Q4 2021 Bond Compass

PriceStats® Analysis: Anything but Average

A look at quarterly measures of inflation, based on prices of millions of items sold by online retailers, to help investors anticipate and evaluate the impact of inflation.

The hope that inflation would be transitory has and continues to be a key theme supporting both fixed income and equity markets. Unfortunately, while elements of the current inflation are beginning to reverse, other factors are emerging to take their place. This could potentially test both the markets’ and policymakers’ patience if underlying inflation does not start to ease soon.

PriceStats allows us to track this in near-real time, with the additional advantage of not directly collecting some sectors distorted by the re-opening so as to capture underlying inflation. If we assume PriceStats returns to its normal seasonal run rate, the annual rate of inflation will be back below 3 percent by the last week in December and back to 2.3 percent by the end of March — a clear and transitory supporting trend. The challenge, however, is that PriceStats has returned at or above average monthly inflation readings for 17 consecutive months, September included. While recent monthly gains have been closer to their historic averages, the longer this run of above average monthly readings continues, the less credible the transitory narrative becomes. This would be true even if the annual inflation rate begins to fall, which it almost inevitably will in the next six months.

US inflation: No shortage of concern

As troubling as the incoming inflation prints are, the market will continue to take some comfort from more limited evidence that inflation is becoming embedded in expectations. While long-term inflation expectations from financial markets, consumer sentiment and economist surveys have all risen, they remain contained and are notably below shorter-horizon expectations. This reflects a continued belief in the transitory inflation narrative. Arguably the biggest threat to this, over and above the current inflation trend itself, is evidence of more robust wage growth. In a similar vein to these expectations themselves, wage growth (adjusted for the changing composition of the workforce) has accelerated, but not yet to levels that would be deemed troubling. Further, with employment levels still substantially below pre-pandemic levels, one might assume that wage growth should not become a serious threat with a plentiful supply of available labor to constrain it. However, the unevenness of the COVID-19 pandemic recovery means that this cannot be taken for granted, and the intensity of mentions of labor shortages in corporate communications is rising once more. With the potential to either restrain output growth or to generate wage growth strong enough to cast doubt on the transitory inflation narrative, the resolution of these pockets of labor market shortages seems likely to be a key tipping point for fixed income markets in the next six months.

Eurozone inflates

The recovery in eurozone output has not been as spectacular as that in the US. Despite an initially hesitant vaccine rollout and disrupted reopening in H1, and more modest direct fiscal stimuli, growth forecasts in the eurozone did not rise earlier in the year as they did in the US. They are, however, beginning to surge higher as the reopening gets underway and retailers appear to have some pricing power. Like other areas, Europe has had to contend with a less friendly global inflationary environment, but has had its own specific, largely political issues with the constrained supply of natural gas. This has taken headline inflation above 3 percent for the first time, a trend that PriceStats had been warning about for a few months prior. But it is notable now that medium-term inflation expectations are beginning to rise in response. In fact, for all the focus on the uptick in inflation in the US, European inflation expectations rose the most in the last quarter. Similar to the US, Europe’s current wage growth is not yet suggestive of potential second-round effects, but this pressure will build the longer inflation remains high.

Emerging inflation plateau?

Inflation trends in emerging markets (EMs) have been a challenge for both investors and policymakers for much of this year and will remain so in Q4. PriceStats was quick to capture the rapid acceleration in EM inflation in the middle of 2020 and the rate of acceleration has only begun to moderate in the last quarter. The good news is that in contrast to developed markets, most EM central banks are showing no signs of accommodating this rise in inflation and tightening cycles are already underway, even with a more uncertain growth outlook. Combined with favorable base effects and currency stability, this means that inflation should start to peak in the coming six months. As we noted earlier, this could prove a key catalyst for the return of long-term investors into EM local currency sovereign markets, if and when the inflation trend finally turns.