Although these dynamics are yet to unravel through the service sector, we are beginning to see the return of pent-up demand, and the shift from pandemic related goods consumption back to services flowing through to higher costs in the service sector. According to the ISM services update yesterday, prices paid by service providers climbed for a third straight month. The imbalances that have manifested throughout the goods economy likely to be evident in the service sector as cashed up, pandemic fatigued consumers return with a vengeance, with the demand recovery outpacing the return to full supply capacity.
We are now entering the period where we will see higher inflation prints as the “base effect cliff” comes firmly into play. Throughout the corresponding period last year, in the throes of the pandemic as the world went into lockdown, we saw a sharp deceleration in prices. These low base effects mean that if the CPI just holds (no increase) month over month in April (unlikely!) the headline read will still be 3.3% yoy. As supply bottlenecks, increasing input costs, and pent-up demand collide with the base effects cliff it is logical to expect higher inflation is coming and that long-end yields will trade higher in the coming months.
Post the pandemic related disruptions, the case for higher inflation over the medium term rests upon Covid-19 becoming a catalyst for a permanent shift away from the status quo, as fiscal primacy takes the reins. The pandemic has turbocharged many pre-existing trends as well as forging new ones. Under a new inclusive agenda, policies in focus are redistributive and aimed at moderating the rise in income inequality, safeguarding jobs and attempting to stimulate demand/investment and green transformation via increased government spending.
Following the enactment of the latest COVID-19 relief bill, on average the poorest quintile of households will see annual incomes boosted ~20%, generating an increased capacity to consume for those with the highest marginal propensity to do so. Framing this against the backdrop of a structural shift toward fiscal dominance, we will see significantly higher spending and transfers to the individual bringing a lasting step-up in consumption, compounding supply constraints. That is why we see a pivotal regime change in interest rates/inflation, supercharged by the new era of fiscal dominance, green transformation and supply constraints.
These trends in pricing and pricing intentions are confirmed in other data which we have outlined previously. Against this backdrop it is logical to expect higher inflation. Markets have recognised this shift, but it remains under-priced, by our methodology CPI could be headed well above 3%. Despite the Fed playing down inflation and continuing to point to transitory inflationary pressures (a trend that is clearly not transpiring in the real world), for markets, fresh drivers of this emergent trend are likely to be found in coming months as economic data collides with extremely favourable base effects, supply shortages and rebounding demand. As a result, upwards pressure on yields remains. A lot of the alpha generated YTD has been in response to a global reflationary cocktail and nascent inflation pressures, as the year progresses it will be increasingly important to be on the right side of these trends, reallocating from bonds to commodities and equities – positioning toward higher inflation, commodities, cyclicals, and higher rates.