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What are we watching? Inflation data. When we look at the current backdrop, we’re reminded of one of our favorite Clint Eastwood films. We have a real mix of data right now: some of it’s looking good, some of it’s looking bad, and some looks downright ugly.
In November, we saw the US Consumer Price Index hit highs not seen since the early 1990s—with headline inflation at 6.2% and core of 4.6%. Higher energy prices, largely driven by natural gas and oil shortages in Europe, appear to have been behind the autumn surge in numbers. Just as one potentially so-called “transitory” inflation driver peaks, another seems to pop up.
Ultimately, the jury is still out on the “transitory” versus “persistent” debate, but transitory, for now, remains our base case. The big question for the next 12 months is: Will it stay that way or will inflationary indicators become persistent? More to the point, will those indicators of “‘sticky” inflation begin to rise?
For most of 2021, the data in those sticky categories (such as rent, education, medical care) were muted. However, toward the end of the year, we began to see some conflicting signals on this front. Of course, a couple of month’s data do not make a trend, but a persistent increase in inflation could create an ugly scenario for the US Federal Reserve (Fed), which currently remains intent on leaving policy rates alone until the taper of bond buying is complete, at the earliest.
We believe this strategy gives the Fed’s dovish wing greater capacity to look through near-term inflation, despite it being particularly elevated. Adding justification to inaction is the fact that the Fed cannot solve near-term supply-chain issues by raising rates.
Although supply-chain issues started to show signs of easing toward the end of 2021 in some of the most affected consumer sectors, not all disruptions have been resolved. Continuing supply-chain disruption will mean, in our view, that inflation will potentially stay elevated for longer—above 3% through the second quarter of 2022.
Those large sticky categories, such as rent, will determine the ongoing run-rate thereafter. In our view, if rents were to accelerate by 4% for a sustained period, that would be a clear warning sign that the Fed faces a more serious inflation problem. Over time, rents, in our view, have proven to be one of the most reliable indicators of inflation, explaining two-thirds of the movements, which is why we believe it will be a key metric to watch in 2022.
A policy-induced catalyst for market volatility in 2022 could cause dramatic swings in bond valuations, according to Insight Investment’s municipal bond team.
Although several factors tend to drive municipal security valuations, a policy-induced catalyst for market volatility in 2022 could impact the preference of retail municipal bond investors (who represent majority ownership of the municipal bond market) and cause dramatic swings in valuations.
Monetary policy—The US Federal Reserve (Fed) remains under pressure as inflation accelerates and the timing of rate policy intervention is debated. The anxiety among fixed-income investors remains high, prompted by worries of higher inflation, increased rate volatility, and/or a potential misstep in Fed policy. Each instance could negatively impact fixed-income returns. Encouragingly, though, historical analysis may reassure market participants that municipals have outperformed in rising-rate environments with lower volatility.
Fiscal policy—The surprise exclusion of several municipal market provisions in the Biden administration’s Build Back Better (BBB) plan gave pause to the rally in municipals during 2021 (to November). With several proposed tax changes irresolute, conclusive supply–demand implications for municipals have yet to be defined.
Raising or eliminating the state and local tax (SALT) deduction cap has the potential to negatively impact demand for tax-exempt municipals. Notwithstanding, we believe retail demand should remain resilient, and that the institution of a minimum in the corporate tax rate could supplement demand from banks and insurance companies.
Despite volatility potential, instances of market dislocation tend to be short-lived and, in our opinion, could present attractive buying opportunities. Municipal bond yields, which typically exhibit lower volatility traits compared to other fixed income asset classes, may offer some defensiveness amid a distinct supportive technical and fundamental backdrop in 2022.
1 US Department of Labor, Bureau of Labor statistics, November 10, 2021.
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