by Jurrien Timmer, Director or Global Macro, Fidelity Investments
The situations in the jobs and housing markets could lead to a little bit of both.
Key takeaways
- Inflation is still on everyone's mind and the question of whether it's transitory or structural is unsettled. I think it could be a little bit of both.
- Based on past cycles, at 5.4% the current inflation spike could start to moderate soon.
- On the other hand, structural inflation has crept into the economy in the past after first appearing to be transitory, for instance in the late 1960s.
- The good news is that I don't see any signs of the stagflation that followed the inflation boom of the late 1960s into the 1970s.
Fall is in the air, and it seems like the markets are sniffing out a change of seasons as well—from an abundance of liquidity to a gradual removal of it. With the Fed expected to start tapering next month, the bond market is starting to price in that outcome. The fed funds curve has ratcheted up a notch and is now pricing in more than one hike for 2022 and 6 hikes through 2025.
The long end of the curve remains below its spring highs of 1.75%, but last week the 10-year started to move higher again. My bond model continues to suggest that we could see 2% before long.
The TIPS market has also woken up again, and the 5-year, 5-year (5y,5y) forward breakeven spread is once again testing the upper end of a long-established range. Will we finally see a breakout?
The 5-year, 5-year forward inflation expectation rate measures inflation expectations for the 5-year period that starts 5 years from today.
The answer likely depends on the "transitory vs. structural inflation" narrative. My take continues to be that it's a little of both. Between the tight labor markets and booming housing market, it sure seems likely that we will have some structural inflation in the coming years, despite the deflationary headwinds caused by technology and demographics. But, mathematically speaking, the inflation rate will always have some transitory aspects as base effects wear off.
My guess is that based on past cycles, at 5.4% the current inflation spike could start to moderate soon. Even during the heady inflationary period of the late 1960s and 1970s, the initial surge appeared to be transitory. After an increase to 6.18%, the inflation rate (CPI) fell back to 2%–3%, before taking off again. Inflation can be very stealthy that way in the early days.
Whether rising inflation was merely cyclical or structural, the initial burst appeared transitory and it wasn't evident until the next cycle whether it would become structural.
There has been a lot of talk about stagflation in recent weeks, but so far I see little evidence of it. Inflation boom? Yes. Stagflation? No. There are several factors we can look at including the Purchasing Managers' Index (PMI), which remains firmly in inflation boom territory.
Another clue: The unemployment gap (the difference between the U–3 jobless rate and full employment) has almost round-tripped to its pre-pandemic peak, and the quit rate is now up to 4.27 million. My guess is that 4-plus million people would not be quitting their jobs if they didn't feel confident that they could get better jobs at higher wages. Inflation boom indeed.
Meanwhile, in the stock market
For equities, the seasonal "wobble" window is coming to a close.
Part of the wobble narrative is the effect that a rise in the discount rate has on the valuation of the long-duration growers (convexity is not just for bonds). (Duration refers to how sensitive a company's cash flow is to changes in interest rates. Long duration stocks are more convex which means they are more sensitive to changes in interest rates than value stocks.)
But another is the transition from the early cycle "V" recovery to a more modest mid-cycle expansion. You can see the baton-pass from valuation to earnings below. We are now heading into a period of compressing valuations and moderating earnings growth. Multiple compression is what happens when a company's earnings are up but the stock price stays the same or falls.
Here is the sequence: First, the market bottoms, then earnings typically bottom a few quarters later. In between those 2 inflection points is a big expansion in the P/E multiple. From there, the P/E ratio peaks on a rate-of-change basis, then earnings growth goes positive, then the change in the P/E ratio turns negative, and then earnings growth peaks.
