Inflation has been broader than just a product of used cars or other parts of the reopening economy.
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The stock market faced its inflation fears this past week, and it came away better for it. But investors better make sure they don’t get too complacent.
Inflation, we all know by now, is running hot—and we didn’t need May’s report to confirm it. The consumer-price index rose 5% last month from a year ago, easily topping forecasts for 4.6%. It was the second blowout report in a row, following April’s 4.2% reading, but the market’s reaction was quite different.
When April’s CPI was released on May 12, the market took it on the chin, with the tech-heavy Nasdaq Composite down 2.7% in one day, taking the brunt of the damage. This past week, however, it was the Dow Jones Industrial Average that was hit hardest, falling 276.79 points, or 0.8%, to 34,479.60. The Nasdaq, on the other hand, rose 1.9%, to 14,069.42, while the S&P 500 index finished up 0.4%, to 4247.44.
Stranger still was the reaction from the U.S. Treasury market. Higher inflation should be bad for bonds, which already yield far less than the inflation rate. But Treasury prices rose this past week, sending yields, which move in the opposite direction, lower. The 10-year yield fell 0.097 point, to 1.462%, its largest one-week drop in about a year.
Lower bond yields in response to higher inflation suggest that the investors have bought what the Federal Reserve, which meets this coming week, is selling—that inflation is temporary and there’s no need to worry about a ’70s-style price shock developing.
Perhaps. But RBC’s Tom Porcelli notes that the Fed’s “transitory” comments were never about hyperinflation but something far tamer: Fed Vice Chair Richard Clarida has said that the central bank wants to see a year’s worth of 2% inflation before tightening monetary policy.
“That’s it,” he says. “Not 5% inflation, not 15% inflation, 2% inflation. We think that is an incredibly low hurdle, which the transitory crowd seems to lack an appreciation for.”
But Porcelli also thinks inflation has a good chance of being stronger than that. It’s been easy to dismiss inflation as just a product of used cars or other parts of the reopening economy, but he notes that it’s been far broader than that. Meanwhile, the services component of the economy is only beginning to reopen, and the same kind of bottlenecks faced in the goods economy could show up there as well. If he’s right, then the market’s recent reaction to inflation could be misguided.
“It almost feels like the market is all-in on transitory inflation,” writes Porcelli, who sees low Treasury yields triggering “a larger volatility event later in the year.”
Of course, falling bond yields could also suggest that the market is starting to price in slower growth—and perhaps even a growth scare later in the year, something that would be deadly for economically sensitive value stocks. History suggests otherwise, writes Sundial Capital Research’s Dean Christians. The S&P 500 closed at a new all-time high this past week, while the 10-year yield closed at its lowest level in three months—only the 18th time since 1968 that the index closed at a three-year high while bonds traded at a near-term low.
On previous occasions, the S&P 500 was higher six months later 82% of the time, with a median gain of 6.9%. Growth stocks gained 5.4% and were higher 71% of the time, while value stocks gained 11.2% and were higher 88% of the time—giving value the upper hand.
Inflation fears are dead. Long live inflation fears.
Write to Ben Levisohn at [email protected]
