Exposure rates of the Dorval Asset Management Range – 14th May 2021

The US consumer price index came out well ahead of consensus estimates for April, driving the narrative of supply bottlenecks and a quickening pace of inflation.

It is now even more difficult than usual to interpret macroeconomic stats given the economy’s highly unusual workings for the past year and more: by way of example, how can we estimate coefficients for correcting seasonal variations after the volatility in monthly data between March and September 2020, or the impact of distortions in consumption baskets when a hefty portion of products are not available for sale? However, let’s look beyond these difficulties and consider the breakdown of these figures. We can ascertain three major price increase categories (cf. chart 1): (1) firstly exceptional price increases that are difficult to replicate. This category includes used vehicles, where prices jumped 10% over the month, probably due to lags in new vehicle production times as a result of semi-conductor shortages, among other factors; (2) increases that are simply a normalization after last year’s plummeting figures i.e., airline tickets (+10% over the month), hotels (+8.8%) and tickets for sporting events (+10%). Prices in this category have not yet returned to pre-crisis levels and should therefore continue to pick up as the economy reopens and; (3) the rest where there is little movement for now, as shown by the much less exceptional rise in median inflation figures (cf. chart 2).

The Federal Reserve’s official stance – as communicated by various members after publication of inflation figures – seeks to reassure for now: the acceleration in inflation is merely a fleeting trend. So, should we just move along, there’s nothing to see here? It’s not quite that simple, and we can single out several factors.

The various supply chain bottlenecks are set to continue affecting prices for another few months (until the end of the year), and this impact is poised to dwindle as the economy begins to operate more normally again. Some recruitment difficulties are a result of partial labor absences (often women) due to school closures. Production capacities are set to gradually increase in the sectors affected: for example, in the semi-conductor industry, TSMC announced investment in additional capacity of $28bn this year and $100bn over the next three years, Intel announced $20bn and Samsung is to hike its investment by 30%. The scenario for a rise in inflation and a slowdown in economic activity due to bottlenecks will not goad the Fed into action.

However, President Biden’s decision to launch massive fiscal stimulus at the start of the year against the backdrop of an already ‘booming’ economy as a result of moves to reopen is raising some questions. These are the excesses described by Larry Summers over the past few months. It is still too soon to tell whether this risk scenario will materialize: it necessarily involves a very swift improvement on the labor market, with a dip in the unemployment rate, alongside an increase in the labor participation rate and a more inclusive labor market. There are still a number of stages to get through before we tip over into this scenario, as shown by the latest disappointing job creation figures, but it is possible.

Lastly, there is still the question of anchoring long-term inflation expectations. However, it is important here to take a step back and look at the bigger picture: it has been more a case of too little than too much when it comes to inflation over the past few years. This sluggish pace of inflation does however raise problems as it robs monetary policy of the leeway it needs to smooth out economic cycles. The risk of inflation projections anchoring too low is oft-mentioned and much opposed by the central banks. It is also one of the reasons behind the Fed’s decision to shift its monetary framework last year, with its average inflation targeting, whereby phases of below-target inflation must be followed by periods above the objective. However, the experience in Japan over the past two decades and events in the US in the 1970-80s demonstrate how difficult it is to change long-term inflation projections once they are solidly anchored. So the increase in long-term inflation expectations is not a problem for the Fed, but rather it is the aim it pursues, to a certain degree.

Looking to the markets, the bond inflation risk premium is surging swiftly, particularly for the short term. Long-term inflation expectations (generally measured by the 5-year, 5-year forward breakeven) based on the TIPS market have been climbing steadily over the past year, but are still short of the pre-2014 pace (cf. chart 3). For now, there is no indication that these long-term inflation projections are taking root for the long term at an overly excessive pace for the Fed’s liking.

The publication of inflation figures has also sometimes acted as an excuse for profit-taking in sectors that benefit quite a bit from inflation, such as commodities. Meanwhile, some market excesses have tailed off (fall on Nasdaq, Bitcoin?). The months ahead will be crucial in assessing the US economy’s risks of overheating, as well as the response from the Fed. In the meantime, we remain cautiously optimistic and continue to invest in recovery themes.

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