Downside Surprise
Representing a pillar of the Federal Reserve’s dual mandate, inflation reports have always been something professional investors took note of. However, these releases have taken on greater importance in the post-pandemic period. At first it was to track what was thought to be a “transitory” increase in inflation as the global economy emerged from Covid lockdowns. But that transitioned to monitoring the impact of stubborn supply problems related to goods, labor, and energy. We’re in the midst of another transition. The concerns about pandemic-related supply chain distortions have been replaced by concerns about tariffs. Judging the impact of trade policy on the economy has been like a game of whack-a-mole for investors: Will the economy continue growing while prices rise, or are businesses and consumers going to cut back on their spending due to uncertainty? It’s far too early for a definitive answer, but the latest consumer price data suggest no price shock quite yet. May CPI rose 0.1% m/m on both a headline and core (i.e. excluding food and energy) basis.Core CPI Month-Over-Month
The downside surprise to core inflation was particularly notable, as it was the fourth straight below-consensus print, with this release coming in below all Bloomberg economist estimates. Usually seen as a more stable read into the underlying inflation trend than the headline number, it caught investors off-guard and pushed Treasury yields lower by 5-10 bps across most maturities.
Widespread Disinflation
Because inflation reports often contain so much data, there’s usually something in them for both upside and downside risk viewpoints to hang their hat on. That’s tougher to do in this report, as most components shifted lower with very little in the way of acceleration. Shelter prices rose 0.3%, one of its lowest increases in the last four years, while the prices of energy, cars, and airfares fell 1.0%, 0.3%, and 2.7%, respectively. More broadly, putting every component into buckets can help visualize the breadth of inflation in its totality. Here’s what that looks like.Distribution of CPI Components by M/M Annualized Rates
The major jump in components that were running at an above-4% inflation rate (magenta) a couple of years ago jumps out, but more importantly for investors is the recent increase in the number of components at a below-2% inflation rate (blue and purple). The slowdown of inflation isn’t being caused by just a few categories. That supports the view that inflation is becoming less and less of a problem.
Now, Later, or Never
Although I said earlier it was too early to have a definitive answer on what impact trade upheaval has been having on the economy, that doesn’t mean we have zero clue. Broadly speaking, prices are a function of supply and demand. Holding supply constant, more demand usually means higher prices, while less demand usually means lower prices. On the other hand, holding demand constant, more supply means lower prices, and lower supply means higher prices. Since inflation data has been consistently surprising to the downside, that leaves us with two plausible drivers: Either supply has been better than expected, or demand has been weaker. Even after accounting for over-ordering to get ahead of possible tariffs, it’s hard to imagine that the upheaval of the last few months has improved the overall supply story. That leaves demand deterioration as the most likely driver of lower inflation prints. This conclusion makes sense given recent consumer sentiment trends, which according to the University of Michigan, is at its lowest levels outside of 1980 and 2022.Consumer Sentiment At Historical Lows
Inflation unexpectedly slowing while consumers feel historically bad about the economy suggests businesses are facing margin pressure. If profit margins contract, that would likely weigh on stock prices, especially given an S&P 500 that has rebounded to near all-time highs. How any of this goes is at the whims of trade policy. If it all gets resolved in an orderly manner, that margin pressure might actually never fully materialize. But outside of a quick resolution, who knows when the margin pressure might become apparent. In that environment, a more defensive posture by investors after a very favorable period for risk assets could be a prudent one.
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