Worry, but don’t worry too much about inflation
Inflation is the major focus of market watchers thanks to a host of unique and unfamiliar circumstances that include record government stimulus spending.
Ask just about any economist or market watcher what they expect to be monitoring during the second half of the year and inflation inevitably will be somewhere near the top of the list.
For some forecasters, inflation is the list.
“Right now, inflation is the number one, two, three and four risk, because it is far and away the biggest risk if it gets out of control,” said Matt Peron, director of research at Janus Henderson Investors.
Like most folks keeping a keen eye on the forces influencing markets and the economy, Peron is careful not to sound the fire alarm just yet, but he also isn’t shy about detailing the fine line those overseeing the country’s monetary and fiscal policies are walking.
“Inflation would be a problem for the equity markets because the Fed would have to come in and end this cycle, and that’s why the Fed is hanging on this path of tapering and tightening, and at a minimum there will be market volatility around that path,” he explained. “It’s very Fed-dependent right now. But that said, typically what happens is the Fed does its thing, the market reacts and the cycle continues.”
In other words, worry, but don’t worry too much.
Inflation has become a chart-topping focus this year thanks to a host of unique and unfamiliar circumstances that include record government stimulus spending, record Federal Reserve balance sheet and monetary policy, lofty household balance sheets boosted by those stimulus programs, global supply-chain disruptions from the pandemic shutdowns, and pent-up demand for just about everything.
Missing from the list, so far, is wage inflation, which is considered the ingredient that typically makes inflation “sticky,” because higher wages are rarely transitory and they force prices higher to keep up.
There have been ominous comparisons to the hyperinflation days of the late 1970s and the series of interest-rate hikes that were needed to tamp everything down. But even as such comparisons help to remind people what this vague and often misunderstood concept called inflation might look like, the current situation only serves as a glancing comparison to the economic road map of more than 40 years ago.
“The Fed is in a little bit of a pickle because, unlike the 1970s, the Fed is actively pushing for higher inflation,” said Liz Ann Sonders, chief investment strategist at Charles Schwab Corp. “We’ve never had the Fed doing that, and their nimbleness, especially in the face of what markets might do, may be tested.”
Sonders appreciates the comparisons to the inflation of the 1970s, but said the current period is “more reminiscent of what we saw in the 2005-2006 period, when we had a bit of an inflation pop.”
“In that case, the Fed actually tightened, but that was the old mode of thinking about policy changes via the windshield — looking ahead — as [current Fed chair Jerome] Powell has said, they were outlook-based,” she said. “Now they’ve become outcome-based, which means they are making decisions based on the rear-view mirror.”
For its part, the Federal Reserve Board of Governors is meticulously measuring its every word by describing most signs of inflation as “transitory” and suggesting it is “talking about talking about” reducing its pace of monthly asset purchases, which have been stuck at $120 billion a month for almost a year.
That level of Fed balance-sheet building is down significantly from April 2020, when the Fed was adding $700 billion a month of Treasury bonds and mortgage-backed securities designed to inoculate the world’s largest economy against the impacts of business shutdowns and lockdowns in the early days of the global Covid-19 pandemic.
But as vaccinations expand, businesses reopen, and people start going back to in-person working, shopping and socializing, there are ominous signs that the piper will need to be paid.
PSYCHOLOGICAL IMPACT
One challenge to appreciating inflation is the varied ways in which it’s measured and calculated. Add to that the psychological impact, which can be worse than inflation itself, and you can start to understand why it is such a slippery topic to nail down.
Jim Stack, money manager and editor at InvesTech Research, pointed out that the core consumer price index, excluding food and energy prices, showed an increase of 3% in April, which dwarfs the Fed’s 2% target. The April reading marks the highest 12-month rate of change in more than 25 years, and is the highest monthly increase since 1981, when inflation was running near 10%.
Then there’s the sleep-at-night flip side of the story, as presented by folks like George Calhoun, founder and director of the quantitative finance program and Hanlon Financial Systems Center at the Stevens Institute of Technology, who stressed keeping things in perspective.
Source: InvestmentNews Research Adviser Outlook Survey
Citing the 6.1% spike in auto insurance rates over the same time last year, for example, Calhoun called that move a “technical bias” because rates were artificially lower in early 2020 as a result of the pandemic, and because current insurance rates are below historic averages.
That’s essentially the Fed’s transitory argument, which has become a kind of Maginot line in the whole debate.
“We think people are getting caught up and seeing current price rises as inflation,” said Jim McDonald, chief investment strategist at Northern Trust Asset Management.
“It is inflation, but it is a onetime rise in prices,” he said.
In other words, don’t expect the higher prices to go back down, but find comfort in the likelihood that prices won’t rise by the same amount again next year.
“This inflation is transitory, temporary, and won’t be repeated year after year,” McDonald said.
Meanwhile, McDonald is one of the forecasters who listed inflation as the “one, two, and three biggest risks to our outlook.”
“We do have our portfolio positioned for some inflationary risk, which means we’re underweight bonds, overweight equities and we have more natural resources,” he said.
BOND MARKET RESPONSE
Skipping past the equity markets for the moment, where the S&P 500 Index is up nearly 12% this year through May and where separate duels have emerged between value and growth stocks and between small-caps and large-caps, the bond market appears to believe that inflation is just passing through.
Frank Rybinski, chief macro strategist at Aegon Asset Management, said that it’s clear the bond market is “agreeing with the transitory story because it is pricing inflation high in the one- and two-year space, but for every year you go out beyond that it goes lower.”
Pricing a break-even curve for bonds, Rybinski sees “zero movement in three-, five- and 10-year bonds, meaning there’s not much concern about inflation.”
Patrick Leary, chief market strategist at Incapital, said that while he’s hoping inflation is transitory, he’s still wondering where the economic fuel will come from during the second half of the year.
“The big surprise for me, in terms of a macro perspective, is how well the vaccines have worked and how quickly the economy has recovered, which creates uncertainty about what the driver will be in the second half,” he said. “Some of the economic optimism I had anticipated has already come to fruition.”
Leary expects the financial markets to follow the Fed’s lead, and likely ride through some volatility along the way.
“What will be key for the markets is what happens at the Fed, because bull markets don’t die of old age, they get murdered,” he said. “At what point does the market force the Fed to get off low rates and do something about inflation? And if the Fed gets behind the inflation curve, it will cause a revolt in bond market and drive equity markets down.”
Saumen Chattopadhyay, chief investment officer at Carson Group, believes the stock market is currently “reassessing what things look like” as the world gradually moves past Covid and confronts the risk of inflation and whatever else might be next.
‘TRANSITION PHASE’
“This is a transition phase in the economy,” he said, downplaying the risk of wage inflation leading to more permanent and widespread inflation.
“From a labor shortage standpoint, businesses are not yet ready to invest in wage growth,” Chattopadhyay added. “Sectors that saw a lot of job losses are slowly coming back, but the unemployment benefits might be giving workers a disincentive to going back to work.”
Jennifer DeSisto, chief investment officer at Anchor Capital Advisors, sees the mountain of government stimulus spending as fuel to drive a positive year for stocks and the economy.
“There’s a lot of tailwind right now, with stimulus dollars and the retail consumer coming back,” she said. “There’s potential for more positive earnings revisions and seeing companies reporting stronger numbers. There’s so much pent-up demand with $1.7 trillion saved last year just by consumers not going out to eat and traveling.”
DeSisto cites this year’s stunning charge by value stocks relative to growth stocks as a reason to be optimistic.
“Typically after every recession, you see that transition point where value rallies the hardest, because it tends to be those companies that are more highly leveraged and more cyclical,” she said. “What we want to see is sustained performance of value going forward.”
This year through May, the iShares Russell 1000 Value ETF (IWD) gained 18.3% following a 2.3% gain last year. By comparison, the iShares Russell 1000 Growth ETF (IWF) gained 6.4% through May, following a 38.3% gain last year.
“I think value will outperform for a number of years,” said DeSisto, who compared the recent technology sector sell-off to the bursting of the dot-com bubble in early 2000.
“I think we’re set up and it presents a great tailwind for value stocks for many years,” she added.
Looking beneath the surface at sectors and industries, Saira Malik, chief investment officer at Nuveen, is betting consumers will “release that spending power on the service sector.”
“We like the areas where you’re getting the most bang for your buck,” she said. “Consumers will be very leveraged to the reopening.”
Malik is bullish on small-cap stocks, consumer and financial-sector stocks, and emerging markets, selectively.
MEASURING GROWTH
Mark Corcoran, outsourced chief investment officer at tru Independence, is bullish on both global and U.S. economic growth — even beyond the contrasting negative growth of 2020 that makes 2021 look so strong.
He points to last year’s 3.5% economic decline compared to this year’s projected 6.4% growth rate, and a still solid 4% projected rate for 2022, as signs that things are working. But he questions some of the methodologies.
“This was a different economic recession because we had a wild-card event,” he said, adding that the challenge will be getting more people back to work after having so much money provided by the government.
“There were 185 million checks sent out and we have 8.2 million job openings right now,” he said. “It’s impossible to say for sure, but it stands to reason if people are getting paid extra to stay home it has to have a negative effect on employment.”
THE FED FACTOR
For Corcoran, it goes back to that delicate fiscal and monetary balancing act and how to move beyond it.
“The long-term economic discussion is how much debt we’re taking on at what interest rate,” he said. “The Fed is not breaking the bank because the interest on that debt is so low. So, as long as rates stay low and bond yields stay low, it’s a more tenable situation.”
The beginning of the end of that situation is where market watchers start to worry about another “taper tantrum” similar to what happened in 2013, said Brent Schutte, chief investment strategist at Northwestern Mutual Wealth Management Co.
Source: InvestmentNews Research Adviser Outlook Survey
“Right now, you have fiscal and monetary policy pushing in the same direction, which is that more is better,” he said. “There may be a market pullback if the Fed announces tapering at its next meeting, and they are starting to grease the skids a bit with the experimental phase of talking about tapering.”
Even if the Fed is still a long way from hiking short-term interest rates, the financial markets have grown so dependent on the Fed’s asset purchases that market watchers are now less focused on the multitrillion-dollar balance sheet than they are on how the Fed signals its next move.
“Communication from Fed will be orderly, and we don’t view it as imminent, and we need strong growth to remain for tapering to happen,” said Nuveen’s Malik, who doesn’t expect any tapering until early next year.
“When they start talking about talking about tapering, that will be the first move to increase the Fed funds rate,” she added.
A TAXING QUESTION
The final thing to worry about this year is actually not expected to kick in until sometime next year: President Joe Biden’s sweeping tax hikes.
“Given how narrowly divided Congress is, not just the Senate but the House, what we’re likely to see in taxes is probably something significantly watered down, and any tax story is probably a 2022 story,” said Schwab’s Sonders.
In less extraordinary times, the threat of waves of corporate and individual tax hikes might send financial planners and market strategists into scramble mode. But as Northern Trust’s McDonald put it, Biden’s tax proposals are being viewed as a pipe dream that falls behind other things to worry about.
Using a golf analogy, McDonald said of the Democrats’ efforts to hike taxes, “It’s like me being hell-bent on breaking 70 in golf. It’s great that they have that ambition, but they are being constrained.”
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