We expect two inflation scenarios moving forward and caution investors against both scenarios given the consequent implications on asset classes.
For the central case, our higher probability scenario, we see hot inflation prints in 2H21 before cooling off in 2022 and 2023. In this scenario, core PCE will likely settle between 2 – 3 per cent over the next two years.
Core PCE inflation decomposed by Covid sensitive and insensitive components
For the hawkish case, our lower probability scenario, we see hot inflation prints extending beyond 2021 and core PCE to remain above 3 per cent over the next two years, reflecting our view of a high level of persistent inflation.
Both our central and hawkish case points to a reversal in the interest rate cycle in late 2022. For the former, we anticipate one rate hike around end-2022 and up to two hikes in 2023. For the latter, we anticipate two rate hikes in 2022 and up to two – three hikes in 2023.
With the higher inflation backdrop presented in both cases, we believe inflation risk is currently underpriced. For our central case, we expect yields to reach 2-3 per cent over the next two years.
If our hawkish case materialises instead, yields may surge even higher to 3-4 per cent in the same timeframe.
For our hawkish case, we expect equities to struggle if the 10-year yield climbs to 3-4 per cent within the next two years.
Core PCE inflation adjusted for base effect
An earnings yield of 6.1 per cent for global equities and a 3-4 per cent yield would imply an excess yield of 2.1 to 3.1 per cent, which is below the 10-year historical average of 3.5 per cent. This implies that bonds should be relatively more attractive than equities.
For our central case – we expect equities to be able to digest a 10-year yield of below 2.7 per cent. An earnings yield of 6.1 per cent and 10-year yield of 2 per cent – 2.6 per cent would imply an excess yield of 3.5 per cent to 4.1 per cent, which is above the 10-year historical average.
This implies that equities should be relatively more attractive than bonds.
Rising home sales price implies higher housing-related inflation (19 per cent of Core PCE) to come
Our US inflation outlook
The US inflation debate remains top of mind for many investors right now. At the moment, US inflation prints (core PCE of 3.4 per cent in May ’21) are at the highest since the early 1990s, with many pondering will such hot prints will be ‘transitory’.
To determine our inflation outlook, we examine the core PCE inflation, the Fed’s primary measurement of inflation which excludes food and energy prices.
A breakdown of core PCE inflation shows that Covid-sensitive categories (likely transitory) have been the predominant driver of inflation). These are categories where either prices or quantities were significantly influenced by the pandemic.
In fact, over the past two months, these categories contributed to more than 75 per cent of the inflation reading. On the other hand, Covid-insensitive categories have just rebounded to their pre-pandemic rate.
Base effect is also a major transitory factor contributing to higher inflation prints as lower comps in 2Q/3Q resulted in a significant skew in prints. Adjusting for base effect (after Feb ’20), the core PCE ends up 30 per cent lower than reported.
As data suggests, a big part of inflation can indeed be attributed to transitory factors, captured by both Covid-sensitive categories and base effect.
We believe this pressure may gradually fade as supply constrain eases, which will take time, likely over the next 2-3 quarters as the global re-opening sequence play out.
However, as these factors fade, it is likely to unveil a certain level of persistent inflation, underpinned by housing-related and monetary inflation Red flags are showing up in housing-related inflation, which represents around an outsized 19 per cent of core PCE.
Over the past year, US median home sales price growth has skyrocketed catalysed by the combination of base effect, higher material cost, and lower mortgage rates.
With rising home prices often portending higher housing inflation (former leads the latter by approximately 13 months), we expect housing-related inflation to bottom and turn higher soon.
A run-up in housing-related inflation towards pre-Covid levels may keep core PCE likely elevated over the next 1-2 years.
The impending reversal in interest rate cycle
We expect a reversal in the interest rate cycle in late-2022
Through our observations from the Fed’s meeting minutes thus far, we believe the cue for a rate hike is likely the product of 3 considerations: core PCE at 2 per cent and above; core PCE exceeding 2 per cent for some time; and maximum employment.
Our current inflation outlook – both central and hawkish case – implies that the first and second criteria can be met by end-2022, leaving the Fed’s employment target as a wildcard to watch in our opinion.
Firstly, payroll gains will have to impress to the tune of 530,000 jobs added monthly on average to close the existing unemployment gap of an estimated nine million jobs between now and pre-pandemic trend. Thus far, payroll gains have averaged at a positive monthly rate of 540,000 in the year-to-date.
While it is still pre-mature to expect gains at such level to continue, the employment recovery seems to be on track based on payroll data.
Secondly, other indicators such as unemployment claims and participation rate have also improved in the last few months, painting the same picture.
Therefore, what is left now is for unemployment rate (which remain stubborn) to dip, thereby confirming an improving labor market.
That said, we opine that the US economy could be on-trend to achieving maximum employment by 2023, prompting an earlier rate hike in 2022. Any upside to inflation risk (our hawkish case) can certainly bring forward rate hikes as well, even before maximum employment is achieved.
Thus, both our central and hawkish case points to a reversal in the interest rate cycle in late 2022, invoking an end to the low interest rate environment.
For our central case, we are anticipating one rate hike around end-2022 and up to two hikes in 2023. For our hawkish case, we see two rate hikes in 2022, and up to two – three hikes in 2023.
Inflation over the next 1-2 years may settle at a higher level as compared to post-GFC
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