Persistent supply bottlenecks and strong consumer demand have kept inflation elevated in many developed countries. Most notably, year-over-year changes in the US Consumer Price Index (CPI) have been above 4% for seven straight months — the longest stretch since 1991 — with a 30-year high CPI print of over 6% in October.1
These pressures are likely to persist into 2022, even though the Federal Reserve (Fed) continues to emphasize that predominantly transitory factors are driving this inflation surge. And while another 6% CPI year-over-year report is unlikely for this cycle, US inflation is forecasted to remain above trend for the next two years at 3.3% for 2022 and 2.3% for 20232 — bumping global forecasts to 3.3% and 2.8%, respectively.3
Because above-trend inflation puts pressure on margins, owning stocks that can pass through cost inflation with pricing increases may be beneficial. This means positioning portfolios toward market segments with lower relative labor intensity (employee-to-sales) and margins that are less impacted by wage inflation, as well as toward areas that historically have exhibited a strong relationship to inflation and inflation expectations.
Higher Prices Ahead
Expectations for higher prices are buoyed by the broad-based nature of these upward pressures. The Dallas Fed 12-Month Trimmed Mean PCE, a metric that removes components with the most extreme price changes, like gasoline and used cars, has steadily climbed to its highest level since 2008.4 The Atlanta Fed’s 12-Month Sticky CPI, a weighted basket of items where prices change relatively slowly, including household furnishings or alcoholic beverages, has also reached a 13-year high.5 And the flexible, more fast moving Altana Fed Flexible CPI figure is at a 40-year high.6
The magnitude and breadth of these inflationary pressures suggest that inflation might not be transitory. In fact, according to the University of Michigan Surveys of Consumers, consumers anticipate an overall inflation rate of 4.8% for 2022, approaching its highest level since 2008, when oil prices were above $100/barrel.7 Market-based short- and medium-term inflation expectations, as represented by the US 2-year and 5-year breakeven rates, also reached new post-global financial crisis highs in November, with the 5-year rate touching the highest level on record.8
Consumer, Small Business and Housing Trends
Supply chain issues that plagued topline Q3 economic growth (2% year-over-year growth)9 may have masked certain inflationary pressures building beneath the surface. First, there was a strong gain in services spending. This may hint at greater momentum for inflation-adjusted services heading into the rest of 2021,10 causing this measure that is still below pandemic levels to catch up to the growth already witnessed within goods.11 A still healthy savings rate, continued momentum in the labor markets, and subsiding COVID-19 infections should further support stronger spending. Credit card trends, with delinquencies at all-time lows,12 also reinforce healthy consumer behavior. Second, in the durable goods orders report, core orders continue to exceed shipments, indicating backlogs13 that may point to investment productivity gains as inventories are built up to meet the demand.
Simply put, strong demand should support prices. And even if supply constraints start to ease, wage increases and rent trends may keep inflation elevated in 2022. Average hourly earnings of all private sectors have increased by more than 4% year over year for four consecutive months,14 but still run below headline CPI inflation. This has resulted in negative real income levels of -1.3%, a figure well below the pre-pandemic average of +0.6%.15
Small businesses are also forecasting higher prices and wages. According to a National Federation of Independent Business survey, currently 53% of business owners are raising prices — the highest percentage ever.16 And more than half plan to increase prices again in the next three months — another record rate that reflects how global price pressures are making an impact at the local community level. While influenced by supply chain disruptions, these price increases are also a result of how small local businesses are responding to elevated job openings. In the same survey, a record number of owners say they have either already raised or are expecting to raise wages in the coming months.
With record-high job openings and quit rates, more wage inflation is likely in 2022, as employers seek to hire enough workers to meet stronger consumer demand. And, if President Biden’s Build Back Better spending package is approved, the roughly $2 trillion in new spending has the potential to boost prices in the short term, even if it’s just from a signaling effect, as tax increases to finance this effort will be spread over many years.17
Inflation rates of rent and owners’ equivalent rent (OER), which account 30% of headline CPI and 40% of Core CPI, were still below their pre-pandemic levels in October.18 Yet, research by the Federal Reserve Bank of Dallas shows that strong housing price growth historically has led to rent and OER inflation for around 18 months.19 Given that prices in the housing market have risen by 25% above pre-pandemic levels,20 the research projects rent and OER inflation to accelerate above historical averages in 2022 and 2023, which could drive overall inflation higher.
Is the Price Right for REITs and Natural Resources?
The prospects of higher wages and overall consumer price inflation mean companies with less labor intensity and more capital intensity may feel less margin pressure in 2022 and beyond. As shown in the following chart, natural resources sectors and real estate investment trusts (REITs) have a higher sales-per-employee ratio than other sectors, indicating less labor intensity. Furthermore, as commercial activity and day-to-day life normalize, demand for commercial and residential real estate space will continue to recover. Combined with higher rent inflation in 2022, this supports REIT dividend growth and potential valuation appreciation.
Sales per Employee
Historically, from a return perspective, natural resources sectors and REITs have helped investors to combat inflation. When 12-month average CPI inflation was in the top quintiles (above 3%), REITs and natural resources equities outperformed broad equities by 14.0% and 7.5% on average over a 12-month period, as shown in the following chart. As of October, the rolling 12-month average CPI inflation rate had increased for seven straight months to sit at 3.4%, putting it within the high inflationary range and providing a supportive environment for REITs and natural resources equities.
Even if rolling average inflation moderates in 2022, falling into the second quintile range, REITs and natural resource equities may still outperform broad equities based on historical trends. Overall, sectors tied more closely to areas that can sell their goods and services at higher prices with little change to their own cost structure may benefit more from a higher inflationary environment.
Average 12-Month Return Over Different Inflation Periods (Since November 2002)
Tilt Toward Small Caps and Banks: Sensitive to Inflation
Historically, small caps have tended to outperform when medium-term inflation expectations rise, as their beta sensitivity to breakevens is much higher than that of large caps (0.60 versus 0.38).21 However, since February 2021, relative performance of small caps has diverged from the upward trend in inflation expectations, lagging large caps by 16%, as challenges around the spread of the delta variant slowed down the recovery momentum.22 In fact, the rolling the six-month correlation between the relative performance of small caps to large caps and the US 5-year breakeven rate is -37%, compared to a historical average of +40%.23
As the economic recovery resumes momentum following the peak in delta cases and inflation expectations remain elevated, small caps may close the performance gap with large caps in the coming months with the correlation tendencies potentially reverting to the mean. The resumption of growth and the ability to respond to inflationary pressures is evident in 2022’s earnings. For 2022, small caps have consensus earnings growth that is six percentage points higher than that of large caps (13.97% versus 8%).24 Plus, small caps’ relative valuations to large caps are at a 15-year low based on the forward price-to-earnings ratio, further supporting the case for small caps for 2022.25
Inflationary pressures are also likely to increase nominal yields, as when the US 10-year rate reacted to the 30-year high CPI print in early November — soaring 11 basis points on the day for the third-largest one-day move in 2021.26 This upward pressure on yields should create a constructive environment for bank stocks, as the banking industry has historically shown a high beta sensitivity to both nominal yields and inflation expectations, as shown in the following chart.
5-Year Beta to 10-Year Treasury Yields and Breakeven Rates
Beyond the macro, there is a fundamental case to be made for banks. Banks’ strong earnings growth and surprises this year have mainly been driven by substantial reserve releases resulting from fast improvement in credit conditions. However, consumer and commercial loan growth has been slow to recover, constraining banks’ top line growth. Yet, as the economic recovery continues and gives consumers and businesses the confidence to borrow, the long-awaited increase in loans may support banks’ earnings growth in 2022.
In addition to the potential tailwinds from the rates market, loan growth should be additive to bank earnings growth and sentiment in the coming quarters. And if the Fed does start to tighten and tamp down inflationary spirits, potentially flattening the curve along the way, history has shown that there doesn’t seem to be a strong correlation between the curve and net interest margins (NIMs).27 In fact, during the last Fed rate hikes, banks’ NIM improved along with the short-term yield increases, despite a flattened curve. A trend that research attributed to the banking environment following an extended period at the zero lower bound and abundant amounts of deposits and liquid assets in the banking system — an environment not unlike today.28
2021’s inflation reports will likely represent the peak of this current cycle. Yet, inflation is likely to remain above long-term averages in 2022. As not-so-transitory higher prices impact market segments differently, focus on inflationary beneficiaries and consider:
1 Bloomberg Finance L.P., as of November 12, 2021. 2 Bloomberg Finance, L.P. as of November 11, 2021, based on consensus economists’ forecasts. 3 Bloomberg Finance, L.P. as of November 11, 2021, based on consensus economists’ forecasts. 4 Bloomberg Finance, L.P. as of November 11, 2021. 5 Bloomberg Finance, L.P. as of November 11, 2021. 6 Bloomberg Finance, L.P. as of November 11, 2021. 7 Source: Bloomberg Finance, L.P. as of 10/31/2021. 8 Bloomberg Finance L.P., as of November 12, 2021. 9 Bloomberg Finance L.P., as of November 12, 2021. 10 “U.S. React: Supply-Crimped GDP Hides Surge in Services Spending,” Bloomberg, October 28, 2021. 11 The level of personal consumer expenditures on services in the US is 2% below pre-pandemic levels while the level for goods is 18% greater per the US Bureau of Economic Analysis as September 30, 2021. 12 Based on the US Credit Card Delinquencies 90+ Days Composite Index, a measure that takes the average US 90+ Delinquency Rate for the following trusts: Amex (Revolving), Bank of America, Capital One, Chase, Citibank and Discover. 13 “US React: Durables Show Capex Momentum Ex-Vehicles, Planes)”, Bloomberg, October 27, 2021. 14 Bureau of Labor Statistics as of November 5, 2021. 15 Bloomberg Finance L.P., as of November 12, 2021. 16 Nat'l Fed. of Ind. Business as of October 31, 2021. 17 “Bidenomics Risks Inflation Push With Spend-Now, Pay-Later Draft”, Bloomberg, October 22, 2021. 18 Bureau of Labor Statistics as of November 10, 2021. 19 “Surging House Prices Expected to Propel Rent Increases, Push Up Inflation”, Federal Reserve Bank of Dallas, August 24, 2021. 20 S&P CoreLogic Case-Shiller 20-City Composite Home Price Index as of November 10, 2021. 21 Bloomberg Finance, L.P. as of October 31, 2021. 22 Bloomberg Finance, L.P., as of November 10, 2021, based on the return of the S&P 600 Index and the S&P 500 Index. 23 Bloomberg Finance, L.P. as of November 10, 2021, based on the performance differential of the S&P 500 and S&P 600 Small Cap Index and the US 5-year breakeven rate. 24 FactSet as of November 10, 2021. 25 FactSet as of November 10, 2021. 26 Bloomberg Finance L.P., as of November 10, 2021. 27 A -10% correlation between changes in banks net interest margins and changes in the difference between the US 10-year and US 2-year yield from 1984 to 2020 based on data from the St. Louis Federal Reserve and SPDR Americas Research Calculations. 28 “Changes in Monetary Policy and Banks' Net Interest Margins: A Comparison across Four Tightening Episodes”, Federal Reserve, 2019.
Breakeven rates The difference in yield between inflation-protected and nominal debt of the same maturity.
Beta Measures the volatility of a security or portfolio in relation to the market, with the broad market usually measured by the S&P 500 Index. A beta of 1 indicates the security will move with the market. A beta of 1.3 means the security is expected to be 30% more volatile than the market, while a beta of 0.8 means the security is expected to be 20% less volatile than the market.
Consumer Price Index (CPI) A measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Indexes are available for the U.S. and various geographic areas. Average price data for select utility, automotive fuel, and food items are also available.
Durable Goods Orders A broad-based monthly survey conducted by the U.S. Census Bureau that measures current industrial activity and is used as an economic indicator by investors.
Flexible Consumer Price Index The Flexible Price Consumer Price Index (CPI) is calculated from a subset of goods and services included in the CPI that change price relatively frequently. Because flexible prices are quick to change, it assumes that when these prices are set, they incorporate less of an expectation about future inflation.
Inflation The decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.
Net Interest Margins (NIMs) A measurement comparing the net interest income a financial firm generates from credit products like loans and mortgages, with the outgoing interest it pays holders of savings accounts and certificates of deposit (CDs). Expressed as a percentage, the NIM is a profitability indicator that approximates the likelihood of a bank or investment firm thriving over the long haul. This metric helps prospective investors determine whether or not to invest in a given financial services firm by providing visibility into the profitability of their interest income versus their interest expenses.
Owners’ Equivalent Rent (OER) Measures how much money a property owner would have to pay in rent to be equivalent to their cost of ownership. OER is used to measure the value of real estate markets, where it can help direct individuals to either buy or rent based on total monthly cost.
Real Estate Investment Trusts (REITs) Companies that own or finance income-producing real estate across a range of property sectors. These real estate companies have to meet a number of requirements to qualify as REITs. Most REITs trade on major stock exchanges, and they offer a number of benefits to investors.
Sticky Consumer Price Index A subset of goods and services included in the CPI that change price relatively infrequently. Because these goods and services change price relatively infrequently, they are thought to incorporate expectations about future inflation to a greater degree than prices that change on a more frequent basis. One possible explanation for sticky prices could be the costs firms incur when changing price.
Trimmed Mean Personal Consumption Expenditures (PCE) The Trimmed Mean PCE inflation rate is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). It is calculated by staff at the Dallas Fed, using data from the Bureau of Economic Analysis (BEA).
Yield The income produced by an investment, typically calculated as the interest received annually divided by the price of the investment. Yield comes from interest-bearing securities, such as bonds and dividend-paying stocks.
The views expressed in this material are the views of Michael Arone, Matthew Bartolini and Anqi Dong through the period ended November 17, 2021 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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