Sign On
by Global Investment Strategy Team
Key takeaways
- The recent decline in commodity prices may produce a sudden drop in headline inflation in the coming months, but other components are likely to keep inflation higher for longer.
- The Federal Reserve (Fed) is unlikely to pivot to an accommodative policy until inflation returns to somewhere between 2% and 3%. Policy seems set to reduce economic growth until demand roughly matches supply.
What it may mean for investors
- Although we believe a recession will result from persistent inflation and continued rises in interest rates, we also expect a recovery beginning in mid-2023, and below we list our investment preferences.
Inflation continues to take headlines. This report considers some frequently asked questions about our inflation outlook and how inflation’s persistence affects policymakers and financial markets.
In the 1980s, it took a long time and interest rates as high as 20% to bring inflation down. Do we expect something similar now to get inflation back down toward 2%?
We believe that the Federal Reserve (Fed) faces fewer obstacles to bringing inflation back to a moderate rate now than it did over 40 years ago. A strong fiscal spending thrust from social spending and military spending fueled inflation in the 1960s. In the 1970s, temporary wage and price controls and the Fed’s reluctance to raise interest rates above the inflation rate made for temporary measures and hesitancy that allowed inflation to take root. By contrast, today the Congressional Budget Office expects the 2022 federal budget deficit to fall from 12.4% of Gross Domestic Product to 4.2%. That would mark the largest such reduction since 1946, when the government was unwinding world-war levels of spending. Most importantly, the current Fed is proactive and aggressive.
Second, some institutional rigidities that helped sustain ultra-high inflation 40 years ago are absent today. Weaker unions today mean fewer cost-of-living agreements to perpetuate inflation. Globalization was far less a cost restraint than it is now. Regulations effectively erected barriers to entry that restricted competition. Not so today. The economy’s greater focus then on manufacturing meant a more capital-intensive economy requiring greater financing for start-ups. Cloud computing and other cost-saving innovations were not yet on the horizon. Online shopping and other technological advances also undercut business pricing power by increasing price transparency in a way not possible 40 years ago.
We believe early relief from historically high inflation should come from gradually easing supply disruptions and a reversal of economically sensitive fuel and other goods inflation as the U.S. and parts of the global economy move through a recession. How quickly the reversal in fuel and other input prices breaks down inflation’s persistence in rents and other long-term contract prices will likely depend on the depth and duration of the economy’s decline and on the Fed’s response to lingering inflation.
Why is the Fed raising interest rates and removing cash from the economy when a lot of the inflation pressures are coming from supply shortages related to COVID-19 and the war in Ukraine?
Fed policymakers do not have the tools to fix supply chains, but current inflation challenges the Fed’s reputation for price control. The only ways the Fed has to face the challenge are to raise interest rates and reduce liquidity. Higher rates raise borrowing costs and raise saving rates for consumers and corporations. Reductions of liquidity shrink the cash available in the marketplace.
The Fed’s goal is to use its tools to reduce spending and to strike a closer balance with the supply of goods. If cars are in short supply, some consumers may look to public transportation. If wheat is more expensive, a shopper now might look for house brands of cereal or switch to eggs. The Fed cannot make more cars or cereal appear. Supply disruptions take time to resolve, but the longer they continue, the more aggressively we believe the Fed has to push spending lower.
What makes gasoline prices go up and down? Is it directly the price of oil globally, or are there other dynamics (for example, what you have to pay truckers to transport gasoline)?
Russia has cut natural gas exports to Western Europe, leaving European transportation companies short of diesel fuel and forcing European factories and power plants to switch from gas to coal and refined petroleum. Distillate (diesel) and gasoline inventories declined sharply in May and June, including in the U.S. (Chart 1). As refineries diverted production to Europe, U.S. fuel prices surged.
Chart 1. U.S. weekly gasoline and distillate inventories and five-year ranges
Sources: Bloomberg, U.S. Energy Information Administration, and Wells Fargo Investment Institute, weekly data, January 6, 2012 to July 22, 2022. Shaded areas represent one standard deviation on either side of the five-year average. Distillates include diesel fuel and fuel oil.
The large increase in gasoline prices this year is weighing on demand, and we are starting to see modestly lower U.S. gasoline consumption (Chart 2). This weakening in demand guided gasoline prices somewhat lower in July. In turn, lower gasoline prices (and diesel prices, not shown in the chart) should contribute to lower transportation costs and some easing of inflation in everything from plastics to food in the near term.
Chart 2. U.S. weekly gasoline consumption, January 9, 2015 – July 15, 2022
Sources: Bloomberg, U.S. Energy Information Administration, and Wells Fargo Investment Institute, weekly data, January 9, 2015 to July 15, 2022.
The low fuel inventories shown in Chart 1 may magnify ups and downs from any unexpected or sudden fuel supply reductions. For example, a hurricane that blocks oil imports or shutters refining activity along the Gulf Coast easily could create new energy supply disruptions during the coming months. Such a disruption while gasoline and diesel inventories are already low could send fuel prices suddenly much higher than if there were larger inventories to buffer the shock. Any such fuel price fluctuations, in turn, likely would raise consumer goods prices because of how important transportation costs are for the prices of goods on the shelves.
The bottom line is that, even if the emerging global slowdown sends energy prices and overall inflation lower, a straight-line decline is unlikely. Consumers may see monthly gasoline prices fluctuate higher and lower. The low gasoline and diesel inventories could accentuate swings in fuel prices and, by extension, overall consumer price inflation.
Does peak inflation matter? Gasoline prices have pulled back somewhat. Shouldn’t that help top-line inflation peak in the next month or two? Can’t the Fed back away from future rate hikes once inflation peaks and moves lower?
Anticipation or disappointment about when inflation will peak has moved equity markets higher or lower, by turns, at least since May. Sometimes the equity market moves have exceeded 10% over the course of weeks. But when inflation will peak is not the right question, in our view. We already have noted the persistence in inflation’s sticky components, such as rents, a large component in the household’s budget. Long-term contracts for other materials or services add weight to the persistence. While inflation among these sticky components remains high, overall inflation may trend lower only gradually.
We believe that the Fed will have to remain aggressive until inflation’s downtrend accelerates toward annual inflation of, perhaps, between 2% and 3%. When or at what level inflation peaks is very unlikely to turn the Fed from its aggressive and proactive path.
The focus on peak inflation also misses the cumulative effect of Fed policy, which we believe will become much more noticeable. Historically, the main economic impact of sustained Fed rate hikes comes 6 to 12 months after the Fed begins its hikes. Today, however, economic growth is deteriorating at an unusually fast pace, so the policy impact could be noticeable in the autumn, closer to six months from the Fed’s first rate hike in March. What’s more, by year-end 2022, the Fed’s liquidity removal policy will have erased approximately $600 billion, if the Fed stays on its published course.
How else might inflation still surprise financial markets in the coming months? What should investors think about inflation’s path in the coming months?
We would not be surprised to see the headline 12-month consumer price inflation reading post a sudden, large drop, maybe from 9.1% for June to 5% or 6% in the next two or three months. Two factors might account for such a surprise: Commodity prices, such as gasoline prices, since the March-to-June period have pulled back, and second, it was at this time last year when inflation really took off. The comparison against inflation last year is important because reports on headline inflation typically measure the change from the same month a year earlier. Especially after the recent commodity price pullback, near-term inflation may lack the “fuel” to push ever higher when compared against 12-month-ago inflation that was rising faster than today.
The important point is that a sudden inflation fillip lower may cheer financial markets — prematurely — into extrapolating a lower number into a new downtrend. Inflation seems very unlikely to fall as quickly as it rose. To reiterate, rents and other long-term contract prices are a large portion of the household and business budget and should decline very slowly. Moreover, we anticipate that tight commodity inventories will keep some upward pressure on overall consumer price inflation. Yes, gasoline and diesel prices are off their summer highs, but tight supplies should keep fuel prices elevated.
As its path lower becomes more of a grind than a glide, we believe inflation should continue to wear down household spending and economic and earnings growth. We doubt that the Fed will be as quick to ease its anti-inflation campaign as equity market enthusiasm may imply if inflation suddenly drops.
Victory for investors in the war against inflation should come when inflation finally declines steadily toward a sustainable rate that again encourages spending and leads the Fed to cut interest rates. But we believe that the battles against inflation’s sticky components are likely to get tougher with each percentage point that inflation falls.
Investment implications
The S&P 500 Index has recently rallied to above 4,100, but we see few signs that a sustainable recovery is at hand. Such signs we would need to see include narrowing credit spreads, rising long-term bond yields, strengthening industrial commodity prices and housing sentiment, new orders outpacing inventories, and bottoming (if not improving) corporate earnings revisions.
Instead, we believe the economy’s struggles against sticky inflation and Fed rate hikes are likely to produce an economic recession and remain ongoing sources of capital market volatility. We stand by our year-end S&P 500 Index target ranges of 3,800 – 4,000 for 2022, and 4,300 – 4,500 for 2023. Our single and consistent message since early 2022 has been to play defense in portfolios, which practically means making patience and quality the daily watchwords.
Holding tightly to those words implies that long-term investors, in particular, can use patience to turn time potentially to an advantage. As we await an eventual economic recovery, the long-term investor can use available cash to add incrementally and in a disciplined way to the portfolio. At these intervals, capital preservation steps include reallocating to quality asset classes and sectors and seeking exposures that diversify or that offer a partial hedge against inflation:
- In equity markets, we favor U.S. over international markets; U.S. Large and Mid Cap over Small Cap Equities; and the Information Technology, Health Care, and Energy sectors.
- In fixed income, we prefer to stay in the shorter and intermediate investment-grade maturities (including in municipal securities) and would not seek yields in non-investment-grade credit.
- As a partial inflation hedge, we favor taking a broad-based commodity exposure, over and above long-term or strategic weights.
- Finally, the Global Macro and Relative Value alternative investment strategies may provide returns and income (via the Relative Value strategy) that diversify portfolios because of low correlations with equity markets.
