Orlando's Outlook: Inflation firming, not spiking


Bottom Line A record 30 major league baseball games were postponed in April due to snow and brutally cold weather, as winter simply refused to release its icy grip. Where’s Punxsutawney Phil and his mid-March end-of-winter forecast when we really needed him? But when the calendar mercifully flipped to May, the winter weather seemingly skipped spring and went right to summer.

Similar story with inflation. The Federal Reserve’s preferred measure of core inflation last hit the Fed’s 2% year-over-year (y/y) target in April 2012, falling to a 1.3% trough in both July 2015 and August 2017. That fanned deflationary fears among investors. But as economic and corporate profit growth began to accelerate last year due to fiscal policy stimulus, markets skipped over their hope for an inflationary Goldilocks period (core PCE approximates of 2-2.5%) and began to worry about a return to much stronger and more damaging inflation trends, which we haven’t seen in a quarter century.

Recent data, however, suggests that those fears of imminent hyperinflation are misplaced, and that inflation likely will continue to grind higher as the economy improves, rather than spike higher. As a result, we continue to believe the Fed is likely to hike rates only twice more in 2018—certainly in June and perhaps in December—and continue to unwind its $4.5 trillion balance sheet, according to Chair Jerome Powell’s blueprint. That should be good news for stocks, too, as relatively benign levels of both inflation and interest rates could allow price/earnings multiples to expand further over time.

Core personal consumption expenditures (PCE) index rises The Fed’s preferred measure of inflation leapt to 1.9% in March 2018 on an annualized y/y basis, roughly matching a 6-year high. That was up sharply from 1.6% in February and from its aforementioned 1.3% cycle trough last August. While this sequential increase sent the equity market into a 3% tailspin, we had cautioned investors that year-ago deflationary influences would soon be rolling off this metric, such that the core PCE would rise to the 2% target, or perhaps slightly higher, in coming months. 

Core consumer price index (CPI) flat This retail inflation metric, strips out volatile food and energy prices, was unchanged in April 2018 at 2.1% on a y/y basis, which was a tick lighter that what the consensus had expected. But that’s still up sharply from 1.8% in February and its cycle trough of 1.7% last November. The 23% increase in crude oil prices over the past three months certainly accounts for some of this recent increase, as does the recent roll off of deflationary pressures from a year ago. Core CPI should grind up toward 2.3-2.5% over the next year.

Core producer price index (PPI) slips This wholesale inflation metric, which strips out volatile food, energy and trade prices, eased to a y/y gain of 2.5% in April 2018 from 2.9% in March, which was a cycle high. This is a relatively new and unseasoned index, introduced only in August 2014. Still, it’s an important measure of pipeline inflation, which troughed at 1.9% last August. April’s sequential decline is chiefly related to a 1.1% m/m decline in food costs, the largest such decline since August 2016.

Average hourly earnings (AHE) flat Wage growth was unchanged in April at a y/y gain of 2.6%. That’s down from a 2.8% cycle high in January, which was the healthiest pace of wage inflation since June 2009, when the Great Recession was ending. Wage growth troughed at a 1.5% y/y increase in October 2012. Despite this recent weakness, we still expect wages to rise to perhaps 4% on a y/y basis by the end of 2019, as the labor market continues to tighten.

Employment cost index (ECI) rises This quarterly measure of wage growth rose a stronger-than-expected 0.8% in the first quarter of 2018 to match a 9-year cycle high, compared with a 0.6% gain in the fourth quarter of 2017 and a 0.5% cycle trough quarter-to-quarter (q/q) increase in the second quarter of 2017.

Unit labor costs and nonfarm productivity both rise Volatile unit labor costs rose a weaker-than-expected 2.7% on an annualized q/q basis in the first quarter of 2018, versus a downwardly revised 2.1% increase in the fourth quarter. That’s the highest reading since a 4.8% gain a year ago, and up from a 1% decline in last year’s second quarter. Productivity rose 0.7% q/q in the first quarter of 2018, up from 0.3% in the fourth quarter, but down from a 2.6% 3-year cycle high in the third quarter.

Crude oil prices surge As measured by West Texas intermediate (WTI), energy prices rose nearly 24% over the past three months, from $58 per 42-gallon barrel in February to a 3-year high of $72 this week. Aside from stronger global demand and the OPEC and non-OPEC accord to cut 1.8 million barrels a day from production starting last year, the anticipated return of sanctions against Iran has spooked the oil market.

Ag prices lower Since the market peak last July, prices for corn, wheat and soy beans (our three most important agricultural commodities) have fallen nearly 11%, although they have collectively rebounded about 9% thus far this year.

Dollar catching a bid The U.S. dollar lost 21% of its value versus the euro over the past year, from 1.03 in January 2017 to 1.26 in February 2018. But with stronger U.S. economic growth and a tighter Fed, the dollar has rallied about 5% recently to 1.18, a trend we expect to continue to 1.15. The stronger dollar may help to brake some of the recent strength in oil and ags. 

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