Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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US CPI: The dilemma for equity investors
Peter Garnry
Chief Investment Strategist
Summary: The US January CPI report shows that core inflation across different measures including the US Services core inflation excluding energy actually rose in January remaining stubbornly high around 7% annualised inflation. S&P 500 futures initially reacted positively to the report and what looks like a weird behaviour most likely reflecting clearing of hedges and other derivatives positions before settling on the clearer interpretation that inflation remains high. Investors are facing a dilemma in equities as high inflation will reflect no recession but likely leading to higher interest rates and lower equity valuations.
Core inflation remains stubbornly high
The US January CPI figure is 0.5% m/m vs est. 0.5% m/m with the December figure revised to 0.1% m/m from previously -0.1% m/m, while the core CPI is 0.4% m/m vs est. 0.4% m/m and revised up to 0.4% m/m from 0.3% m/m in December. The initial reaction was positive across equities with S&P 500 futures rallying as high as 4,186.50 as the US 10-year yield also retreated lower. Commentator initially focused on the core services CPI excluding shelter, which has been highlighted by Fed Chair Powell, which cooled y/y in January.
Outside of this narrow inflation definition, both the headline and core CPI remained high and with the upward revision in December the easing of inflation seems limited. The US Services CPI excluding energy, which is around 57% of the CPI basket, rose 0.55% m/m in January pushing the 6-month average up to 0.59% m/m indicating that the broader US services sector is seeing stubbornly high inflation of over 7% annualised. The initial reaction has shifted to a more negative interpretation with the S&P 500 futures now declining from yesterday’s close while the US 10-year yield is adjusting higher.
Investors are in a dilemma because equities are priced for perfection with equity valuation moving back above historical averages as shown in last week’s equity update. That perfection of no recession, easing inflation, and limited margin pressure among companies is difficult to work out. If China is successful in its reopening and macroeconomic data in the developed world remains that of avoiding a recession then inflation will likely remain higher for longer risking to turn sticky at a much higher level than what the US 10-year yield is currently reflecting. That would cause equity valuations to be under pressure from higher bond yields coupled with margin pressure as China’s reopening should keep commodity prices elevated or even going higher again.
If inflation does in fact ease back to the levels reflected in inflation swaps then the global economy might slip into a recession and that could cause the equity risk premium to increase and equity valuation to decline on top of lower growth. In other words, equity investors are in a dilemma and with strong gains already delivered in the first seven weeks of the year, investors might experience a more bumpy road from here on.
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