Inflation’s Hidden Risks: A Dive into the July CPI Report
The July 2024 Consumer Price Index (CPI) report, showing a 2.9% year-over-year increase from July, might appear to be a signal of a continued moderation in inflation. However, this surface-level figure masks several underlying factors that could concern investors, particularly those who have been lulled into a sense of security by recent trends.
Shelter Costs: A Persistent Pressure Point
One of the most significant contributors to the CPI’s monthly increase was shelter costs, which rose by 0.4%. This number is back up to a heightened level, after a brief dip to 0.2% in June. This category has been a consistent driver of inflation over the past year, reflecting the tight housing market and rising rents across the country. Even as other components of the CPI fluctuate, shelter costs have remained stubbornly high, driven by a combination of high demand and limited supply.
The shelter index, encompassing both rent and owners’ equivalent rent (OER), is a lagging indicator, meaning its effects on inflation are often felt more persistently over time. This stickiness suggests that shelter costs will continue to exert upward pressure on inflation in the coming months.
Energy Prices: Volatility on the Horizon
Another critical area of concern is energy prices. While the overall energy index showed no change in July, this stabilization follows a period of negative growth, with energy prices having declined by 2% in the prior months. This recent stabilization, while seemingly positive, could be the calm before the storm. Utility (piped) gas service showed a 0.7% m/m change, yet it is likely this segment picks up notably as we move into the winter months.
Energy prices are notoriously volatile, influenced by a range of factors including geopolitical tensions, supply chain disruptions, and changes in global demand. The current geopolitical stress in the Middle East could act as a catalyst for rising energy costs in the near future. History has shown that energy prices can spike rapidly, contributing to sudden increases in the overall inflation rate. For investors, this unpredictability adds another layer of risk to the current economic environment.
The Consumer’s Role in Sustaining Inflation
While other economic factors fluctuate, the resilience of the consumer plays a pivotal role in sustaining demand—and by extension, inflation. The massive government stimulus during the COVID-19 pandemic left many households with a significant cash cushion. This liquidity, coupled with the fact that a large number of homeowners locked in low interest rates on 30-year mortgages before rates began to rise, has left consumers largely insulated from the immediate impacts of higher borrowing costs.
This unique situation has led to sustained consumer spending, which continues to drive demand across the economy. With robust balance sheets and manageable debt levels, consumers are well-positioned to maintain their current spending levels, even in the face of higher prices. This ongoing demand is likely to support inflation in the medium term, as businesses pass on higher costs to consumers who are still willing—and able—to pay, at least for now.
The Debt and Deficit Connection
Beyond the immediate pressures from shelter and energy costs, there is a broader, more cyclical concern which we’ve discussed in earlier webinars: the impact of high interest rates on the U.S. government’s debt burden. As interest rates rise, so do the government’s interest payments on its massive debt. These rising costs contribute to a growing budget deficit, which, in turn, can fuel inflation.
This cyclical relationship between debt, interest rates, and inflation creates a feedback loop that can be difficult to break. As the government’s interest payments increase, the need for additional borrowing grows, further expanding the deficit. This increased borrowing can lead to higher inflation, as more money is pumped into the economy. For investors, this is a significant concern, as it suggests that inflation could remain elevated for longer than many currently anticipate.
Market Misalignment: A Word of Caution
Given these dynamics, and the recent eyewatering decline in bond yields, we are increasingly concerned that the market is misaligned with the realities of the current economic environment. Many investors have priced in expectations of lower interest rates and cooling inflation, based on the assumption that the Federal Reserve will soon pivot to a more dovish stance, and they likely will at least for a cut or two. However, if inflation does indeed tick higher in the coming months, as the factors outlined above suggest it might, this expectation could prove to be dangerously off-base and the Federal Reserve could find inflation uncomfortably higher than their target.
Market valuations are already stretched, with many asset prices reflecting a best-case scenario of declining inflation and lower rates. If inflation remains persistent, the Federal Reserve may be forced to maintain or even increase interest rates, which could lead to a sharp re-pricing of assets. In such an environment, investors could face significant losses if they are not adequately diversified and prepared for higher inflation. Meanwhile, while the consumer remains mostly immune from higher interest rates, we don’t believe this will go on forever.
Conclusion: Staying Cautious and Diversified
In light of these risks, it is crucial for investors to remain cautious and to diversify their portfolios. The current economic landscape is fraught with uncertainty, and the potential for higher inflation continues to pose a real threat to market stability. For those looking to navigate these challenges, seeking professional guidance is more important than ever.
Euro Pacific Asset Management offers a range of services designed to help investors manage risk and capitalize on opportunities in a complex economic environment. We encourage readers to reach out to one of our advisors to discuss how our strategies can help protect and grow your wealth in these uncertain times.
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