Last week saw a set of inflation data that surprised markets. US CPI rose from 2.6% to 4.2%, with core inflation hitting 3.0%; these were both a lot stronger than expected. There were large gains in used car prices, hotel and motel charges, car & truck rental rates and air fares.
This indicates that some of the upside surprise may have come from the ‘re-opening’ factor, where sectors particularly hard hit by Covid have passed on price increases as the economy reopens. I expect the rise in inflation to be transitory, but my worry factor has certainly increased, especially as there are some signs of bottlenecks in the labour market too.
Does inflation really matter? Surely a good dose of inflation is what we need to reduce debt burdens and to free us from the zombie world of low growth, low productivity, and artificial long bond yields? Be careful what you wish for is all I can say. As an economics undergraduate in the early 1980s I can recall that inflation was the obsession in macroeconomic lectures and that politicians continually struggled to get control. The consequences were there for everyone to see: the erosion of savings particularly for the elderly, distorted consumer and business decisions and a general lack of confidence in governments and central banks.
It is tempting to look at inflation only through a developed economy prism – after all that is where we live – but an interesting article I read last week brought home the real damage inflation can cause in less developed economies. The rise in commodity prices (particularly food) has been relatively well absorbed in the US, Europe, and Japan but the impact on emerging markets is much more serious – look at the price of soya, rice, and wheat. Food makes up 30% of consumer expenditure in India and double that in parts of sub-Saharan Africa. Let’s not forget the ‘Arab Spring’ political unrest of 2011 started as protests in Tunisia about high food prices. What this means is, that unless there is a reversal of trends, we should expect a rise in political tension in large parts of the world. Does this matter to markets? Probably not in the short term but the consequences can never be predicted. We can expect more attempted migration to Europe from Africa and Asia. This may fuel more nationalism within the Euro area and could impact the outcomes of elections due this year and next. The call by Michel Barnier for a halt to immigration from outside the EU for three to five years shows the current sensitivities – global food price inflation will heighten these tensions.
Cash, government bonds and currencies
Markets reflected the higher inflation data – but despite headlines the overall impact was muted. Cash rates were flat and the pricing of future rate rises in the US was little changed. The US dollar weakened again with sterling hitting 1.41 (compared with a low of 1.15 in March 2020). Sterling also strengthened against the euro.
US 10-year yields above 1.6% but this remained below the levels seen in early April. What is different is the implied inflation rate, rising above 2.5% at 10 and 20 years. In the UK 10-year yields went above 0.9% on Thursday but recovered ground on Friday to end at 0.87%. The move higher was consistent across the UK curve with 30-year yields moving above 1.4%. Unlike the US breakeven implied inflation rates were little changed as real yields mirrored the move in nominal rates. Euro yields continued to drift higher with 10-year German and French rates hitting year-to-date highs of -0.12% and 0.27% respectively.
Credit spreads were wider over the week but nothing major to report. Issuance in high yield markets continued to be strong and there was a large slew of results to digest for our credit analysts. We bought into a new issue from Great Lakes – the largest dredging company in the US – offering a coupon of 5.25% and purchased some unsecured Cerba bonds, a French lab company. We looked at Dish, a company building out a 5G network in the US, but decided to pass – we liked the issuer but not the pricing of the bonds.
In sterling we bought new issues from Paradigm Homes and Virgin Money – quite a contrast really. The former is a long-dated sustainability bond offering a yield of 2.25%, whilst the latter came at a yield of 2.625% but for a shorter period.
Inflation will be the determinant of where markets go next. The nervousness shown in equities last week was less evident in government and credit markets, but we should not be complacent. Inflation does matter – not just to real savings, bond yields and the affordability of a nice meal out. It is a matter of life and death in parts of the world.
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