Figure 1 – Inflation Hedge vs. Inflation Fade (1/1/22–10/31/22)
Source: Natixis Investment Managers SolutionsFor the first half of 2022, the Inflation Hedge portfolio outperformed meaningfully (Figure 1). But more recently, the Inflation Fade portfolio has started to outperform. Based on this data, is there a fundamental reason to believe that inflation could be poised to roll over in the coming months and quarters? We did some digging into historical core CPI (Consumer Price Index) prints to better understand the drivers of recent inflation and help answer that question.
Six Key Inflation Drivers
There are just a handful of line items driving the bulk of inflation above pre-Covid levels. Of the 14 broad line items in core CPI, just six are driving over 80% of core CPI above the pre-Covid trend (Figure 2). In particular, we think there are three components worth watching to signal that inflation normalization is under way: transportation, shelter and health insurance costs.
Figure 2 – 2022 CPI Trend vs. Pre-Covid Trend
Source: Natixis Investment Managers Solutions, BloombergTransportation: Used Vehicles Getting Cheaper
We think it’s reasonable to expect substantial deflation in goods prices over the next year – especially used vehicles. Over the three-year period from 2017 through 2019, used car and truck prices remained flat. Since mid-2020, however, used vehicle prices have increased over 50% as supply chain disruptions from Covid caused a major shortage in new cars and pushed buyers – like rental car companies – to the used car market. Today, with supply chains showing improvement, rental car fleets largely rebuilt, and massive inventory builds at car manufacturers, we think it’s reasonable to expect significant deflation in used cars and trucks. Deflation in key goods items like this is critical in making meaningful progress back to pre-Covid levels of inflation.
Figure 3 – Used Cars and Trucks CIP Index Growth (12/31/16–8/31/22)
Source: Natixis Investment Managers Solutions, BloombergShelter Inflation is Set to Slow
Shelter makes up over 40% of core CPI, and we think it’s reasonable to expect significant disinflation in housing costs over the next year. It’s important to note the lagged effects in how shelter CPI is measured. Rent CPI, a major component of shelter CPI, reflects what the average person currently pays for rent, not the prevailing market rate. It’s very common for renters to sign leases for at least a year, so it takes time for the average rent being paid to catch up with prevailing market rates. The acceleration in rent CPI in 2022 largely reflects rent increases in 2021, which were off the charts – up almost 18%, according to Apartment List rent estimates. Market rent increases in 2022 have been much more modest, so it stands to reason that rent CPI should reflect this slower pace of growth in 2023.
Health Insurance Will Be a Drag on CPI in 2023
There are a number of methodological “quirks” in the CPI calculation, most notably in health insurance premiums. Health insurance costs are set annually and are a function of prices and utilization. This index is calculated each September or October based on the prior year’s change in retained earnings for health insurers. Higher retained earnings translate to lower health insurance costs, and vice-versa.
In 2021, we saw a massive increase in health insurance utilization as the pandemic faded, and thus, a decline in retained earnings for insurers. This decline translated to a large increase in the health insurance index for most of 2022. But starting with the October CPI print that was just released, an increase in health insurer retained earnings has caused the health insurance index to flip back into deflationary territory. Given the CPI methodology, this deflation should persist for the next year. Putting some actual numbers around it, this line item is set to flip from a 28% increase in health insurance costs over the past year to a 39% decline over the next year. At just a 1% weight within the core CPI basket, this represents nearly a 0.70% decline in year-over-year core CPI inflation.
Other Potential Contributors to Slowing Inflation
In addition to the three areas highlighted above, several other key CPI line items also have the potential to drive significant disinflation due to the impact of changing economic conditions:
- Household furnishings and supplies (5% weight in core CPI) – Falling shipping costs, excess inventory, and post-Covid demand slowdown
- Apparel (3% core CPI weight) – Deflationary pressures similar to household furnishings and supplies
- New vehicles (5% core CPI weight) – Semiconductor availability improving, car manufacturer inventory builds, wholesale car prices plummeting, and rising financing costs
- Airfare (0.9% core CPI weight) – Revenge spending on travel can’t last forever, oil prices cooling off, and pilot shortage slowly improving are all deflationary forces
- Motor vehicle insurance (3% core CPI weight) – Expect leveling off, given high correlation with vehicle miles traveled, which have recovered to pre-pandemic highs
All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided. Investors should fully understand the risks associated with any investment prior to investing.
CFA® and Chartered Financial Analyst® are registered trademarks owned by the CFA Institute.
This document may contain references to copyrights, indexes and trademarks that may not be registered in all jurisdictions. Third party registrations are the property of their respective owners and are not affiliated with Natixis Investment Managers or any of its related or affiliated companies (collectively “Natixis”). Such third party owners do not sponsor, endorse or participate in the provision of any Natixis services, funds or other financial products.