CHAPEL HILL, NC (MarketWatch) – Retirees and near-retirees were understandably alarmed by this week’s report on a sharp rise in the consumer price index.
It was on Wednesday (May 12) that the Bureau of Labor Statistics reported that the CPI over the past 12 months had risen at a rate of 4.2%, a 13-year high. A month ago, the 12-month rate of change of the CPI was “only” 2.6%.
In response, the Dow Jones Industrial Average plunged nearly 700 points.
My advice? Don’t make any changes that you haven’t already planned to make for other reasons. This is even though I fully recognize that inflation is wreaking particular havoc on the portfolios of retirees.
There are several reasons for this otherwise surprising advice. The first is that the CPI’s latest leap does nothing more than bring it back to where it would have been without the pandemic. This is illustrated in the attached chart, which plots the actual CPI next to what it would have been if, since January 2020, it had increased at the 2019 rate. Note that the actual CPI is now in line with this hypothetical trend line.
It’s all about perspective, in other words. If you focus more on the two-year rate of change of the CPI, as opposed to its 12-month rate, then there is nothing wrong with it.
It should also be noted that the increase in the CPI in 2019, which is what I used to construct the trendline in the attached chart, was at the time considered by some to be low. When reporting the 2019 CPI increase in January 2020, my colleague Jeffrey Bartash said the Federal Reserve was more “worried that inflation could fall even more than it is now. ‘it is not currently’.
If the 2019 inflation rate initially seemed too low to some, including the Fed, then why panic when the CPI simply reverts to that trendline?
The same conclusion emerges when we focus on expected inflation: what the markets implicitly bet on the rate of increase in inflation will be in the months and years to come. According to an expected inflation model maintained by the Federal Reserve Bank of Cleveland, the reported jump this week in the CPI was a non-event.
The Cleveland Fed model has a number of inputs, including “Treasury bill yields, inflation data, inflation swaps, and survey-based measures of inflation expectations.” Prior to this week’s CPI report, this model calculated that markets expected inflation over the next 10 years to average 1.58% annualized. After this week’s report, the model calculated it to be 1.57%.
A similar picture is painted by the five-year data: The Cleveland Fed model concluded that expected inflation over the next five years was 1.48% before this week, and that’s where it stayed in the wake of this week’s report.
A similar conclusion emerges when we look at the so-called break-even inflation rate, which is the difference between the nominal Treasury yield and that of TIPS with the same maturity. As of this writing, the 5-year breakeven inflation rate is exactly the same as it was a week ago, before this week’s report on the CPI leap. The 10-year breakeven inflation rate is only 2 basis points. (A basis point is one hundredth of one percent.)
Of course, the markets can be wrong. But don’t dismiss what they say too quickly. The bond markets are collectively the most important in the world, far more important than the stock markets. Traders, who watch the market second by second every day, will buy or sell billions of dollars in bonds when they see an arbitrage opportunity involving only a few basis points.
You can always insist that the CPI will continue to rise over the next two years at the above 4% rate reported this week, of course. Just know that you have billions of dollars in the bond market betting you are wrong.
Correlation between inflation and the stock market
The other reason for not recommending changes to your portfolio in response to the latest CPI data: changes in the rate of inflation have very little explanatory power in predicting the future performance of the stock market.
Consider a statistic known as the r-squared, which represents the extent to which changes in the 12-month growth rates of the CPI have historically been able to explain or predict changes in the adjusted return based on inflation and dividends over the following year. The r-squared ranges from a theoretical maximum of 100% (which would mean that the stock market responds perfectly to changes in changes in the CPI) to a minimum of 0% (which would mean that the stock market and the CPI are completely uncorrelated).
Focusing on the period going back to 1871, using data from Professor Robert Shiller of Yale University, the r-squared is only 1.1%. This is only marginally statistically significant, in fact – only significant at the 90% confidence level, and not at the 95% confidence level that statisticians often use to determine whether a model is authentic.
Regardless of its statistical significance, however, the low squared reading indicates that the stock market price over the next year will be influenced much, much more by factors other than the CPI. So even though the last jump was more than just trend reversal, it’s not clear that you need to adjust your expectations for the stock market in the coming year.
None of these discussions should be taken to mean that the stock market will not suffer in the months and years to come. I actually think there is a good chance that it is, given the current overvaluation in the stock market. If this is the case, however, the culprit will not be inflation but this overvaluation.
Bottom line: focus on what really matters. And this month’s rise in inflation is far from at the top of that list.Mark Hulbert is a regular contributor to MarketWatch. Its Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. It can be reached at [email protected]