In this episode of Markets in Focus

The inflation of 2021 had no shortage of drivers — including spiking consumer demand, supply chain disruptions, and unprecedented monetary and fiscal support for the economy. But what about the inflation of 2022? Rising housing costs are likely to continue to be a factor, while base effects could contribute to inflation peaking. Matt Orton, CFA, Chief Market Strategist at Carillon Tower Advisers, talks with John Lagowski, CFA, Research Analyst with Eagle Asset Management, about inflation’s likely direction and what investors should think about in the coming year.

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Transcript

Matt Orton:
Inflation has been one of the most debated topics over the past year. What started as a discussion around “Is it transitory or not?” has evolved into calls by market strategists and economists for five, six, or even seven rate hikes this year. It's easy to see how everyone has started to snipe at the Fed and complain of rampant inflation. Energy prices are elevated with a challenging supply demand backdrop, supply chain dislocations are still here and continue to be challenged by lockdowns overseas, and the labor market is one of the tightest in history. But in my opinion, we need to take a more nuanced view. Worries over a period of 1970s-style stagflation are probably overdone, but it's also clear that inflationary pressures are going to be with us for a while.

I've asked John Lagowski, Research Analyst at Eagle Asset Management, who focuses on fixed income and income solutions, to join us today and share his thoughts and experience on the subject. His broad macro focus and closeness to clients should provide the nuance that we need on the subject of inflation.

This is Markets in Focus from Carillon Tower Advisers. I'm your host, Matt Orton. Join me and my colleagues as we discuss the latest trends in developments driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights.

So, John, thank you for joining us today.

John Lagowski:
Hey, Matt. Yeah, it's great to be here.

Matt Orton:
Yeah. So let's start with the transitory call since this is where we've seen a really sharp turn over the past few months by the Fed and many other market prognosticators. So how did so many, including the Fed, get the inflation call so wrong? And how did we quickly go from transitory to something that now looks more persistent?

John Lagowski:
Yeah, well, I think we probably need to cut the Fed a little bit of slack. Forecasting in general is notoriously difficult under normal conditions, but especially in the past two years. There's just no historical context for shutting down the entire economy. Also, keep in mind that interest rate policy tends to affect the economy on about a 12-month lag, give or take few months, depending on which economists you ask. So, the Fed would have needed to potentially start raising rates in December of 2020 to get ahead of current conditions. Difficult proposition considering the first COVID-19 vaccines were just being considered for emergency use authorization. CPI (Consumer Price Index) was only at about 1.3% at the time. And obviously a lot of uncertainty still remained about the economy as a whole. However, I would mention the fact also remains that really the main models or data that the Fed officials rely on, such as the Phillips curve or velocity of money or inflation expectations, just don't have a great track record at predicting inflation, certainly at least not in the past couple of decades. And there's even a paper out by Daniel Tarullo. He's a former governor of the Federal Reserve Board and he wrote this paper reflecting on his time at the Fed. And in that paper, he goes on to basically suggest the Fed doesn't even have a working theory of inflation. Now, there's been other critics of the Fed's approach of holding on too closely to some of these academic theories in the past.

But, if you move away from the theoretical models, there are some steps you can take to get a decent sense for at least the path that inflation is likely to take in the short to intermediate term. And what I mean by that is, our team is certainly makes it easier on ourselves by not necessarily trying to put an exact level on inflation, or growth, or really any other major indicator, for that matter.

You know, I know in financial circles, people always ask for certain levels, but instead, we try and gauge whether inflation is likely to accelerate or decelerate, because the implications on investment decision-making is really the same. Whether you could have told me a year ago that CPI would be at exactly 7.03%, or if you simply told us that inflation would keep moving higher, we would have made the same adjustments in the portfolios. And that's because the markets tend to respond to the rate of change, or whether things are getting better or worse, and not necessarily to absolute levels.

Matt Orton:
Yeah. I think that's a great point. The rate of change versus absolute levels is something that's very important. And I think something that folks are looking more closely at as we digest a lot of this data, but maybe you can give an example of what you mean by that. And what are some ways that you can assess the acceleration of inflation right now?

John Lagowski:
Sure. Yeah. And one great example in the past few years is looking at owner's equivalent rent or OER. Now OER is part of the shelter or the housing component in the Consumer Price Index, and shelter, which also includes rent of primary residence, lodging away from home – so kind of inflation and hotel prices – and OER is by far the single largest weighting in the CPI basket. But OER even on its own still accounts for about a quarter of CPI and almost a third of core CPI. So clearly an important piece to consider if you're trying to assess and forecast inflation. Now, the interesting thing about OER is how it's constructed. It's based on the survey as with, all the other components of CPI. So the Bureau of Labor Statistics has this big survey set of housing units, which they then separate into six parts.

And so the program collects rent data, for each sampled unit every six months. So only one sixth of the survey is updated each month; that OER inflation is reported as part of CPI. Basically, they drop the earliest reading, plug in the most recent reading with the other five prior months remaining. The point is that OER is this highly smooth, average reading, which normally works fine because rents change rather infrequently. However, when you're in a period like we have been, when housing prices and rents are changing quickly and trending, this creates a lag in the CPI measure of housing-related inflation relative to what's actually happening in the housing market. So the benefit to us is that housing prices and market rents are easily observable through the Case-Shiller National Home Price Index, or Zillow, or really any number of third-party sources.

And so when we saw home prices and rent prices take off in late 2020, it was almost obvious that the OER would start accelerating higher as well. So keeping that in mind, home prices have only recently peaked back in August and haven't exactly rolled over much, meaning there's still quite a runway for OER to keep heading higher and providing a foundation for elevated levels of inflation to continue. Interestingly enough, some economists at the Dallas Fed actually did put out a research report, acknowledging exactly this dynamic and forecasting that OER inflation could get up to as high as 7%. Keep in mind it's current only about 3.8%. However, and again, I can't tell you what level OER inflation will get to. The Dallas Fed’s economists’ forecasts are probably as good as any, but what we do know right now with a relatively high probability is that OER trends higher for the next few months to possibly over a year based on data we've already been able to observe in terms of the Case-Shiller Home Price Index.

Matt Orton:
Yeah. I think those are all very good points and highlight some of, I'd say that, the difficulties in looking at some of the measures like CPI that include a lot of these smooth components, but let's also move in addition to OER, which was a great example, John, I'm also curious how you think about supply chain disruptions because they have been a huge source of uncertainty and, and they have been a key contributor to the inflationary pressures we've seen for goods. And it's also one that's probably most frequently been characterized as transitory.

John Lagowski:
Sure. Yeah. And so actually on Tuesday, the ISM^® (Institute for Supply Management^®) released its manufacturing PMI (Purchasing Managers’ Index) report, which included kind of the last piece of data for the January reading of our supplier delivery times indicator. Basically we standardized the supplier delivery readings from five of the main sources that provide such data, the ISM report, and four of the Federal Reserve’s regional surveys. What I can tell you is the data suggests, there is kind of a short trend of marginal improvement in supply chain constraints. However, the reading still remains high. In fact, you'd have to go back to the energy crisis and the shortages related to that in the early 1970s to find a similar reading. So, supply chain issues are still very much present, but incrementally improving, which I would also say is kind of the consensus from what we've heard on fourth-quarter earnings calls so far.

The main point, though, is that historically the average time from significant peaks in delivery times to zero is about 10 months. And this indicator started flashing warning signals in January 2021 and only got worse as the months went on. So the idea of transitory supply chain disruptions was never really something we bought into. I’ll also just mentioned that it wasn't until October when the indicator peaked at its highest reading or longest delivery times on record, and the earliest readings go back to about 1950s, mind you. So a pretty robust data set. So if October ends up being the peak, which I think it probably will when cross-referencing it with other things that we look at, we're still several months away from normalization, which obviously has implications for how we think about inflation as well. I will mention that timeframe is again, actually something similar to what we've been hearing on earnings calls with management teams, suggesting that the back half of 2022 is really when they expect some meaningful improvement in the supply chains.

Now, we're obviously talking about historical averages, and each situation is different. We don't know what will happen with COVID and other possible variants or what the response will be in terms of preventative measures. But I think having a process in place and consistently evaluating the situation is a pretty solid baseline, a good place to start instead of just kind of moving from one headline to the next and reading into all these supply chain issues and everything else. Speaking more generally, my thoughts on supply chain disruptions are that, yes, we've absolutely seen examples of true shortages, such as the well-documented chip shortage and other observable disruptions in trucking or shipping. But I also think there’s a strong case to be made that some of the issues aren't because the supply chain is necessarily broken, but that it simply cannot keep up with the unprecedented demand we have seen driven by the extraordinary marriage of monetary and fiscal stimulus. For example, if you look at container volume for the 10 largest ports in the U.S., it's been at record levels throughout the entire year in 2021, despite all the headlines about port congestion and everything else. And I think that's also reflected in overall corporate earnings and revenue growth. Yes, companies have been dealing with supply chains and inflation, but they've still delivered record financial results in many cases. So the problem is that, once some of that demand dissipates, and, remember that retail sales have surged well above normal pre-pandemic trends, so all it would take is for demand to kind of revert back to the mean, if you will, there's a real risk of an inventory imbalance forming. So that's really kind of what we're going to be paying attention to going forward.

Matt Orton:
Those are great points, John, and I especially like that you brought up corporate earnings and the need to pay attention to corporate earnings. That's something that I've talked to a lot of our clients about getting cues for where we stand in this economic cycle with respect to inflation and margins and where the market might go. Thank you for bringing that up. And I think one other area that's worth discussing that we heard a lot about probably both from corporations and especially from economists, as it relates to this transitory discussion is the notion of base effects. And I know you and your team at Eagle have frequently cited base effects as a contributor to the uncomfortable inflation prints we've seen over the past year. So perhaps you could provide some color around what base effects are, how you think about them within the context of the sustainability of inflationary pressures, and their potential impact on the data going forward. Sorry that that's a lot of questions.

John Lagowski:
No worries, but you know, great questions, and yeah, base effects or comparables or simply comps are very interesting and not just to the conversation about inflation, but I think in trying to forecast almost any macroeconomic indicator. And I'm glad that you kind of brought up that this has been talked about in terms of corporate earnings, because really equity analysts and credit analysts have been looking at comps for a very long time when evaluating corporate financials. So it's not exactly a stretch to apply some of this to economic-related data points, but you know, the advantage to incorporating comps into your thinking about forward projections or scenarios is the simplicity. It's basic math. What I mean is when we think about the inflation rate – so right now about 7% in December – we get that rate by comparing current price levels for a given month, in this case, December, to the price level in the same month, a year ago.

The actual equation is current prices divided by one year ago prices minus one. It's just a basic equation to calculate growth or performance returns for a single period. And when you look at the equation, the historical or the beginning level is in the denominator or the base of the equation. So that's kind of how you get the base effects. The reason it matters is that the change in base effects for inflation can explain a lot about whether the actual inflation rate will come in stronger or weaker relative to preceding period. For example, let's say, we're trying to determine if CPI inflation will likely be higher or lower in January relative to the current rate of about 7%. Well, if we look back to see what happened a year ago during these two months, and we see that in the prior year, inflation really accelerated higher from December to January, then we know that the comps are higher or tougher for the January CPI report.

And just knowing that, just looking back at the historical trend would typically give you about a 70% chance of guessing right that inflation should decelerate from December to January in the current period because the base effects are getting tougher. Now it's a little bit more complicated than that. The 70% chance is actually based on quarterly data and you need to use a two-year average base rate, but it's still just kind of simple math.

And this concept is also why forecasting anything past 12 months gets way less accurate. Now base effects got a lot of attention, as you mentioned, in 2021 because they were so dramatic as a result of the hole that was left in the economy by the shutdowns during March and April 2020. However, base effects, don't just go away, and soon we'll be entering a steepening backdrop. So focusing on inflation, the majority of core indicators still have a relatively flat base effect dynamic for the next couple of months, which is why inflation can certainly, and is likely to push a little bit higher in January and maybe even in February, all else being equal. But after that, the comps get more difficult, which is also part of the reason why our team has called or has been calling out a likely peaking process for inflation.

Matt Orton:
Right. Thank you, John. And thank you for, for remembering all of those questions I threw at you. So I think now it maybe makes sense to look at where we are now because transitory has basically been removed from the Fed’s lexicon and what I would describe as a decidedly hawkish pivot, and one that has continued this year. Even (Fed Chairman Jerome) Powell's most recent press conference, I would describe as very hawkish, we've gone from expecting two rate hikes coming into this year, and now we've got up to seven rate hikes being forecasted by some strategists. So what I'd like to know is what is your team's outlook on monetary policy and how that relates to the economic forecast?

John Lagowski:
Yeah, man. So the easy questions are over, huh?

Look, in terms of our team's thinking, I probably need to preface this response with a disclaimer that there's been a lot of discussion, debate and slightly different views on our team regarding how our outlook for inflation and growth is likely to impact the Fed's decision making and interest rates in general. And I would obviously characterize that as a very healthy sharing of ideas and views. But it does probably also reflect a lot of the uncertainty about how things play out, at least in the next three to six months, give or take, because our views generally tend to kind of converge after that. I should also probably add there's some nuance to our inflation likely peaking near term outlook. And that is that we are still in the persistent camp, as we have been for the majority of the year, in the sense that we still believe there's a potential regime change underway and that inflation longer term will settle down at elevated levels above the Fed's 2% target. But that's still a little ways off. And so I think the more pressing issue that the markets and investors will have to contend with is the likelihood of inflation slowing from current levels to something in the plus or minus, 3, 3½ % area. That said, in terms of my personal views and touching on some of the thoughts I shared earlier about, inflation and economic growth, likely slowing on a rate of change basis the closer we get to midyear, I don't think we'll see seven or even four rate hikes this year. With the recent statement from the FOMC (Federal Open Market Committee) and Chair Powell's comments suggesting a March hike is on the table, I think that gets done because, as I mentioned, the final CPI reading, the Fed will see before they have to make their decision in March could be the peak inflationary print of the cycle.

And even if it's not the peak reading, it's still going to be in that 7% area. But after that, when the market gets confirmation, that inflation is going from, about 7% to 6.8% to 6.5%, I think the Fed's going to have to contend with that. And even more important is whether growth can catch a second wind here after the omicron wave abates, because if both growth and inflation start to slow, in my view, it won't matter that both will be at elevated levels by recent historical standards.

Just to use an example from the prior rate hike cycle during 2015 to 2018: By the end of 2018, GDP (Gross Domestic Product) growth had accelerated for almost nine consecutive quarters, the longest streak of acceleration, reaching over 3% growth while CPI got up to 2.9%, which at that time, both those readings were some of the highest numbers we had seen for both metrics in quite a while. Well, CPI peaked in July of 2018 and by December inflation had slowed to about 2.2%, still respectable. Growth, meanwhile, peaked between the second and third quarter and it wasn't really even by much. Still, the markets got skittish, with the yield curve continuing to flatten, yet the Fed was on a path and still raised rates in December. And then Powell spent the next several months apologizing to the markets, and it was one of the biggest and quickest dovish pivots in history. I’ll also just mention 2018 is when there were market participants calling for a four or five handle on the 10-year yield and Chair Powell described the Fed's plan for balance sheet roll-off would be like watching paint dry. So I'm not saying it's going to play out exactly like that, but there's a lot of crosscurrents in the current macroeconomic landscape, and if growth and inflation starts slowing together, I think it sets up for kind of more volatility, like we've already seen to some extent here in January. And I think the Treasury market is also reflecting a lot of that concern, if you look at the precipitous drop in the 10s-2s yield curve, which currently sits at the tightest level we've seen since big initial steepening at the onset of the reflationary environment in late 2020. So I'll sum it up like this: The past year and a half, despite the incredible challenges associated with pandemic, we've seen multiple consecutive quarters of just extraordinary and sometimes bewildering strength in the economy. That was at least in part propelled by stimulus, both monetary and fiscal.

But that period is sunsetting, and now we're moving to something less great, and transitions can be messy, which means the backdrop for risk-taking is changing. I don't want to sound too dire. The economic cycle cycles, right? So toward the end of the year, the positives will likely start to outweigh the risks again, but in the near term, the markets will likely have to kind of go through a digestive period before we get a better sense of what the economy will look like once we get past some of these irregularities created it by base effects or the pandemic or stimulus, et cetera.

Matt Orton:
I appreciate you bringing up that historical analog of 2018, because even when you look at equity market performance, if you overlay the S&P 500 from ‘18 around this hiking cycle to where we are now, there are some very stark similarities to what is happening, for whatever that's worth when we look forward. And that's exactly what I want to do. So if we build on your outlook and what you've just discussed, my natural follow-up question is how should investors position given the inflationary backdrop ahead? And maybe you can share how you and your team are positioning portfolios right now.

John Lagowski:
Yeah, no, absolutely. Right. Well, I mean, first and foremost, and just kind of, as I mentioned, the onus on security and sector selection, flexibility, nimbleness, and particularly risk management increases when the macroeconomic backdrop transitions from such an extraordinary one to something less great. Right? So in terms of positioning, it's really almost the opposite of what we were doing for the past few quarters. So as rates move higher, those moves now should be used to adjust position to a more neutral stance on Treasuries and duration. It probably makes sense being patient, especially since the markets have a tendency to kind of overextend themselves, and with higher inflation over the next two months not out of the question, rates can still move up. But again, now is the time to start kind of making those incremental adjustments and taking in a slightly more defensive posture.

So regarding sector rotation, we're no longer focusing on the pro-cyclical sectors like financials and materials. You know, we're looking more at names in the staple space, healthcare, maybe some solid industrials, tech and at the individual security level, it's thinking more about high-quality companies that have good balance sheets, solid free cash flows, and that have shown the ability to withstand supply chain pressures and inflation because while the call might be for slowing inflation and kind of easing bottlenecks, as I mentioned earlier, they're not going away that quickly.

Matt Orton:
Yeah. I appreciate that outlook. And I think the last place I'd like to conclude the conversation is then asking about some risks to your forecast. What are the biggest risks that you see right now based on what you just shared, and is there anything else that investors should be thinking about or doing?

John Lagowski:
You know, there's always risks, right. And I'm happy to admit, there's always randomness in the process and in how things tend to play out. But the interesting thing I don't necessarily think the strategy or positioning changes too much in terms of some of the scenarios where if we're wrong on inflation. For example, let's say inflation doesn't start to decelerate, but continues to trend higher, or maybe even just go sideways at the 7%-plus level. Well, then the Fed is further behind than almost anyone thought. And they may have to keep raising rates until they potentially break the economy. Obviously that wouldn't be good for risk assets. And so being wrong on inflation as it moves to the upside would still suggest taking a more defensive stance.

We could also obviously be wrong to the downside and inflation slows faster than expected, but if the Fed doesn't back off of its current hawkish stance, that would also put pressure on risk assets as well. So I think the biggest risk and the thing that cures a lot of our concerns is if growth can continue to improve to the upside or at least trend at current levels. However, we just don't see that being as the highest probability scenario. Not that it can't happen, so certainly a risk to the outlook, but I think it’d actually be a welcome risk at that.

Matt Orton:
Indeed. I think it would be a welcome risk to all investors across equities, fixed income, and all other asset classes. Well, John, thank you so much for your time today. This has been a great discussion on what I think is a very, very topical subject. So we appreciate all of your insights and thank you very much to our listeners for tuning in and until next time, take care.

Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insights at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.