BMO Family Office
U.S. CPI soared 7.0% (year-over-year) in December, outpacing prior-month readings and closing out 2021 at a 40-year high
[Exhibit 1]. Core prices, which exclude food and energy, hit 5.5% — their largest gain since 1991. Market reaction to the news was tame, as the results were largely in line with forecasts and did little to alter expectations around Fed policy.
Elevated price-pressures are likely to persist throughout 2022, but we don’t believe they will by themselves derail the economy. That said, it is important that inflation begins to show signs of peaking — a development we expect to materialize in coming months as supply-chain problems ease and consumer demand rebalances between goods and services. Once inflation has peaked, we anticipate its path downward will be gradual rather than a sharp drop. Currently, financial markets and economists project falling, if still elevated, inflation over the next two years [Exhibit 2].
The arrival of Omicron does represent something of a wild card and has the potential to postpone supply-chain normalization and the return to more traditional consumption patterns. Beyond those nearer-term challenges, though, the transformation of current inflationary pressure into a long-lasting, endemic problem remains unlikely. For a full-blown, high-inflation process of that strength to take hold, inflation expectations would have to become untethered and/or wages would need to spiral upwards. At present, neither of those issues is visible on the horizon, although we are tracking developments in that area closely.
A related risk we’re monitoring closely is the Fed’s emerging response to current inflation dynamics. Markets now expect the Fed to raise interest rates three or four times in 2022; a forecast that is up sharply from just a few months ago. Furthermore, the Fed’s December meeting minutes, released on January 5, revealed an in-depth discussion of the Fed’s intention to reduce the size of its massive balance sheet sooner than markets had been anticipating. The big question is not whether the economy and markets can withstand a few interest rate increases this year, but rather as we move toward year end what does the interest rate trajectory look like then? Ongoing tightening would eventually become challenging for equity markets. Such a scenario playing out is not our central view at this time because we do expect inflation to moderate and Fed hawkishness to moderate. Persistent Fed tightening, however, is the greatest risk to U.S. equity markets over the tactical horizon and, therefore, a factor that merits close, ongoing scrutiny.
In the meantime, our recommended portfolio positioning of overweight U.S. Equities and Real Estate and underweight Core Fixed Income is intended to be more inflation resistant. U.S. Equities and Real Estate typically provide a natural inflation hedge through price increases, and Core Bonds are likely to see ongoing pressure as the Fed takes action in 2022. Clients are encouraged to discuss their individual circumstances with their advisor.
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