By Eric Parnell, CFA on February 17, 2025February 17, 2025 It has been the primary downside risk confronting financial markets for the last few years: the persistent threat of a renewed rise in inflation. The kindling continues to be placed to reignite a new inflationary blaze. Only time will reveal how high the flames will reach if and when the next fire starts to burn. “Often is the case of these sudden transformations one can prove that an archetype has been at work for a long time in the unconscious, skillfully arranging circumstances that will unavoidably lead to a crisis.” Carl Jung, Symbols and the Interpretation of Dreams, 1961 The Heat. We’ve seen this story before. For many of us, it dominated our introductory macroeconomics curriculum in college two or more decades ago. It recurred repeatedly during The Great Inflation from the late 1960s through the early 1980s. And after nearly four decades of lying dormant, it returned with a vengeance just a few years ago. It is the heat of high and rising inflation. The forces can accumulate gradually over a period of time, only to suddenly ignite from an unexpected spark. The 1973 OPEC Oil Embargo. The 1979 Oil Crisis following the Iranian revolution. The 2022 Russian invasion of the Ukraine. The kindling for all of these inflation outbreaks had been laid in the months if not years prior – overly easy fiscal and monetary policy, sporadic supply chain disruptions, an excessive policy focus on supporting economic growth to avoid recession. And once the event catalyst finally struck, the inflationary flames suddenly burned hot. Both stock and bond prices were left to struggle mightily in the heat. But why? For bonds, it’s a straightforward explanation. If you are receiving a fixed interest rate on money that you have lent to a borrower and the inflation rate in the surrounding economy is increasing, it means that the inflation adjusted, or “real”, interest rate on your bond is not only shrinking but may even turn negative. Quick illustrative example for you Silicon Valley Bank fans out there – you lend money to high quality borrows to go out and buy houses at an interest rate of say 3%. If the inflation rate is only 1%, it’s all good, as you’re getting a real interest rate of effectively 3% nominal minus 1% inflation equals 2%. But suppose the inflation rate suddenly spikes to 9%. Not so good, as you’re now getting a real interest rate of effectively 3% minus 9% equals -6%. Add on the fact that the mortgages that people were refinancing every two years or so on average so you’d get your money back fairly quickly anyway suddenly remained locked and loaded for decades into the future (do you know anyone that wants to refinance their roughly 3% fixed rate 30-year mortgage with mortgage rates at 5.5% today? Me neither), and you’re left with a bond asset that is likely worth a lot less in price versus what you may have initially paid for it. But what about stocks? Simple. In order to justify the additional risk of owning stocks in a rational world, investors need to receive a higher premium in terms of their relative expected total return. This is known as the equity risk premium (ERP), which in its most basic form is the expected return on stocks less the expected returns on risk-free bonds, or the amount of net interest you are hoping to receive for putting your money at risk. In the zero interest rate world of 2009 to 2021 where the Federal Reserve was struggling in vain to get the inflation rate up to its 2% target, the expected return on risk-free bonds was virtually nil, so investors could justify owning stocks at virtually boundless valuations as measured by the price-to-earnings ratio, as they were receiving a positive equity risk premium for owning stocks. But suppose the inflation rate suddenly spikes toward 9%, and the Federal Reserve has to respond to the problem by jacking the Fed funds rate (and subsequently the risk-free rate) from 0% to 5.5%. Now all of the sudden, only the stocks that you own with a price-to-earnings ratio of 18.1 less are providing you with a positive equity risk premium all else equal (why a P/E ratio of 18.1? Compute the earnings yield = E/P = 1/18.1 = 5.52% minus the risk-free rate of 5.50% = +0.02%). Of course, not all else is equal, and your stocks with a P/E ratio well north of 18 can be justified as long as their future earnings growth (the “E” in the P/E ratio) is sufficiently strong to shrink the P/E ratio in the future to something toward 18 or below in this scenario (if the “E” denominator gets bigger at a faster rate than the stock price “P” rises, the P/E ratio will shrink), but nonetheless it is much easier for stock investors over time to step over a bar laying on the floor (2009-2021) than to vault over a bar 18 feet off the ground (since 2022). Put simply, the higher the inflation, the worse for stocks, the worse for bonds. (Huzzah for precious metals, commodities, and managed futures, but such is the topic for another article on later potential day). “The rhythm is below me The rhythm of the heat The rhythm is around me The rhythm has control” Peter Gabriel, The Rhythm Of The Heat, 1982 The rhythm of the heat. So what is the latest kindling that could potentially ignite the next inflationary fire? On Wednesday, the U.S Bureau of Labor Statistics released their latest Consumer Price Index report on inflation for the month of January. The report, in a word, was HOT. The headline inflation rate moved higher for the fourth consecutive month and is now back at 3%. As for core inflation that excludes the more volatile food and energy components, this also ticked higher to 3.3% after having flatlined since May of last year. It should be noted that while these readings are indeed higher, they remain at levels that would still be considered more than reasonable. These aren’t chronically low post Great Financial Crisis (GFC) readings to be sure, but there was a time not that long ago before the GFC where a 3% inflation rate was considered textbook average inflation rate for an economy with pricing pressures under control in the Principles of Macro classes I was teaching upwards of three times a day, three days a week. With that said, a closer look underneath the surface of these headline inflation readings reveals a potentially troubling development for the months ahead. Pricing in our economy can be divided into two primary baskets – goods and services. Now, the reason we were seeing the headline and core inflation rates dropping toward 2% for so long was not because of the services side of the economy. In fact, services inflation has been holding persistently hot in the post-2022 period at well above 4% even when excluding rent of shelter costs. Instead, the disinflationary forces were coming from the goods side of the economy, as goods prices have been in chronic deflation since the end of 2022. But this goods deflation has been quickly evaporating over the last few months, and with the need to replace a wide variety of goods in the wake of the California wildfires coupled with a wave of tariffs that may be imposed on imported goods across a broad spectrum of the economy, it seems only a short matter of time before goods inflation potentially turns meaningfully positive (note that durable goods inflation was pushing toward 20% back in 2022 before finally peaking out). This screams of potentially growing inflationary flames in the months ahead. A look at the month-over-month increase across these four pricing measures adds to the inflation concerns. Not only did headline and core inflation generate their hottest monthly increases in inflation in nearly a year, both services and goods inflation were running even hotter in the most recent report. Now it should be noted that a month does not a trend make. After all, we saw similar monthly developments arise in September only to cool off somewhat in subsequent months. Nonetheless, the broader trends remain hotter, and it will be as important as ever to keep a laser sharp eye on the next CPI readings for February when they are released in mid-March. Fanning the flames. Of course, investors wishing to monitor whether the increasingly dry pricing conditions might ultimately spark an inflationary wildfire, waiting an entire month for a handful of data points is woefully insufficient. Fortunately, we have a real-time indicator in the 5-year breakeven inflation rate that is available each day that the bond market is open. Based on the spread between the comparably dated nominal and inflation adjusted Treasury bond yields in order to derive an expected average annual inflation rate over the next five years, this reading has been generating increasingly troubling signals with each passing trading day as of late. After bottoming below 2% in September, the 5-Year breakeven inflation rate started surging higher simultaneously with the Federal Reserve announcing their first rate cut since before the outbreak of inflation in 2021 and 2022. And in recent weeks, 5-year breakevens have surged above the key 2.5% level to as high as nearly 2.7% as of Wednesday’s close. If inflation expectations turn back lower in the coming weeks, the market will likely be all good. Conversely, if inflation expectations continue to surge beyond 3% or higher, both the stock and bond market are increasingly likely to recoil amid the expectations that the Federal Reserve may not only have to abandon cutting interest rates any further but may instead have to turn toward raising interest rates, potentially meaningfully. Bottom line. The inflation fire that so many investors thought was over is showing signs of rekindling itself. The situation continues to appear under control today, but each new successive data point as of late is adding fuel to the idea that the inflation fires may burn anew. These are developments that remain as important as ever to continue monitoring closely in the days and weeks ahead. I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. 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