This past May we explained that one of the officially stated reasons why the Fed had delayed hiking rates (a situation that remains unchanged some 5 months later) is because CPI inflation in late 2015 and early 2016 had been lower than the Fed's bogey. And, based at least on the CPI's basket weighing of headline input prices, the Fed may have been right: the main reason for this is that tumbling energy prices kept gas prices at the pump in check, which because it is one of the primary drivers of Headline CPI, kept inflation subdued.
Needless to say, following the early 2016 market rout, which was the functional tightening equivalent of three rate hikes, Yellen was happy that inflation was low enough to let her get away without a rate hike so far this year. However, as we pointed out nearly six months ago, as we approach the anniversary of last year's oil - and gasoline - price lows and the "base-effect" kicks in, the recent pick up in gas prices is set to have an even sharper upward impact on the Consumer Price Inflation basket. It will also wreak havoc on the Fed's strategy of playing possum and not hiking as long as inflation remained "stubbornly low" because suddenly inflation will be the highest it has been in years.
In short, as we put it then, "the Fed will have a problem" as we cross the "unchanged" YoY threshold relative to last year's oil and gasoline price lows, and as the year-over-year base effect goes from being a major drag on CPI inflation, to a substantial contributor, CPI is set to jump.
As a simple heuristic of just how prominent the impact of oil, and thus gas, prices on inflation will be, we showed that CPI would accelerate to 3.5% yoy under a bull case where the wholesale gasoline cost rises to $2.06/gallon in December, pushes over 2% in a baseline scenario in which gas costs $1.41/gallon and rises "only" 1.6% in a bear case of $1.07/gallon.
This is how Bank of America summarized the relation between the base effect of rising gas prices and inflation.
One of the key reasons why we think CPI is set to head higher later this year is because of base effects: gasoline prices were so low late last year that it’s hard to get to a lower year-on-year comparison point come late-2016. This “base effect” will push the year-on-year rate higher in late 2016. Beyond that, we continue to see elevated inflation, but the trajectory slows slightly through 2017.
* * *
Fast forward to today, when it is Morgan Stanley's chief global asset strategist Andrew Sheets to remind his clients just how acute the impact of the base effect will be in the next few months: as he puts it, "in June, oil was still down 20% relative to a year prior. Last month, that year-over-year change had already risen to 0%. And if prices hold at current levels, oil will be up 45% at year-end. To repeat for emphasis, that’s -20% YoY to +45% YoY in the space of six months."
He then repeats what we said in May, observing that "such swings create the potential for rapid change in usually slow-moving YoY inflation numbers. Last week, China PPI moved from -0.8% (August) to +0.1% (September) in a single month. Next Tuesday, US CPI should rise from 1.1% to 1.5% and UK CPI should rise from 0.6% to 0.9%."
Which means that should oil continue to drift higher, and wholesale gasoline rebounds above $2.00, the Fed may have no choice but to hike in December, and perhaps as soon as next month, now that the base effect anniversary is in the books.
* * *
Here is Sheets' full note:
Rounding the Base Effects
As an American living in London, I’m trying not to be alarmed by either the state of my presidential race or the rapid decline in my local currency. Baseball seems as good a distraction as any, and with the turn of the leaves and the drop in the temperature, an exciting post-season is under way. Baseball, if you don’t follow it, is a sport where you run to get back to where you started. That’s an idea that seems particularly relevant heading into a crucial week for inflation and earnings.
A good deal of caution permeates our discussions with investors, and it’s not hard to imagine why. Despite an extraordinary amount of monetary easing, central banks have been unable to lift inflation, raising the unhappy possibility that they lack the tools to do so. Equity markets remain range-bound with expensive P/E ratios, hamstrung by earnings that have been falling since the middle of 2014. Corporate leverage has been rising, fuelled, no doubt, by similarly weak trends in EBITDA.
Two years without inflation or earnings growth make these issues seem like a given. But are they? The next several months, and even next several weeks, could play a crucial role in the narratives for both. Crucial, because of the potential for base effects to drive meaningful changes to headline numbers.
You probably don’t need reminding, but the third and fourth quarters of 2015 were bad. Really bad. US and European inflation were dragged lower by a 35% decline in oil prices and a 7% rise in CNY. Energy sector profits were hit badly by that decline in oil, financial sector profits were hit by the resulting market volatility, and the US industrial sector showed production declines typically associated with recession. Taken together, profits and inflation prints in the second half of last year were unusually depressed.
This matters because so much of the data we focus on, rightly or not, compares changes relative to a year ago. And with each passing month, a bad print from 2H15 is potentially replaced by a better reading from more recent times.
Consider any series affected by the price of oil. In June, oil was still down 20% relative to a year prior. Last month, that year-over-year change had already risen to 0%. And if prices hold at current levels, oil will be up 45% at year-end. To repeat for emphasis, that’s -20% YoY to +45% YoY in the space of six months.
Such swings create the potential for rapid change in usually slow-moving YoY inflation numbers. Last week, China PPI moved from -0.8% (August) to +0.1% (September) in a single month. Next Tuesday, US CPI should rise from 1.1% to 1.5% and UK CPI should rise from 0.6% to 0.9%. Bond markets may shrug off these increases if core inflation rises less.
But my colleague Anton Heese thinks the risk/reward is attractive for being long short-dated eurozone linkers with deflation floors (Nov-19 SPGBei, for example), and to continue being short gilts outright.
For earnings, the question over whether easier comparisons will matter will be resolved over the coming weeks. My colleague Adam Parker thinks US earnings estimates are achievable, helping S&P 500 EPS growth to rise from -1.3% in 2Q to 6.3% in 4Q. He has moved Industrials to Overweight, in part due to the easier year-over-year comparisons that our analysts see relative to 2015. While we remain more cautious on European stocks (outright and relative to the US), our EU equity strategists note that 3Q might be the last quarter of negative European EPS growth.
Troughs in earnings and inflation have proven elusive before. And rising headline inflation poses a whole separate issue of how willing markets and central banks will be to look through it. We remain broadly equal-weight equities, and see better return potential in carry-based strategies. But it’s not often that slow-moving series like inflation and earnings change rapidly, and even more rare that they could change at the same time. It’s what I’ll be watching, in addition to the playoffs, over the coming weeks.