Consumer inflation was higher than expected for the month of August and there are many worrying trends as we take a closer look at the data. This increases the likelihood of steeper rate increases the Fed as the market now sees it as possible that the forthcoming rate hike will come at 100 basis points. Persistently high inflation remains a major concern for the passing narrative, and further rate hikes coupled with an ongoing economic downturn increase the risk of stagflation. In this article, we’ll take a look at some key data points and show where investors could find some remedial action.
August inflation data was abysmal
Markets, media and politicians had hoped inflationary pressures would ease in August compared to the previous month. A negative month-to-month print was expected, but it didn’t materialize. Despite a recent decline in oil prices, August inflation was well above expectations and prices rose from July:
But the headline pressure isn’t even the worst part of the report. Instead, larger problems emerge when we look more closely. Core CPI, which counters swings in volatile categories like energy and food, came in well above expectations:
This directly contradicts the thesis that inflation is primarily driven by high energy prices. Instead, the opposite was true in August: core CPI was significantly higher m/m than the headline number, which appears to be underlying inflation (which is dampening the impact of energy prices). acceleration. Not surprisingly, core CPI also came in higher-than-expected at 6.3% year-on-year versus 6.1% expected.
If we look at some of the categories that make up CPI inflation overall, I think there is little reason to think that inflation won’t be an issue anytime soon.
The chart below shows the CPI impact of renting accommodation:
We can see that the impact of rising rents has been dramatic in recent months. CPI influence has increased and has not slowed down at all. In fact, it looks like the impact has actually gotten worse in recent months, suggesting that rising rents will keep pushing overall CPI pressure higher. The fact that this slower-moving item is currently well above historical norms suggests, in my view, that inflation could be an ongoing macroeconomic issue for an extended period of time.
The chart below shows the contribution of different categories to headline inflation:
We see that overall CPI readings have declined over the past two months, but this can be fully attributed to the easing of pressure from the energy category. Oil prices have retreated from this year’s multi-year highs, which had a waning effect on headline CPI data. But apart from energy, things get even worse: the sum of all other categories outside of energy hit a new high in August, partly driven by a sharp increase in service costs. That doesn’t fit the impermanence narrative in my opinion – if inflation were impermanent, non-energy elements would be where they historically have been, and that doesn’t seem to be the case.
For these reasons, I believe inflation will remain well above the 2% mark for the foreseeable future. Headlines should continue to soften over the coming months unless energy prices rise above current levels, but with core inflation above 6% there is little to celebrate. Producer price index also remains elevated at 9.8% over the past month consistent with my belief that consumer inflation will remain elevated.
The Fed must keep rising: will this lead to stagflation?
Persistently high inflation is forcing the Fed to become increasingly restrictive. The central bank has hiked interest rates significantly this year, but real yields are still deeply negative. It is therefore very likely that the Fed will hike interest rates further significantly in the coming meetings.
Markets are now pricing in over a 20% chance of a sharp 100 basis point rally this month and if there is no 100 basis point rally, a 75 basis point rise seems almost guaranteed. That would be the third such 75bps hike in a row, which would be a historic event – and according to the market, it’s not the most hawkish scenario, as an even larger 100bps hike is possible, albeit not the highest likely scenario (for now).
With the upcoming rate hike in September, rates will most likely be hiked again later this year. This, of course, leads to a number of effects, some of which are undesirable. A further rise in interest rates, for example, will put pressure on the housing market, which has already slowed in recent months due to a sharp rise in mortgage rates that has made houses less affordable.
Rising interest rates will also slow business investment, and consumers will likely spend less on discretionary things like home upgrades, new vehicles, and so on.
The US was already in a technical recession in the first half of the current year as GDP was negative in Q1 and Q2. However, the economic slowdown could intensify in the coming months as further interest rate hikes simultaneously put additional pressure on the US economy and the global economy. Macro issues like lockdowns in China and transportation issues in the US are also not helping and could further accelerate an economic downturn.
Stagflation is defined as a period when the economy stagnates while prices rise. The term became popular in the 1970s when the oil crisis led to an economic slowdown coupled with high CPI readings. The same could happen this year as global energy supplies are disrupted (although this is more of a European than US issue) while inflation is at multi-decade highs. And yet, at the same time, the economy is not really in a strong position. To prepare for a potentially stagflationary environment, it might be worth looking at what worked in the 1970s when the macro environment wasn’t all that different. The chart below shows the real returns of a range of asset classes in the 1970s (or more specifically, the decade from 1971):
Energy stocks (XLE) and REITs (VNQ) were asset classes with a clearly positive real return – investors made more money than they lost to inflation. The broad stock market, government bonds etc. posted negative returns in real terms.
In a high-inflation environment, it seems sensible to be long real assets. Especially when they benefit from inflation, which is the case with energy and real estate. Both require large investments in land in the case of real estate and in oil rigs, pipelines, etc. in the case of energy stocks. These investments were paid for with yesterday’s dollars and partly financed with debt. That debt is being blown away, and those assets are generating much more revenue and cash flows in a high-inflation world due to higher energy prices and higher rents. Not surprisingly, we’ve written about the benefits of owning energy and real estate in previous articles devoted to inflation, like here and here, when many politicians and central bankers were still talking about inflation being temporary.
So which assets are particularly attractive right now? There is a very wide range of energy and real estate names. Some of our favorites are Canadian oil (sands) companies as they generally have low production costs, long reserve lives, low decline rates and shareholder-friendly management. And they are very cheap:
Cenovus Energy (CVE), Canadian Natural Resources (CNQ) and Vermillion Energy (VET) are trading at 3.0x to 3.8x EBITDA. VET is particularly interesting because of its European natural gas assets, which are extremely profitable in the current environment. But other oil stocks could also be attractive, including supermajors like Exxon Mobil (XOM) and BP (BP), which offer a combination of share price upside potential, dividends and buybacks.
Energy infrastructure names are also attractive in our view. Pipeline companies like Enterprise Products (EPD), Energy Transfer (ET) or MPLX (MPLX) offer high dividend yields and trade at cheap valuations. Their debt is blown away, and high CPI prints and commodity prices allow them to charge higher fees to move oil or gas from A to B. Their business models are generally more resilient than oil producers, making them better suited to risk-averse investors and buy-and-hold investments.
Among the property names, there are many solid options at current prices. For example, class-a-mall REIT Simon Property Group (SPG) offers a 7% yield and trades at a fairly cheap 8x FFO multiple. Triple-net tenanted REITs like Realty Income (O) or National Retail Properties (NNN) offer solid yields in the 4% to 5% range and have historically performed well in all sorts of economic conditions — and they’ve continued to grow their dividends , no matter what. Even residential REITs like AvalonBay Communities (AVB) could be solid investments since they trade at significant discounts to net asset value, making them much more attractive than direct real estate investments.
Inflationary pressures have long been underestimated by many pundits and politicians. Apparently they still are as the August inflation report was bad across the board. Inflation is no longer an energy-driven issue – instead, inflation is high in all sorts of categories, including rents, services, groceries, and so on.
This will force the Fed to hike further, putting even more pressure on the economy, which is also grappling with several other macro headwinds. Overall, this makes for an unconvincing macro picture – stagflation seems to be a possible scenario.
Investors should look at what worked the last time the US was in a similar situation — buying physical assets, particularly real estate and energy, worked well then. It might make sense to look for investments in these sectors. At the same time, government bonds and other fixed income investments do not look attractive due to their strongly negative yields. Long-dated stocks, like the often unprofitable growth stocks that ARK Investment (ARKK) owns, also don’t seem like good choices in the current environment. I think it makes sense to be selective when investing in stocks.