By Justin Pawl, CFA, CAIA, CFP®
Last Week Today. January retail sales blew away estimates, jumping 5.3% as reduced social-distancing restrictions and effects of the $900 billion in additional stimulus approved under Trump before he left office took hold. | The Atlanta Fed GDPNow Q1 forecast rose to 9.7%, reflecting strength in consumption, though it’s too early in the quarter to ascribe much weight to the forecast. | Closer to home, extremely cold temperatures caused widespread power outages and human tragedy in Texas and across much of the central U.S. | The Producer Price Index reading exceeded expectations, with Core PPI rising 1.2% month-over-month. Yet, the year-over-year reading was 2.0%, indicating more of a return to economic normalcy than breakout inflation. | President Biden and Treasury Secretary Janet Yellen continued to lobby for the $1.9 trillion stimulus plan. Given the building momentum, a smaller and more targeted plan would better serve the economy in the long run.
After sprinting higher by 5% in the first two weeks of February, equity markets took a breather last week. Bond markets, on the other hand, offered more action. The yield on the 10-year bond rose 14.5 basis points to 1.34%, the highest level since just before the pandemic forced the government to pull the emergency brake on the economy. Even as Treasury yields have moved higher over the last few months, corporate bond spreads tightened, offsetting some of the interest rate rise. At this point, investors should be asking where’s the “high” in high-yield bonds, which, at a yield of less than 4%, present little return per unit of risk. For detailed asset class performance, click on the table below.
Godot’s Arrived (Sort Of). Over the last several years, our Investment Committee has held the view that looking for inflation in the economy was tantamount to the plot in Samuel Beckett’s play “Waiting for Godot.” Godot never showed up in the story, and inflation above the Federal Reserve’s 2% target didn’t either. That will change, albeit likely temporarily, in the coming months. In January, the Core Consumer Price Index (CPI) surprised to the downside and was flat vs. expectations of a 0.2% rise. We believe that was a bit of a head fake and that inflation is likely to rise quite steeply in the coming months. The first reason is that airline (-3.2%), hotel (-1.9%), and entertainment (-5.5%) prices depressed January’s Core CPI reading. COVID was particularly impactful on those sectors as case numbers and hospitalizations rose sharply in January, resulting in more government restrictions on businesses and consumers self-selecting to stay home. Now that the vaccine rollout is gaining traction and the recent COVID wave is receding, these sectors should see increasing demand.
A second reason to expect inflation to rise is that WTI Crude prices have increased 70% since October. While Core CPI excludes energy, higher energy prices indirectly bleed into Core CPI by pushing up input costs. For example, higher oil prices raise the cost to manufacture plastics, some of which will likely show up in prices consumers pay for products at the store. The chart below shows how the level of Core Personal Consumption Expenditures (a cousin of Core CPI) tends to be about one month behind gasoline prices.
A third reason, and perhaps the strongest argument for expecting higher inflation in the coming months, is what’s known as a “base effect.” In the three years before the pandemic, Core CPI averaged about 2% year-over-year. As concern about the pandemic increased and governments began enforcing social distancing restrictions, Core CPI declined quickly during the Great Lockdown. By April, Core CPI had fallen to 1.4% and ultimately bottomed at 1.2% in June. Now that earth has nearly completed its annual trip around the sun, we can expect that today’s higher level of demand relative to that during the Great Lockdown will generate higher comparative prices, and Core CPI will increase pretty dramatically in the coming months.
But how lasting will the inflation spike be? Some pundits make the case that 1970’s inflation is around the corner, citing supply chain disruptions and the amount of liquidity in the economy from fiscal and monetary policies. While we agree that the risk of sustainably elevated inflation is likely the greatest it’s been in the last 20 years, our base case forecast is that inflation will not get out of control. Instead, we believe the more likely path forward is one in which the era of disinflation is over, and that reflation will be the norm for the next couple of years as the economy continues to recover from the pandemic.
A key reason our baseline forecast is more reflation than inflation, at least for the next couple of years, is the strong relationship between inflation and unemployment. Currently, there are ~10 million more people unemployed than there were before the pandemic. Additionally, there are an estimated 4 million more people who became frustrated finding work and stopped looking. These workers are not considered part of the labor pool by the government. While the official unemployment rate was 6.3% in January, a more realistic estimate is probably closer to 8.3%, according to Harvard University economist Jason Furman. Before the pandemic, the unemployment rate reached 3.5%, but inflation remained below the Federal Reserve’s 2% target. It’s possible the economy was on the brink of a severe bout of inflation at that time, but we’ll never know. In fact, since the early 1990s, every time unemployment has reached levels where inflation could have asserted itself, a market or exogenous event pushed unemployment levels higher. In the early 1990’s it was the Savings & Loan Crisis cratering commercial real estate prices; in the early 2000’s it was the Dot-com bust; in 2008, it was the Global Financial Crisis; and last year, it was COVID-19.
Source: BCA Research
Currently, the labor market has enormous slack, and it will likely take years of job creation to re-employ all of the people who lost their jobs during the last year. In the absence of a tight labor market, widespread wage inflation should remain muted as employers (on average) will not be forced to raise wages to retain or attract talent. Low levels of unemployment and rising wages can certainly cause inflation, but unfortunately, the economy is a long way from that condition.
Bottom Line: While inflation expectations have increased, they are not yet at a level that forces the Federal Reserve’s hand to raise interest rates. Inflation readings will rise in the coming months, but the Fed has already said it will view the spike as transitory and will not raise interest rates in response. The inflationary pulse may lead to a repricing of risk assets, but we currently believe any such setback will be temporary. The current reflationary Goldilocks conditions provide a tailwind to risk assets, but it won’t last forever. Moreover, the threat of sustainably high inflation (i.e., inflation that would cause the Fed to taper their $120 billion per month asset purchasing program and raise interest rates) in the coming years is non-trivial. Hence, investors need to prepare their investment portfolios for a broader set of potential outcomes. Traditional fixed-income investments look particularly vulnerable as the Fed has clearly stated it will accept inflation that exceeds its 2% target to compensate for past shortfalls.