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CPI, Financial Markets, and Inflation

There remain widespread concerns about inflation, at least based on the recent headline news of the sky is falling. Americans polled this year listed economic issues and specifically rising inflation, as the number one problem. There is no doubt there is inflationary pressure. Shopping at the local grocery stores prices is much higher. Higher bills are also evidenced at restaurants. Filling up your car at gas stations costs so much more. Gas and electric utility bills have also skyrocketed. Prices have risen rapidly over the past year and continue to rise further.


We are in an environment that many of us have never experienced. Last year we witnessed a once-in-hundred-year pandemic, which subsequently led to an unprecedented global lockdown. The reopening soon after sparked a once-in-a-lifetime pent-up demand. The unusual increase in demand by consumers for products and services created a global imbalance, exacerbating the supply chain bottlenecks, and hence rising prices everywhere.


So, the question is inflation longer-lasting or transitory?


The charts offer mixed signals. Some are showing inflationary concerns, and others suggest temporary situations. A brief review of the Fed policies, financial markets, and inflation is summarized below.


Federal Reserve Mandates


The Fed's primary objective is to implement monetary policies to influence money and credit conditions in the economy. The Fed's two mandates – full employment and stable prices.


Fed Chair Powell again reiterated inflation is temporary (transitory), but now he expects it to sustain longer than anticipated. Powell also reminds investors the FED does not expect the tapering and the raising of interest rates to derail the economic recovery. We will let the financial markets be the final judge of this.

Rising Inflation Beyond the 2% Threshold?


Although Chairman Powell may eventually be proven correct, he has been wrong over the near-to-medium term. The March, April, and May 2020 monthly Core CPI readings (i.e., -0.3%, -0.7%, and -0.1%) were quite unusual, the Core Consumer Price Index does not typically decline, except only extreme conditions like a global shut-down last year. It is normal for prices to rise month over month and year over year. The Core CPI has been flat or up for 441 out of the past 444 months.


It is disturbing that after more than one year after the lock-down, the Core CPI 12-month rate of change readings remain elevated. Yes, it is reasonable to expect that once the depressed March-May 2020 numbers roll off, the next 3-month's CPI core numbers (Mar 2021 +0.6%, Apr 2021 +0.8%, and May 2021 +0.6%) will rise, resulting in the year-over-year rate of inflation rising and exceeding the FED's 2% threshold. However, the 12-month year-over-year change remains relatively high, suggesting there may be underlying forces keeping prices up. It will be interesting to see what Mar 2022, Apr 2022, and May 2021 Core CPI numbers will be. When last year’s number rolls off, if the annual inflation rate does not decline in a meaningful way by the second quarter of 2022, then inflationary pressures are sticky and problematic. However, if the annual inflation rate decline in a meaningful way, then you can expect investors to bid up equities sharply higher, specifically growth stocks stand to benefit from the resumption of the low inflation trend.


Previous Periods of Rising Inflation


In the past 20-years, the US economy has experienced two bouts of rising inflation – from Nov 2014 to Sep 2016 and Oct 2010-Apr 2012. Both times, the Core CPI soared sharply higher. From 2014-2016, the Core CPI skyrocketed from 1.09% to 2.93%. From 2010-2012 the Core CPI exploded from a low of 0.60% to a high of 2.31%.


Two important points:


First, the two previous periods of rising inflation were not sustainable as the Core CPI eventually resumed its downtrends. Second, during the two prior periods of soaring inflation, the financial markets reacted differently.


From November 2014 to September 2016 timeframe:


As the Core CPI exploded from a low of 1.09% to a high of 2.93%, the following occurred in the financial markets: US Dollar Index was mixed. It initially jumped sharply higher from a low of 80.85, reaching a high of 91.57 before plummeting sharply lower toward the end of the rising inflationary period. Commodities, as represented by the CRB Index, also exploded from the mid-260s to the mid-300s. US interest rates witnessed a spectacular jump as the 10-year US treasury yields (TNX) soared from 3.84% to 5.14%. The US stock market rallied strongly, as SPX rose from around 1,100 to a high of 1,340. From the perspective of the growth versus value call, S&P Growth Index (SGX) underperformed S&P Value Index (SVX). During the same period, the technology sector (XLK) also underperformed the SPX Index (SPX).


From October 2010-April 2012 time frame:


As the Core CPI skyrocketed from 0.60% to 2.31%, the following occurred in the financial markets. US Dollar Index (USD) quickly soared from a low of 72.93, reaching a high of 83.04 before leveling. The CRB Index plummeted from a high of 370.56 to a low of 272.97 during this timeframe. US interest rates (TNX) also declined sharply from a high of 3.45% to a low of 1.49%. The US stock market experienced a volatile sideways trading range, fluctuating between 1,131.42 and 1,408.47. The growth versus value call favored S&P Growth Index (SGX) as this investment style outperformed S&P Value Index (SVX). Also, the technology sector (XLK) modestly outperformed the SPX Index (SPX) during this timeframe.

From March 2020-Present


The Core CPI 12-month rate of change year over year change has exploded from a low of 1.28% (Jun 2020) to the recent high of 4.96% (Dec 2021).


USD continues to trend higher within its 5-year triangle pattern. A breakout above 97-99.09 confirms the start of an intermediate-term uptrend in USD. Failure to breakout can lead to the continuation of the sideways trading range scenario. Although USD reacts to more than just inflation if inflation pressure is sustainable, the dollar will begin to decline precipitously.


CRB index has already broken out above key resistance at 202.84 (May 2021). The action hints at an intermediate-term bottom. However, an overbought condition has led to a pullback. Watch for a pivotal test of its prior breakout at 202.84. A successful test warns of higher commodity prices and can fuel rising inflationary pressure. Failure to retain the previous breakout level warns of lower commodity prices and tame inflation.


The 10-year Treasury yields (TNX) are approaching critical resistance at 1.537-1.846%, coinciding with the 38.2-50% retracement from Oct 2018-Jul 2020 decline and prior technical breakdown. Sustainable higher interest rates warn of inflation pressures, while a return to lower interest rates signals waning inflation.


The Growth versus Value call and the Technology versus SPX Index currently favor Growth and Technology. However, SGX/SVX is nearing critical resistance at 1.905, coinciding with the Aug 2020 high. The XLK/SPX has already broken out, suggesting technology outperformance. Although an overbought condition has developed, the relative strength trend still favors the technology sector over SPX in, longer-term. Rising inflation typically hurts future growth and growth stocks’ valuations, making future earnings less valuable. The enclosed two relative strength analyses show investors continue to favor growth and technology stocks. If inflation is a real concern, investors favor value and non-technology stocks.


Gold is a hedge and an inflation indicator. Gold will rally ahead of investment fear and the onset of rising inflation. Gold has been declining for the past one-plus year. However, a significant cup-and-handle pattern is ominous. A breakout above the handle warns of rising inflation or widespread fear in the marketplace.


Conclusion


The press and media have no idea if inflation is real or transitory. However, the financial markets and the charts will know well in advance of actual inflation. The year-over-year change in the Core CPI in the second quarter of 2022 will be crucial. Lack of a meaningful decline in the 12-month rate of change warns of sustainable inflation. However, if the 12-month rate declines, it bodes well for inflation fears to abate. Financial markets such as TNX, SPX, CRB, Growth/Value, XLK/SPX are leading indicators of business cycles. These markets tend to discount the economy many months and possibly quarters ahead of the actual occurrence. The mixed signals are worrisome. But some of the market pundits and commentators calling for run-away inflation seems exaggerated, possibly to increase viewers or readers.


Source: Courtesy of StockCharts.com

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