The post-pandemic cycle has featured higher inflation and interest rates for the first time in decades. The good news is that over the course of 2022 we think these pressures will abate as the economy recalibrates, even as spillover constraints from Russia-Ukraine may pose challenges. The bad news is that investors will likely still be contending with a new normal level of 2%+ inflation going forward. In this environment, we see renewed reasons to consider real assets and global equities in portfolios.
Pandemic-induced imbalances in goods demand and supply led prices higher, with the US core consumer price index (CPI) and personal consumption expenditures (PCE) printing at their highest levels since the 1980s at 6.4% and 5.4%, respectively, in February. Consumer spending on goods accelerated 12.1% in 2021 as people opted to use pent-up savings on items rather than services. Inventories were quickly depleted, and disruptions across supply chains — from factories to shipping containers to ports to retailers — struggled to keep up with demand. As a result, supply-constrained categories have driven 50% of the inflation overshoot in 2021.
We have already seen meaningful supply relief as logistical congestions come off peak levels. In line with Exhibit 1, categories that contributed to inflation in 2021 should become a drag by the end of 2022 and into 2023. Still, we watch this data closely as persistent geopolitical conflict may constrain inputs again in the near-term.
Source: Department of Commerce and Goldman Sachs Global Investment Research. As of April 3, 2022. The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation.
More recently, inflation has become more broad based. Housing CPI rose 5.9% from February 2021 to February 2022, compared to 1.8% the year prior. Demand has been accelerated by low mortgage rates, millennial household formation, and suburban flight, but we think that it will continue even after some of these effects fade. At current levels, the US housing market is approximately 2.8 million homes underbuilt. This imbalance will take time to restore as demand will likely continue to outstrip supply.
Wage pressures may also keep inflation above its pre-pandemic trend as the labor market remains tight. Goldman Sachs Global Investment Research’s GS wage tracker estimates that wage growth was roughly 5.4% year-over-year (YoY) on aggregate in Q1, and even higher at lower wage brackets. With an estimated 5 million workers having exited the labor force during the pandemic — two-thirds of whom are over age 55 and likely will not return — and an already-low unemployment rate of 3.6% in March, we think the supply-demand imbalance will likely continue to keep wage prices high.
Commodity prices are also likely to keep inflation pressures firm in the medium-term. Years of underinvestment in capital expenditures have led to depleted supplies failing to meet surging demand as activity recovers. Supply constraints from Russia have amplified global imbalances. Energy prices are 185% above pre-pandemic levels and rising. Industrial metals are also more than 185% higher and set to climb as infrastructure and clean technologies are built out. Even as the boost from commodity prices on YoY core PCE inflation eases from a peak of 85bp in Q1 2022, we expect it will still contribute 70bp to YoY core PCE in Q4 2022.
We think the path to more manageable inflation will come from supply chain relief, demand normalization, and easing growth to bring price pressures down to 4.0% core PCE by year end. However, inflation may continue to print above 2% in the medium-term as housing price acceleration, sustained labor undersupply, and commodity price pressures lift the baseline. For investors, a focus on generating real returns after accounting for inflation may be top of mind.
Fortunately, investing in a higher inflation world does not preclude positive returns. A higher baseline, alongside healthy GDP growth, may still reflect a solid backdrop for risk assets. Historically, real assets such as commodities, real estate, and infrastructure have outperformed in high and rising inflation environments — as we have seen over the past year. In high and falling inflation environments, global equities have taken the lead as earnings and margin strength can outpace price pressures.
Source: Goldman Sachs Global Investment Research. As of December 31, 2021. Past performance does not guarantee future results, which may vary.
Investors may continue to see volatility as markets recalibrate to the new normal, and geopolitical concerns have amplified risks in recent weeks. But in the long-run, data shows that risk asset returns have historically outpaced the inflation rate. In the post-pandemic cycle, we continue to believe in a strategic approach to weathering both the good and the bad.