Expected Market Inflation and Consumer Sentiment
Generally accepted sentiment in the market is that inflation is expected to remain high over the course of the next 5 years. The numerical value attached to this sentiment is the highest it has been since 2003, and is even +0.55% above the 10Y breakeven rate. The 10Y rate is also at its highest since 2003. Essentially, the market currently expects inflation to remain elevated for at least the next 5 years before it begins to ease off. It is our contention that the breakeven rate may be overstated due to current geopolitical events. If this is the case, the rate will decline hopefully during Q2 of 2022.
The Fed tightening up is not necessarily an indication that inflation will ease. While this is the idea behind their actions, historically, it is not always the result. During February, CPI inflation soared, and is expected to remain high. The idea that the Fed tightening does not have quite the effect on inflation that we hope it would is supported by the graph below, in which is it seen that PCE Inflation, the Fed’s own preferred measure, did not decline during the first 24 months of any of the last six tightening periods.
The issue with this is that the Fed’s tools are designed to address demand. While they are successful in doing this, they fall short of addressing current inflationary pressures, which are based more in commodity supply deficits and global supply chain disruptions.
According to the University of Michigan Data, the Consumer Sentiment Index dropped below 60 during March. To provide historical perspective, this has only occurred 4 times since 1950, with the other instances happening around recessionary periods as well, in 1980, 2008, and 2011, before last month. It is important to note that these other periods occurred after decades which saw weak returns from the S&P 500, which was not the case for this 2022 occurrence. In this case, it could be because investors are simply ignoring consumer unhappiness. The effect of this type of investing not something that has been studied, and could prove to be dangerous, as consumers provide for about 70% of all economic activity.
For some good news, manufacturing purchasing is remaining strong. The ISM PMI is a monthly measurement of economic activity through the lens of purchasing managers at more than 300 U.S.-based manufacturing firms. Based on this metric, February marks the 19th consecutive month of expansion, and March would make for the second longest period of expansion after the period from 2017-2018. This is useful in evaluating the expansion of manufacturing as a part of the American economy, which many view as a point of emphasis on the overall health of our economy. Coming during (hopefully) the closing ceremonies of the pandemic, this is to be expected but encouraging
5 Yr US Treasury vs. 10 Year US Treasury Breakeven Rate
Although we may hope to curb inflation here in the U.S., we may encounter a situation where the strength of the USD abroad weakens throughout the course of the next few quarters. This past month, the Fed raised the fed funds rate. Historically, in the year leading up to a rate hike like this, the USD tends to strengthen, as foreign investors anticipate higher to weaken for at least the first year, and for a period of up to 36 months, as this is generally the time that things bottom out. As for the remainder of this year, this indicates the USD could weaken up to about -5% by the end of December.
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