(BlackRock) Inflation was at the heart of debates among BlackRock portfolio managers at our 2022 Outlook Forum last week. Inflation is being driven by the unusual supply shocks tied to the restart.
We expect these imbalances to resolve over the next year, but see inflation as persistent and settling at a higher level than pre-Covid. We prefer equities in such an environment, as we expect a more muted yield response to inflation than in the past. This should keep real yields low, supporting stocks.
U.S. core CPI breakdown, 2003-2021
Sources: BlackRock Investment Institute and U.S. Bureau of Labor Statistics, with data from Haver Analytics, November 2021. Notes: The chart shows the annual rate of the core goods and core services consumer price index (CPI).
The U.S. CPI rose more than expected in October. This caught markets off guard, but as we have argued previously we shouldn’t be surprised by surprising data given the unique nature of the economic restart. It shows how little is known about restart dynamics. Although price rises are broad based, the mix of inflation shows the unusual restart dynamics at play. The run-up of inflation has been due to supply bottlenecks coupled with unusually strong household spending on goods rather than services. The shares of goods spending in the total personal consumption expenditures jumped to around 36%, the highest level in 15 years. Prices of goods excluding food and energy – which had been in deflation for most of the past decade – have surged way beyond core services prices, reflecting the restart disruptions and shifts in spending patterns. See the chart above. Participants at our 2022 Outlook Forum generally agreed: 1) that higher inflation will persist next year while spending on goods remains high and supply bottlenecks continue, and; 2) this supply-demand mismatch should resolve as the restart plays through, supply comes back on stream fully and spending on goods switches back to services. As a result we are still broadly pro-risk headed into 2022.
Our new nominal theme has guided us all year. Central banks, especially those with new policy frameworks such as the Federal Reserve and European Central bank, are more tolerant of higher inflation. The Fed may have achieved its new inflation mandate to make up for past misses, but will likely still keep rates low to achieve its more ambitious full employment mandate. We have moved forward our expectation for the Fed to start raising rates next year – if not as soon as the market pricing. But what matters is the overall policy rate trajectory, not just the liftoff timing. We expect the most muted response of policy – and nominal government bond yields – to higher inflation in decades, underpinning the new nominal.
The policy reaction is not uniform. Other developed market central banks, such as the Bank of England, have signalled a policy rate path with steeper initial increases. That has created volatility in short-term interest rate markets over the past month. Thinning liquidity and crowded positions in bond markets have led to exaggerated moves and confusing yield signals. Yet even these central banks seem to be looking only to remove the pandemic-era stimulus and get back to the pre-Covid stance that they consider “neutral,” instead of seeking to lean against current inflation. In the market’s view, there are risks in this approach – moving too sharply could prove to be a mistake. A policy reversal has been priced in for the UK.
There are risks to our new nominal theme. Central banks could drop their new frameworks– although we see the bar for doing so as very high. And higher inflation could increasingly become a political issue or start to shape expectations of future inflation, putting pressure on central banks to adopt a more aggressive stance. And the journey to reach net-zero emissions by 2050 may be more chaotic than we expect, raising the specter of more inflation later. The widening gap between governments’ ambition to cut emissions and implementation raises the risks of such a disorderly transition.
Bottom line: We see equities as a potential buffer against inflation because we expect a more muted response of yields to inflation than in the past. Real, or inflation-adjusted, yields should remain low or negative as a result, making equities attractive. In addition, many companies so far have been able to pass on higher input costs and keep their margins intact. We are overweight equities and inflation-linked bonds, and underweight nominal government bonds on both tactical and strategic horizons. Trading liquidity in bond markets has declined, resulting in exaggerated moves that add to the confusion of reading yield move signals
