CHAPEL HILL, N.C. (MarketWatch) – Retirees and near-retirees were understandably alarmed by this week’s report of a big jump in the Consumer Price Index.
It was on Wednesday (May 12) that the Bureau of Labor Statistics reported that the CPI over the last 12 months had risen at a 4.2% pace, a 13-year high. A month ago, the CPI’s 12-month rate of change had been “just” 2.6%.
In reaction, the Dow Jones Industrial Average plunged nearly 700 points.
My advice? Make no changes you weren’t already planning to make for other reasons. That’s even though I fully acknowledge that inflation wreaks particular havoc on retirees’ portfolios.
There are several reasons for this otherwise-surprising advice. The first is that the CPI’s latest jump does nothing more than bring it back to where it would have been but for the pandemic. This is illustrated in the accompanying chart, which plots the actual CPI alongside where it would have been if, since January 2020, it had grown at 2019’s rate. Notice that the actual CPI is now right in line with that hypothetical trendline.
It’s all a matter of perspective, in other words. If you expand your focus to the CPI’s two-year rate of change, as opposed to its 12-month pace, there is nothing to write home about.
It’s also worth noting that the CPI’s 2019 increase, which is what I used to construct the trendline in the accompanying chart, was at the time thought by some to be too low. When reporting the CPI’s 2019 increase, in January 2020, my colleague Jeffrey Bartash reported that the Federal Reserve was more “worried that inflation may slip even lower than it is currently than it is about a sustained increase in prices.”
If 2019’s inflation rate initially seemed to some, including some at the Fed, to be too low, then why freak out when the CPI merely returns to that trendline?
Expected Inflation
The same conclusion emerges when we focus on expected inflation: What the markets are implicitly betting inflation’s rate of increase will be in coming months and years. According to a model of expected inflation maintained by the Federal Reserve Bank of Cleveland, this week’s reported jump in the CPI was a non-event.
The Cleveland Fed’s model has a number of inputs, including “Treasury yields, inflation data, inflation swaps, and survey-based measures of inflation expectations.” Prior to the CPI report this week, this model calculated that the markets were expecting inflation over the next 10 years to average 1.58% annualized. After this week’s report, the model calculated it to be 1.57%.
A similar picture is painted by the five-year data: The Cleveland Fed model concluded that expected inflation over the next five years stood at 1.48% before this week, and that’s where it stayed in the wake of this week’s report.
A similar conclusion emerges when we focus on the so-called breakeven inflation rate, which is the difference between the yield on the nominal Treasury and that of TIPS of the same maturity. As this is written, the 5-year breakeven inflation is precisely the same as it was one week ago, before this week’s report of the big jump in the CPI. The 10-year breakeven inflation rate is just 2 basis points higher. (A basis point is one-hundredth of one percent.)
To be sure, the markets can be wrong. But don’t be too quick to dismiss what they’re saying. The bond markets collectively are the largest in the world, far bigger than the equity markets. Traders, who monitor the market on a second-by-second basis every day, will buy or sell billions of dollars’ worth of bonds when they perceive an arbitrage opportunity involving just a couple of basis points.
You may still insist that the CPI will continue rising over the coming year or two at the greater-than-4% rate reported this week, of course. Just know that you have trillions of dollars in the bond market betting that you’re wrong.
Correlation between inflation and the stock market
The other reason not to recommend any changes in your portfolio in reaction to the latest CPI data: Changes in the inflation rate have very little explanatory power in forecasting the stock market’s subsequent return.
Consider a statistic known as the r-squared, which represents the degree to which changes in the CPI’s 12-month growth rates have historically been able to explain or predict changes in the stock market’s inflation- and dividend-adjusted return over the subsequent year. The r-squared ranges from a theoretical maximum of 100% (which would mean that the stock market responds in perfect lockstep to changes in the CPI changes) to a minimum of 0% (which would mean that the stock market and the CPI are completely uncorrelated).
Focusing on the period back to 1871, courtesy of data from Yale University professor Robert Shiller, the r-squared is just 1.1%. It is only marginally statistically significant, in fact—only significant at the 90% confidence level, not the 95% confidence level that statisticians often use when determining if a pattern is genuine.
Regardless of its statistical significance, however, the low r-squared reading indicates that the course of the stock market over the next year will be influenced far, far more by other factors besides the CPI. So even if the latest jump were more than just a snapback to trend, it’s not clear you should adjust your expectations for the stock market over the coming year.
None of this discussion should be taken to mean that the stock market won’t struggle in coming months and years. I actually think there are good odds it will, due to the stock market’s current overvaluation. If it does so, however, the culprit won’t be inflation but that overvaluation.
The bottom line: Focus on what really matters. And this month’s increase in inflation is nowhere near the top of that list.Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected]
