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Inflation and Labor Markets

Inflation data in the US has been mixed in 2023, with headline CPI declining on a YoY basis but core CPI remaining high. While leading indicators suggest decelerating inflation rates, the pace of deceleration and ultimate trajectory remain uncertain, with the Fed predicting higher short-term rates into 2024.

In the US, inflation data has been mixed thus far in 2023.   

On a YOY basis, US headline CPI growth declined to 5.0% in March vs. the 9.1% peak experienced in June.  On a MOM basis, US CPI increased by 0.1%.

The sharp declines in headline CPI have primarily been driven by sharply lower food and energy costs.  The decline in energy prices may prove transitory as oil prices have recently increased and may surge as the summer months and peak driving season nears.  

Core CPI inflation has proven stickier and increased by 5.5% YOY in March (down from a 6.6% peak in September) and 0.4% MOM.  The Fed’s preferred Core CPE inflation gauge increased by 4.6% YOY in February (down from a 5.6% peak) and increased 0.3% MOM.  

Over the last four months, core CPI has averaged 0.4% MOM or 4.8% annually (still well higher than the Fed’s 2.0% target levels)

Services inflation remains high at 0.8% MOM in February and 8.1% YOY.   However, 80% of services inflation was driven by shelter costs (lagging indicator as these do not reflect new in place leases).

Encouragingly, several leading indicators such as new rental lease rates, commodity prices and producer prices paid are all showing swiftly decelerating inflation rates.  

In Europe, the inflation data is also mixed. 

Headline CPI has declined to 8.5% YOY in February (down from 10.7% peak in October) but Core CPI continues to trend upwards and has reached a peak of 5.6% in February.   

Canada’s inflation data is trending positively. 

Headline CPI declined to 4.3% YOY in March (down from 8.1% peak in June 2022).   Core CPI declined to 4.5% YOY and has averaged 0.3% MOM for the past several months.  

Labor markets are showing signs of loosening in the US although remain very tight in Canada.

The US added 236K jobs in March (still very strong although lower than the 472K and 326K gains in January and February).   

However, the ADP private employment survey was weaker than expected and the unfilled job vacancies fell to below 10 million for the first time since May 2021.

Wage growth declined to 4.3% YOY and has averaged 0.3% MOM (3.6% annualized) for the past three months.  This level is largely consistent with the 3.5% annual wage growth targeted by the Fed (consistent with 2% overall inflation).    

Layoffs have been relatively limited thus far to predominantly white-collar jobs at technology companies and some financial institutions.   Labor continues to be much tighter across service industries such as hospitality, restaurants, and health care.  

Canada’s unemployment rate declined to a historically low 5.0% with a still high level of unfilled job vacancies.

While inflation is decelerating, its pace of deceleration and ultimate trajectory remain highly uncertain.  

The Fed is currently forecasting Core PCE to decelerate from 4.7% YOY currently to 3.6% for 2023 and 2.4% for 2024 (vs. its 2% long-term target).

There remains a large divergence between Fed forecast and bond market investor forecasts regarding interest rates at YE2023. 

The Fed has forecast peak rates of 5.1% in 2023 and anticipates maintaining that level for several quarters.  

Conversely, financial markets are presently forecasting that the Fed will raise rates to 5.0% in May 2023, but then cut rates shortly thereafter with Fed Fund rates ending the year at 4.1%.   

We see two likely scenarios:

A mild US recession (if any) occurs later in 2023.   Core inflation remains higher than Fed targets and the Fed maintains higher short-term rates into 2024.   

This scenario is somewhat negative for equity markets as multiples compress driven by higher rates and investor fears regarding ultimate deeper economic stress from some dislocation.

Lending at regional banks to consumers and small businesses slows sharply, leading to a faster than expected contraction in economic activity.

This scenario is more negative for equity markets as corporate earnings forecasts would likely be significantly reduced.   While faster than expected rate cuts may lend support to multiples, generally equity markets do not trough until earnings expectations stop declining.

Inflation expectations are mixed.  

Consumer perceptions for 1-year inflation increased by almost 100bps to 4.6% in March.

However, long-term inflation expectations remain well anchored.  US 5-year and 10-year break-evens (inflation forecasts) have declined and are now at 2.4% and 2.3% respectively.  

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