Skip to main content

Inflation Outlook - Market Implications and What's Next?

Source: Shechar Dworski, PhD, CFA
Publish Date: Jun 16, 2022
Read Time: 6 minutes

Our view on inflation following the U.S. Federal Reserve's decision to hike interest rates by 75 bps.

Market volatility surged again across markets earlier this week as investors anticipated a greater likelihood of a large interest rate hike from the U.S. Federal Reserve (Fed) in order to ease inflation pressures. The Federal Open Market Committee (FOMC) concluded the policy-setting meeting held on June 14-15, 2022 and decided to raise interest rates by 75 basis points according to the FOMC statement following the meeting.

At Picton Mahoney, we have been monitoring the new inflation data very closely and are sharing our view on some new developments:

Core inflation: It seems to be decelerating, though not as quickly as we hoped. The strength is generally coming from core services (Fig. 1).

  •  Core goods prices are starting to turn into a headwind as evidenced by negative contribution of many durable and household goods.
  • China Producer Price Index continues to decelerate as well, indicating that global price pressures for manufactured goods are dissipating.
  • The supply constraints that led to goods inflation happened early in 2020 and were being mended in 2021. It seems to be better now, though it is not 100% back to normal yet.
  • Core Services is accelerating and is the main problem – this is largely driven by labor shortages resulting in capacity constraints.
  • This was less of a 2020 problem but developed in 2021 because of the second round of Covid lockdowns. After renewed lockdown cycles, service businesses did not fully re-open back to full capacity. They waited to see. Unfortunately, it is generally harder to find labor now to get back to full capacity. The situation may take time to resolve, but this is also a transient problem (i.e., not necessarily a cause of sustainable long-term inflation).

Change in Topline Contributions to Headline and Core U.S. CPI graph as of May 31 2022

Wages: Because inflation is higher than wage growth, real wage growth is negative and consumer sentiment plunged again (Fig. 2).

  • Demand almost always follows, but this time there is a lag due to the long tail of Covid lockdown pent-up demand. Lower demand will likely negatively impact prices in due course. Retail inventories (ex-autos) are already quite high, a sign that demand is waning.

Recession and the University of Michigan Consumer Expectations Index graph as of  May 31 2022

Housing: Shelter was also a big and rising contributor to core inflation.

  • There is evidence in Canada that home prices are already falling in response to higher interest rates.
  • US housing sales/inventory ratio is in our view at a dangerous level (similar to 2005).
  • The recent surge in mortgage rates and home prices has made the cost of carrying new homes in the US the highest it has been in decades (Fig. 3).

U.S.Monthly Mortgage Payment on Average-Priced New Home graph as of May 31 2022

What is the Fed looking for?
The Fed hiked 75 bps now, but the “dot plot” suggests that another +200bps is expected over 4 meetings this year as they want policy to be at restrictive levels at the end of the year. They consider economic activity as improving after a weak Q1 2022. Fed Chair Jerome Powell sees the financial conditions tightening as “very healthy”.

The biggest change in the statement is this line: “The Committee is strongly committed to returning inflation to its 2 percent objective”. There were also big changes to the Summary of Economic Projections. Taken together, it seems like they are saying that they need to crush growth and employment in order to remain on target with inflation goals and are strongly committed to doing this.

In order to ease off the current tightening path, the Fed is looking for a "series" of declining monthly inflation readings. Also, they seem to be quite spooked by rising inflation expectations data recently and want to see that improve i.e., the University of Michigan long term expected inflation survey going from 3.0% to 3.3% (Fig. 4).

University of Michigan Expected Change in Prices During the Next 5-10 Years median graph as at May 31 2022

“The race is on between demand destruction and supply responses” is a good way to summarize it. We continue to monitor the situation extremely closely, and we are managing our strategies diligently, using our hedging and risk mitigation tools. For more information, please reach out to your Picton Mahoney sales representative.

This material has been published by Picton Mahoney Asset Management (“PMAM”) on June 16, 2022. It is provided as a general source of information, is subject to change without notification and should not be construed as investment advice. This material should not be relied upon for any investment decision and is not a recommendation, solicitation or offering of any security in any jurisdiction. The information contained in this material has been obtained from sources believed reliable, however, the accuracy and/or completeness of the information is not guaranteed by PMAM, nor does PMAM assume any responsibility or liability whatsoever. All investments involve risk and may lose value. This information is not intended to provide financial, investment, tax, legal or accounting advice specific to any person, and should not be relied upon in that regard. Tax, investment and all other decisions should be made, as appropriate, only with guidance from a qualified professional.

This material is intended for use by accredited investors or permitted clients in Canada only.

This material contains “forward-looking information” that is not purely historical in nature. These forward-looking statements are based upon the reasonable beliefs, expectations, estimates and projections of PMAM as of the date they are made. PMAM assumes no duty, and does not undertake, to update any forward-looking statement. Forward-looking statements are not guarantees of future performance, are subject to numerous assumptions, and involve inherent risks and uncertainties about general economic factors which change over time.

There is no guarantee that any forward-looking statements will come to pass. We caution you not to place undue reliance on these statements as a number of important factors could cause actual events or results to differ materially from those expressed or implied in any forward-looking statement made. There is no guarantee that a hedging strategy will be effective or achieve its intended effect. The use of derivatives or short selling carries several risks which may restrict a strategy in realizing its profits, limiting its losses, or, which cause a strategy to realize or magnify losses. There may be additional costs and expenses associated with the use of derivatives and short selling in a hedging strategy.

©2022 Picton Mahoney Asset Management. All rights reserved.