US: inflation turning into a headwind?

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 The week of 13 February 2017 saw the publication of several leading indicators for the US economy including retail sales, industrial production, inflation and housing data. Overall, the data points to a situation in the US where the economy may be starting to generate some inflation.

Although the level of US consumer confidence fell a little recently, it is still running at a high level.

The improvement in confidence in recent months was reflected in strong retail sales in January (see Exhibit 1 below). The overall annual growth rate jumped to 5.6%, the fastest pace since March 2012. Stripping out components that do not go into the consumer spending data for the calculation of GDP, core retail sales grew at a slower 4.0% year-on-year (YoY), which is still the fastest pace in two years. One of the main differences between headline and core sales is petrol sales, which were up by 14.2% YoY due to higher crude oil prices.

Exhibit 1: US retail sales data in January 2017 reflected an improvement in consumer confidencerising US inflation

Source: Bloomberg, Datastream, BNP Paribas Asset Management, as of 20 February 2017

So that is one headwind for consumers in the US (and not just the US): rising headline inflation due to higher energy prices. West Texas Intermediate (WTI) oil prices have surged by just over 80% in the last year year. This has had a profound impact on headline inflation. In the first half of 2016 the rate of headline inflation was steady at around 1%, but it jumped to 2.5% in January 2017. Over this period core inflation rose marginally from 2.2% to 2.3%. Apart from energy, US inflation in the past year has been driven by higher housing costs. Digging deeper into the categories and taking some base effects into account, the rate of inflation may still be moderate, but the impact on wages is clearly visible. Nominal hourly earnings grew at 2.5% YoY in January, but in real terms, growth was a modest 0.4%. So we do not foresee sustainably higher growth of private consumption.

Will corporate spending take over?

The Empire State manufacturing index and the Philadelphia Fed business index both jumped in February 2017. Actual industrial production however fell in January from December 2016. Annual production growth was flat, which is an improvement from the declines in most of 2016, but far from strong. Manufacturing output, which excludes mining and utilities, is growing at a marginally better 0.5% YoY. Capacity utilisation fell in January and has been below its long-term average since the financial crisis. So the need for companies to invest is limited, in our view. Some of the new administration’s proposals on corporate taxes, deregulation and repatriation of corporate profits may turn out to be beneficial for the corporate sector, but uncertainty is high and companies may adopt a wait-and-see approach. From the housing market we learned that while homebuilders’ confidence slipped in January and February, activity seems to have found a new uptrend.

What does this mean for the Federal Reserve (the Fed)?

In her semi-annual testimony before Congress on 14/02/17, Federal Reserve chair Yellen was on the hawkish side, pointing to the risk of letting the economy run hot eventually resulting in the need to raise rates rapidly. Yellen said that the Federal Open Market Committee (FOMC) will assess whether employment and inflation are continuing to develop in line with the Fed’s expectations and if further adjustments of the federal funds rate are appropriate. This is not a definitive signal that rates will rise at the next FOMC meeting on 14/15 March, but we believe the option is certainly on the table. The probability of a March hike currently discounted by fed funds futures is 32%. It spiked to over 40% after Yellen’s speech. What could hold back the Fed is political uncertainty. Markets could also question the Fed’s declared intention of ‘gradual rate hikes’ if it were to move in March 2017, just three months after raising rates in December 2016.

Interestingly, US equity markets were not alarmed by Yellen’s comments, even though ten-year US Treasury yields gained a couple of basis points. We take it that equity markets were emboldened in their faith in the reflation trade. We think some complacency has entered perceptions here.

Bond markets on the other hand appear to be priced on the basis that there are grounds for doubting how much stimulus the administration will deliver and therefore a question mark as to whether the Fed will need to raise rates as much as it says it has said it will in 2017.

Written on 20 February 2017

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