in 2021:
- The economy has been growing well-above the long-term trend rate and seems set to grow at an above-average pace in 2022, and the leading economic indicators have firmed;
- Household spending has been strong, and there is scope for more spending as household balance sheets are still flush with cash and wages are rising;
- S&P 500 corporate earnings growth has been robust and is on pace to rise 50 percent in 2021 and could tack on another 7 percent in 2022, according to the consensus forecasts;
- Some industries, such as commodity producers, benefit from inflation as do companies in other industries that are able to pass along any inflation in input costs by charging higher prices to their customers (in other words, companies with pricing power);
- Many companies, especially large firms, are effectively managing their expenses, offsetting or at least partially mitigating inflation’s effects, and;
- More and more companies are using technology to improve productivity and contain or reduce labor costs and other expenses.
Importantly, there is a perception among equity market participants that COVID-19 is the main contributor to inflation, and that as the pandemic continues to dissipate and supply chains start to function more normally, inflation rates will begin to retreat.
We think there is some truth to this. Also, the unprecedented and significant amounts of U.S. fiscal and monetary stimulus have stoked inflation, in our view. And, yes, all of these inflationary impulses should wane as we get further away from the darkest days of the pandemic and policies begin to normalize.
U.S. wages continue to rise
Broad measures of U.S. wage inflation (year-over-year percentage change)
Source - RBC Wealth Management, Bloomberg; quarterly data through September 2021; ECI data begins in 2001
But RBC Capital Markets, LLC’s Chief U.S. Economist Tom Porcelli points out that not all of the inflation pressures are tied up with COVID-19 and the related supply chain disruptions. Inflation was starting to simmer before the pandemic, and now it has become broad-based, with 10 of the 15 major consumer inflation categories he monitors rising at the same time in the past few months. Furthermore, inflation in the service sector—by far the largest segment of the U.S. economy—is starting to perk up, according to Porcelli.
Even though the U.S. equity market has coped well with high and rising inflation thus far, it did react negatively to October’s CPI surge. The S&P 500 retreated 0.8 percent on the day the data were released, and was particularly impacted by the related rise in bond yields and flattening of the Treasury yield curve.
What could make inflation morph into a problem for the equity market?
- An inflation spike to even higher levels, which could put greater pressure on S&P 500 profit margins to the degree that earnings growth could become constrained or outright retreat in 2022;
- Heightened fear of a Fed policy mistake or an actual policy mistake—with the central bank either responding too aggressively or not responding aggressively enough to inflation—such that it would threaten the economic recovery and notably increase recession risks, and/or;
- A change in perception that inflation has become entrenched and could last much longer than equity market participants currently expect.
Consumers foresee high inflation in the next year and elevated inflation further out
Consumer inflation expectations: Near-term versus medium-term (%)
Source - RBC Wealth Management, New York Fed Survey of Consumer Expectations; monthly data through 10/31/21
Easing, but not pleasing
Our base-case forecast is that inflation pressures should ease next year, and even Porcelli, an inflation hawk, anticipates this will occur. But as we’ve stated on many occasions, we think U.S. inflation levels will remain uncomfortably elevated for the next couple years. It’s unclear whether the equity market has fully factored in this scenario.
Depending on the path of inflation and, importantly, the Fed’s response to it—whether it manages the situation effectively or ineffectively—inflation could generate volatility for the U.S. equity market in 2022.