Sticky, Sticky, Sticky Inflation

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede.

The March Consumer Price Index report last Wednesday was hotter than expected, with both headline and core CPI both printing 0.4% month-over-month gains. This is now the third straight month to start 2024 where inflation has re-accelerated, pushing near-term trends further away from the Fed’s preferred range of around 2 – 3%.

In addition, the underlying details are a warning sign that this pickup in inflation is likely not an outlier to be ignored. Although core goods continue to see some outright deflation, services prices excluding shelter accelerated 0.8% month-over-month. In fact, on a three-month annualized change basis, services ex-shelter prices have been increasing nearly 9%. On top of that, energy prices were some of the strongest gainers in the March CPI report, increasing 1.1% for the month. However, more inflation could be coming down the pipeline from energy. The latest rally in crude oil may take some time to be fully reflected in the CPI figures as higher prices trickle down to the pump. Altogether, it’s not just the magnitude of inflation, but the share of components in the CPI basket that are moving in the wrong direction.

The initial market reaction after the release was risk-off for both stocks and bonds. The move higher in interest rates was particularly notable, as the yield on 10-year Treasury bonds eclipsed 4.5% for the first time since last fall. Yields had already been drifting higher heading into last week, but the CPI report was a catalyst for a further backup in yields. When inflation runs hot, investors are forced to recalibrate the yield they demand on their fixed income investments to preserve purchasing power, which has led 10-year Treasury yields to climb to 4.6% from 3.9% to start the year.

Another factor is how the Fed may react to stubborn inflation. The Fed telegraphed with its dot plot projections last month that most of its voting members expected to see three rate cuts this year and another three in 2025. However, markets seem to have a different view. Fed funds futures react in real-time to the latest information and are now expecting only two rate cuts this year and a shallower path of rate cuts through 2025. This stands in stark contrast to the start of the year when markets were expecting 6 – 7 rate cuts. Because inflation has remained a tough nut to crack, this is likely to prompt the Fed to push out the first rate cut of this cycle to either late summer or fall and potentially downgrade the number of cuts to be expected this year.

So what does this mean for investors? Higher inflation has meant higher bond yields, so fixed income now offers an incrementally more compelling value proposition. On the other side, equities may be at risk of adjustments to their already premium valuations due to higher rates. That’s especially so for growth companies, which often prove more sensitive to interest rates.

So to summarize, the March CPI report exceeded expectations, and the underlying details revealed concerning trends in sticky price inflation and the potential for further energy inflation in the pipeline. Although bond yields were already increasing in the lead-up to last week, the CPI report served as a trigger for another leg higher in yields. All eyes are on the Fed now, which is still heavily focused on inflation and will likely have to push out its first rate cut of the cycle and possibly revise down the number of cuts to be expected for this year. For investors, incrementally more compelling bond yields makes fixed income a more compelling value proposition going forward, though equities may face rate-related risks to their premium valuations.

Thanks for listening! And please don’t hesitate to reach out with any questions.