The US is shedding excess capacity at a faster rate than most of its developed world peers, which supports our outlook for inflation to strengthen and sharpens our focus on the risk of rates volatility.
We believe the US is at the forefront of a long-anticipated but slow-moving trend of global reflation. Despite softness in recent price data, we believe the longer-term strengthening trend in US inflation is intact. Year-over-year consumer price inflation (CPI) is twice what it was a year ago. Core CPI has been flatter, but has spent 17 of the last 20 months above the important 2% threshold. Sticky prices—which are slow moving and so considered more likely to incorporate inflation expectations —are on a reasonably steady upward trend. We have been positioned for rising inflation since the first half of last year, which has generally played out well.
Source: Federal Reserve Bank of Atlanta, as of April 2017
This scenario puts the US well ahead of the other largest developed economies in its cycle. The euro area is struggling with inflation below 1% and still has sufficient spare capacity to avoid significant pressures this year and next.
So far the drivers of inflation have been concentrated, predominantly in energy and housing, but we expect more broad-based contributions in the future, due to a lack of spare capacity. This expansion of pressures fuels our concern about the potential for a rapid re-pricing in rates markets.
Oil price fluctuations have clearly played a part in higher headline CPI numbers via base effects in the year-over-year calculation. The combination of a recovery in oil markets, and prior weakness dropping out of the annual comparison, has led to a major reversal in energy’s impact on CPI. Energy exerted a -1.5% drag on the index in 2015, and contributed 0.7% in April 2017. That latest contribution ranks energy as the biggest driver of price increases after housing, which has been consistently strong over several years. Contrary to some reports, the contribution of healthcare costs has been by and large steady.
We expect these dominant pressures to fade as oil prices have moderated and rental prices are likely to weaken as more supply comes online at this stage of the cycle. Looking ahead, we anticipate broader support from service sectors, catalyzed by upward momentum in wages.
Source: Bureau of Labor Statistics, as of April 2017
We expect that momentum to come from a lack of spare capacity in the economy. Unemployment in the US is around levels that typically herald meaningful wage growth, having moved decisively below the Fed’s estimate of the equilibrium rate of 4.7%, to 4.4% in April. The employment cost index (ECI) is at its highest level since 2007. Despite a couple of weaker prints recently, average hourly earnings have been rising toward the 3%-4% range from the second half of the last cycle. That should not surprise: headline unemployment has been below 5% for a year, and the U-6 measure of underemployment has fallen by one percentage point in six months, a one standard deviation move.
Moreover, the number of people quitting jobs has risen in tandem with hiring rates. Both of these metrics are among the ‘labor market dashboard’ of data that Fed Chair Janet Yellen has flagged as significant, and their elevated levels are promising for wage growth. People tend to leave jobs when they are confident of finding new employment on more favorable terms quickly. Further signs of a tightening labor market come from the Manpower Group Employment Outlook Survey, as employers’ hiring intentions have resumed their long-term upward trend in the second quarter of this year.
Offsetting these positive labor market statistics somewhat is the drag from low productivity, which acts as a headwind to how quickly wages can rise.
But contrary to the common perception, spare labor market capacity in the US has wound up relatively rapidly in comparison with past recoveries (see chart below). We think the speed of the adjustment may increase the risk of an overshoot in inflation, and we believe the Fed is behind the curve. This leads us to a discussion on the market pricing of these inflationary pressures, which is conspicuous mainly in its absence.
Source: GSAM, Bureau of Labor Statistics. Employment improvement reflects decline in unemployment from peak (pp)
We think that rates in the US are mispriced. Yields fell on the recent consecutive declines in Core CPI and a lower-than-expected PCE print, coupled with some risk aversion before the French election. But we expect the upward trend to resume on further rate hikes and talk of balance sheet normalization. This tightening could cause volatility and we are wary of a sell-off in rates precipitating declines in equities or credit. We highlighted this possibility in our 2017 Outlook but given that bonds, unlike equities, have not yet priced positive macro developments, we believe the risk is more acute now.
We believe a re-pricing of rates is a key risk for portfolios as many investors rely on the correlation between rates and equities for diversification. Our Asset Allocation piece details how we are varying our dynamic exposures to deal with the evolving macro environment.
Recent US price data appear to challenge our view that US inflation is on a sustainable upward trend. Consumer price data for March and April disappointed and the Fed’s preferred measure fell on the month for the first time since 2009, driving market expectations lower. We are paying close attention to upcoming readings, but we think this weakness is temporary, US inflation is closing in on the 2% target and the Fed’s projection for three hikes this year remains intact.
The latest wage data fell short of expectations, as average hourly earnings slipped for the second month in a row, to 2.5% on the year. But another measure on the Yellen labor market dashboard, the Employment Cost Index (ECI), was up 2.4% on the year in the first quarter, accelerating from 2.2% at the end of 2016.
Diving into Core PCE—which is the Fed’s focus and shares many features of the consumer price index—we saw some unexpected contributors to the -0.2% month-on-month drop in March. We estimate half of the decline was technical, due to a change in calculations in the Communications sector as cellular providers introduced unlimited data plans. Indeed, the index corrected in April with a 0.2% increase, though the prior month’s dip dragged the year-on-year reading to a 16-month low of 1.5%.
Other weak spots in recent data were in prices of new and used cars and apparel, which corrected sharply after three strong readings. The more surprising drop was in owners equivalent rent (OER).
The steep decline in housing costs, which is a large component of PCE, seems inconsistent with our outlook for higher inflation. However, we do expect some drop-off in pressure from OER, which has been a strong inflationary driver in the US for several years. Over the coming months we expect more upward pressure from services inflation, which covers discretionary costs such as recreation and so tends to respond more to wage growth and late-cycle dynamics. The wild card is goods inflation, which has been negative for the past year, and we don’t expect to contribute much in the foreseeable future.
At this stage we see core inflation around 1.7% at the end of 2017. Based on the latest data we think the Fed is likely to revise down its 1.9% forecast, but leave its projections for three rate hikes this year. In our view the main risks to that outlook would be more pronounced weakness in inflation or labor market data.