Fears about rising inflation have been cited as one cause behind the recent correction in equity markets, which started after US economic data showed that wages grew by their fastest rate in nine years in January. Understandably investors were focused on this week’s release of consumer price data in both the US and UK.
In both cases, consumer price inflation surprised to the upside. Headline inflation in the US rose by 2.1% year-on-year in January, above expectations of 1.9%. Whilst the move up in prices was broadly based, it is worth noting that the energy component of the index was up 5.5%. With energy prices showing signs of declining – US gasoline prices have fallen 9% thus far in February – it is possible that the impulse from this source starts to fade. Nonetheless, even with stripping out food and energy prices – which can be volatile – it is clear that prices have been moving higher. It was a similar picture in the UK, where core CPI (consumer price index) rose by 2.7%, up from 2.5% in the previous month and above estimates of 2.6%.
At the margin, these higher inflation readings increase the likelihood that Central Bankers in both countries will move again to raise interest rates. As it stands, the market is already fully pricing in an interest rate increase of 0.25% by the Federal Reserve when it next meets in March, and puts the probability of four hikes this year at more than 90%. In the UK, the probability of an interest rate hike by May has risen to 63%, from 33% three weeks ago.
Bond yields rose on the data, whilst so called inflation hedges also benefited, one example being Gold, which has rallied back close to its 12 month high. The yield on a 10 year UK Government bond now stands at 1.67%, up from 1.20% at the start of the year. Whilst higher, it is still very low (and therefore expensive) relative to its 10 year history.
Aside from a short sharp move lower in early trading on Wednesday, the firmer inflation data had limited impact on equity markets, which have continued to recover off the lows seen in early February. This would lend support to the thesis that the correction was driven by other technical factors, as opposed to just inflation fears. In addition, it would appear that the ‘buy the dip’ mentality still prevails.
Looking forward, investors should continue to watch for further signs of rising inflationary pressures in developed markets. Economic momentum remains strong, and with capacity tight in certain labour markets and industries, higher prices cannot be ruled out. More rapid moves up in inflation would cause Central Banks to tighten monetary policy quicker than expected, causing bond prices to fall further and potentially bringing forward the end of the current economic cycle. There are no signs that the latter is imminent, but it will pay to remain vigilant as we move through the year.