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Is Inflation Coming?

Alfred Lee

Is Inflation Coming?

  • One of the greatest concerns for investors right now is whether inflation is upon us. The Consumer Price Index (CPI), which is a weighted average basket of consumer goods and services purchased by households, tends to be the most commonly used indicator of inflation. Recently, the CPI reading for April 2021 in Canada came in at 3.4%, while the May CPI reading in the U.S. was 5.0%.1
  • These numbers alone aren’t alarming, given that CPI is a year-over-year (YoY) measure, and because the comparison to lower numbers may exaggerate readings, also known as the “base effect”. In addition, CPI has historically risen coming out of a recession, given the reflationary environment. When looking at the economic backdrop, however, there are signs which may show inflation is a greater concern.
  • While CPI numbers both north and south of the border are well above the 2% rate that the Bank of Canada and U.S. Federal Reserve (Fed) use as a target, both have expressed that recent numbers are more short-term in nature, and have signaled that they are willing to let inflation run at the risk of thwarting the economic recovery. The Fed, in particular, made a historical move last summer, in which it changed its CPI target to long-term in nature, meaning it is willing to put up with more pricing volatility over the short term.
  • Producer Price Index (PPI) in the U.S. has come in alarmingly high in recent months with the recent reading of 9.5%2 –a level not seen since before the Great Financial Crisis. PPI measures the price of inputs used by producers and can be seen as a leading indicator for CPI. Given demand has been relatively low, with most economies not fully open yet, producers have not had the ability to pass on higher input costs to end consumers. However, as inoculation rates in various economies have increased and we finally move past the COVID-19 pandemic, higher demand will shortly follow, which will allow higher costs to burden end consumers.
  • When looking at many industries, supply and demand dynamics are facing imbalances, which is why some are indicating inflation will likely be transitory. However, while supply will come back on line as production ensues, demand in many areas is likely to return at a faster pace. In addition, some costs exhibit what is known as “price stickiness” on the way down, or “sticky-down”, where after increasing, the price doesn’t easily move back down. Wages are a good example, and must be factored into the profitability of goods and services.
  • While it can be argued that CPI is a lagging indicator, the changes in commodity prices tend to be much quicker, and some have argued that they’re a better indicator of inflation. The CRB (Commodity Research Bureau) Index (Chart B), which tracks the U.S. spot prices for all commodities, has seen a straight-line ascent since it bottomed in April 2020. Since that period, it has gained 61.6%,2 which will have an impact on the cost of goods.
  • With central banks limited to how much they want to tighten monetary policy, it is likely they won’t want to immediately raise interest rates, which would also be supportive of keeping the US dollar weak and commodity prices high.


Chart A: U.S. CPI and PPI Rise Significantly

Source: Bloomberg, as of April 30, 2021.


Chart B: Commodity Prices Rise in a Straight Line

Source: Bloomberg, as of June 10, 2021.

Trade Idea

Equities:

  • Commodities are a natural hedge against inflation, as they are real assets that are priced in US dollars. In addition, given where we are in the economic cycle and the current supply and demand imbalances, this may be further intensified.
  • BMO Equal Weight Oil & Gas Index ETF (ZEO) provides exposure to an equal-weighted basket of Canadian energy companies. We believe oil may be the best positioned commodity at the moment, as air travel and summer driving season open, supporting further demand for oil. In addition, with oil rig counts in the U.S. at half pre-COVID levels, it’s unlikely that supply will be able to match demand over the short term. This will likely be supportive of higher oil prices, which would be favourable for Canadian energy companies that have a higher cost of production.
  • BMO Equal Weight REITs Index ETF (ZRE) provides exposure to Canadian real estate investment trusts (REITs). Real property provides a hedge against inflation, and in addition, we view REITs as a late state re-opening play as higher vaccination rates will remove much of the uncertainty with office and retail REITs, which have weighed on the sector in recent months. In addition, investors in ZRE also receive a distribution yield of 4.2%.2

Bonds:

  • BMO Short-Term US TIPS Index ETF (Hedged Units) (ZTIP.F) provides exposure to U.S. Treasury Inflation Protected Securities (TIPS), with a maturity of less than five years. By focusing on the short end of the curve, investors benefit from a purer inflation exposure, as the impact of a steepening yield curve will have less of an impact.
  • BMO Laddered Preferred Share Index ETF (ZPR) provides exposure to the rate reset portion of the Canadian preferred share market. As rate resets have dividends tied to the 5-year Government of Canada bond yield, they can potentially be used to protect fixed income assets against rising inflation.




1 Consumer Price Index (CPI), as of April 30, 2021.

2 As of June 10, 2021.

Alfred Lee

Is Inflation Coming?

  • One of the greatest concerns for investors right now is whether inflation is upon us. The Consumer Price Index (CPI), which is a weighted average basket of consumer goods and services purchased by households, tends to be the most commonly used indicator of inflation. Recently, the CPI reading for April 2021 in Canada came in at 3.4%, while the May CPI reading in the U.S. was 5.0%.1
  • These numbers alone aren’t alarming, given that CPI is a year-over-year (YoY) measure, and because the comparison to lower numbers may exaggerate readings, also known as the “base effect”. In addition, CPI has historically risen coming out of a recession, given the reflationary environment. When looking at the economic backdrop, however, there are signs which may show inflation is a greater concern.
  • While CPI numbers both north and south of the border are well above the 2% rate that the Bank of Canada and U.S. Federal Reserve (Fed) use as a target, both have expressed that recent numbers are more short-term in nature, and have signaled that they are willing to let inflation run at the risk of thwarting the economic recovery. The Fed, in particular, made a historical move last summer, in which it changed its CPI target to long-term in nature, meaning it is willing to put up with more pricing volatility over the short term.
  • Producer Price Index (PPI) in the U.S. has come in alarmingly high in recent months with the recent reading of 9.5%2 –a level not seen since before the Great Financial Crisis. PPI measures the price of inputs used by producers and can be seen as a leading indicator for CPI. Given demand has been relatively low, with most economies not fully open yet, producers have not had the ability to pass on higher input costs to end consumers. However, as inoculation rates in various economies have increased and we finally move past the COVID-19 pandemic, higher demand will shortly follow, which will allow higher costs to burden end consumers.
  • When looking at many industries, supply and demand dynamics are facing imbalances, which is why some are indicating inflation will likely be transitory. However, while supply will come back on line as production ensues, demand in many areas is likely to return at a faster pace. In addition, some costs exhibit what is known as “price stickiness” on the way down, or “sticky-down”, where after increasing, the price doesn’t easily move back down. Wages are a good example, and must be factored into the profitability of goods and services.
  • While it can be argued that CPI is a lagging indicator, the changes in commodity prices tend to be much quicker, and some have argued that they’re a better indicator of inflation. The CRB (Commodity Research Bureau) Index (Chart B), which tracks the U.S. spot prices for all commodities, has seen a straight-line ascent since it bottomed in April 2020. Since that period, it has gained 61.6%,2 which will have an impact on the cost of goods.
  • With central banks limited to how much they want to tighten monetary policy, it is likely they won’t want to immediately raise interest rates, which would also be supportive of keeping the US dollar weak and commodity prices high.


Chart A: U.S. CPI and PPI Rise Significantly

Source: Bloomberg, as of April 30, 2021.


Chart B: Commodity Prices Rise in a Straight Line

Source: Bloomberg, as of June 10, 2021.

Trade Idea

Equities:

  • Commodities are a natural hedge against inflation, as they are real assets that are priced in US dollars. In addition, given where we are in the economic cycle and the current supply and demand imbalances, this may be further intensified.
  • BMO Equal Weight Oil & Gas Index ETF (ZEO) provides exposure to an equal-weighted basket of Canadian energy companies. We believe oil may be the best positioned commodity at the moment, as air travel and summer driving season open, supporting further demand for oil. In addition, with oil rig counts in the U.S. at half pre-COVID levels, it’s unlikely that supply will be able to match demand over the short term. This will likely be supportive of higher oil prices, which would be favourable for Canadian energy companies that have a higher cost of production.
  • BMO Equal Weight REITs Index ETF (ZRE) provides exposure to Canadian real estate investment trusts (REITs). Real property provides a hedge against inflation, and in addition, we view REITs as a late state re-opening play as higher vaccination rates will remove much of the uncertainty with office and retail REITs, which have weighed on the sector in recent months. In addition, investors in ZRE also receive a distribution yield of 4.2%.2

Bonds:

  • BMO Short-Term US TIPS Index ETF (Hedged Units) (ZTIP.F) provides exposure to U.S. Treasury Inflation Protected Securities (TIPS), with a maturity of less than five years. By focusing on the short end of the curve, investors benefit from a purer inflation exposure, as the impact of a steepening yield curve will have less of an impact.
  • BMO Laddered Preferred Share Index ETF (ZPR) provides exposure to the rate reset portion of the Canadian preferred share market. As rate resets have dividends tied to the 5-year Government of Canada bond yield, they can potentially be used to protect fixed income assets against rising inflation.




1 Consumer Price Index (CPI), as of April 30, 2021.

2 As of June 10, 2021.

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