Should You Be Afraid of Inflation?
The focus in news reports and markets in the past weeks was on inflation. The headline U.S. Consumer Price Index (CPI) number in May came in at 4.2% on a 12-month basis, which was higher than most people expected.
To place this in context, April 2020 was when the global pandemic-induced recession bottomed. Since then money growth has exploded in the U.S. and to a lesser degree, in the other major developed economies. The increase in the money supply has been largely driven by stimulus checks flooding into household bank accounts and increased precautionary savings by corporations.
Why Is The Market So Concerned With Inflation Data?
Inflation is definitely better for the economy than deflation. It will stimulate consumers to spend or invest more. Employees can ask for higher wages, companies can generate higher revenues.
Inflation combined with low-interest rates is generally positive for risk assets like equities and real estate.
The fear factor is that sustained inflation can threaten economic stability and to avoid that happening central banks will step in and tighten monetary policy by raising interest rates. And this can have a negative impact on asset prices and that is obviously what investors are concerned about.
What is interesting to note is that bank lending has not accelerated in line with the sharp increase in broad money growth, however. After briefly jumping at the outset of the pandemic, U.S. bank loans outstanding have been shrinking. The subdued pace of bank lending will mitigate inflationary pressures in the near term. However, inflation could still eventually rise in a sustained manner once the U.S. economy begins to overheat.
It is possible that the Gross Domestic Product (GDP) growth in the second quarter will again surprise to the upside. One indicator for that is that the US Trade deficit number came in much lower than expected, which points to increased economic activity. Global economic activity is rapidly gaining back what was lost during the pandemic. While at the same time still millions of people are out of work. If jobs growth stays strong this will only add to GDP growth in the coming quarters.
Speaking of jobs growth. There was a lot of attention to the fact that the April jobs data in the U.S. came in much lower than expected. Immediately there were many news reports talking about stagflation, which refers to low economic growth combined with higher inflation. Subsequently, the May jobs data came in higher but still lower than expected. In our opinion, this shows that the U.S. economy is recovering but there is no reason for the Fed to make any changes to its policy any time soon.
Our base-case scenario is to expect strong growth and accommodative monetary policy. Strong growth is assured as long as the virus doesn’t come roaring back, and the Fed still isn’t even talking about tapering its asset purchases, much less hiking the fed funds rate. Which means our risk-friendly asset allocation recommendations remain unchanged.
The risk for markets is to get caught up in short-term thinking, especially in a period where there is not much other news. The next earnings season will only start in mid-July, the pandemic is subsiding in every country that is actively vaccinating, and there will be no new stimulus plan announcements. And we are getting closer to the summer period which is traditionally a period where we see trading volume in the markets, which can create additional volatility. Despite this, markets were very calm during May. The bond market does not seem to be too concerned about inflation pressures yet and bond yields came down. The equity market traded in a narrow range and ended slightly positive for the month, which was the fourth positive month in a row for equity markets.
An important issue to watch will be new spending legislation. We think it is likely there will be a bipartisan infrastructure bill. In the end, Republicans will join Democrats since all want spending in their states and localities. Although we think the economic impact of Biden’s infrastructure bill will be limited in the short term as spending will be spread out over 8 years. If it passes it could have an impact on the Fed’s policy, as it would be counterproductive to tighten monetary policy at the same time the government is loosening fiscal policy.
Another argument why we think the Fed will not deviate from its stated plan to stay put is that Chairman’s Powell term ends early next year, and Powell and other candidates would be seeking to stay aligned with President Biden’s ideas.
The “Transitory” Debate
Most investors would agree that 3-4 months of higher consumer price increases would not be, in and of themselves, economically significant or investment relevant. But the question of whether even a temporary period of high inflation could persist over a 12-month or multi-year time horizon has become prominent in the marketplace, with some investors believing that it has high odds of supporting higher prices in a way that becomes self-reinforcing among consumers and firms.
A shift in the market narrative from a relatively benign longer-term inflation outlook to a belief that a more durable uptrend is developing, could trigger a taper tantrum-like surge in bond yields, with negative knock-on effects for risk asset markets. For now, the Fed is sticking with its view that any uptick in core inflation will be transitory, despite upgrading its own economic forecast. From an investment perspective, the outlook for inflation is important mostly because of its implications for Fed policy, and thus interest rates and equity valuation multiples.
We do expect inflation to rise significantly over the long haul. However, our view is that it will take another 2 to 3 years before we see structural inflation. As the example of the 1960s illustrates, a long period of overheating is often necessary to push up inflation in a sustained manner. The U.S. unemployment rate reached its full employment level in 1962. However, it was not until 1966, when the unemployment rate was two full percentage points below equilibrium, that inflation finally took off.
Also, the official core Consumer Price Index (CPI) likely overstates underlying inflationary pressures. The pandemic threw all sorts of prices out of whack. One needs more refined measures of inflation such as the Dallas Fed’s trimmed mean Personal Consumption Expenditures (PCE) indicator, which only rose a modest 1.8% in April. Similarly, relatively clean measures of wage growth, such as the Atlanta Fed Wage Tracker, do not point to an imminent wage-price spiral. All this means that the Fed can afford to sustain an exceptionally easy monetary policy. That should keep growth at an above-trend pace and continue to support equity valuations.
The U.S. and global stock markets have been stuck in a narrow range for more than a month now. Not only that, but the strong equity market gains of the last 12 months can actually be accounted for almost entirely in terms of rising earnings expectations, which is exactly what all the textbooks say should happen. Markets seldom behave so perfectly in line with theory as they have done over the last year. Forward equity earnings already price in a complete earnings recovery, but for now there is no sign of slowing earnings momentum. Net revisions remain positive, and positive earnings surprises have risen to their strongest levels on record.
US GDP grew at 6.4% in the first quarter, powered by 10.7% growth in consumption. The six largest companies in the S&P 500 reported first-quarter earnings that exceeded expectations by an average of 41%, and the Fed remained resolutely dovish.
Within a global equity portfolio, there has been a modest uptick in global ex-U.S. equity performance, led by European stocks. Europe, which has badly lagged the economic performance of the U.S. in the last 6 months, is primed for its best period of growth since 2017 and should close the growth gap with the U.S. Moreover, the euro area has the potential to provide more positive economic surprises ahead, in comparison to the already roaring U.S. economy, especially as it has more exposure to the strengthening global trade cycle.
A resilient Chinese economy should support other emerging markets. Progress on the pandemic front should also help. The United Nations estimates that as many as 15 billion vaccine doses could be produced by the second half of 2021, enough to inoculate most of the world’s population. The shortages of vaccines in emerging markets could turn into a surplus by the end of this year, something that market participants do not seem to fully appreciate. The rotation in growth momentum from the U.S. to the rest of the world could put downward pressure on the U.S. dollar. A weaker dollar, in turn, usually coincides with the outperformance of international stock markets.
The U.S. 10-Year Treasury yield has traded sideways since mid-March. The strengthening economy in combination with the improving jobs markets should keep upwards pressure on bond yield in the next 12 months. Although we expect the rise to be more modest, we still favor a short duration stance within a fixed-income portfolio. Although our view is that inflation pressures will abate in the coming months, we keep exposure to Treasury Inflation-Protected Securities (TIPS) as a core hedge position in the portfolio.
Another key portfolio hedge is local currency emerging market government bonds. Two key drivers of Emerging Markets (EM) bond returns will offer a constructive backdrop in the year ahead. The U.S. dollar will likely soften in the face of strong global growth conditions, with economic momentum now firming up in lagging major economies such as the euro area.
In the meantime, rising U.S. Treasury yields are typically associated with spread narrowing for EM debt. In the case of EM local currency-denominated debt, there is plenty of room for nominal spreads to tighten, and real yields are already positive with plenty of room to fall as global inflationary pressures build up. Strong global trade momentum and firm commodity prices, along with a relatively high nominal yield and generally undervalued currencies, are additional tailwinds for emerging market bonds.
Cryptocurrencies experienced a ‘flash crash’ in May with the whole crypto market falling by more than 50% in a few days’ time. There are many reasons cited in the media, including Elon Musk’s tweets, but the main reason is an old-fashioned one: Cryptocurrencies are being used as an investment asset and a speculative bubble was building up, which was bound to correct at some point.
We do not think this is the end of cryptocurrencies as the underlying technology is potentially disruptive for a large part of the financial ecosystem. Interest in digital assets is growing among private and institutional investors. We do believe in the potential of cryptocurrencies, but we do not believe there will be room for that many of them. Therefore, we prefer to only invest in the largest ones and that constitutes an original technology like Bitcoin and Ethereum.
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