By Justin Pawl, CFA, CAIA, CFP®
Last Week Today. The International Monetary Fund (IMF) upped its 2021 global growth forecast to 6% (highest since 1980). | Somehow, Treasury Secretary Yellen convinced the IMF to argue for a minimum global corporate tax rate, which would make the expected increase in U.S. corporate taxes look less severe if enacted. | The March ISM Services index jumped about 8 points to 63.7. It’s the highest level in the 24-year history of the data series and another sign the economy is successfully reopening. | Minutes from the March FOMC meeting showed the Fed remains sanguine about the economy and inflation and is not yet considering tapering bond purchases, let alone raising interest rates. | During a 60 Minutes interview on Sunday, Fed Chair Powell sounded optimistic about the economy, suggesting the economy could grow 6%-7% in 2021 (highest in 30 years) and that the Fed “…will continue to support the economy until the recovery is really complete.”
It was another record-setting week in which both the S&P 500 (+10.4% YTD) and Dow Jones (+11.0% YTD) closed at new highs. Since late March, Growth stocks have taken back the role of market leadership, and the Nasdaq rose 3.1% last week to come within 1.4% of a new record level. Outside of the U.S., developed international stocks gained about 2% while China dragged down emerging equities to close the week down -0.6%. Reflecting a faster economic recovery and better near-term growth prospects, U.S. stocks are ahead year-to-date vs. the developed international MXEA Index (+6.2%) and emerging markets MXEF Index (+3.3%). Interest rates are finding their groove after a rapid rise from below 1% in the first quarter, with the 10-year UST yield trading in a tight 1.58% – 1.77% range over the last three weeks.
Meanwhile, the VIX Index has declined from 30 to 17.5 in the last four weeks, the significance being that traders expect a smaller range of daily price fluctuations for the S&P 500 in the next month. Thanks to Kevin O’Malley at Chatham Asset Management for describing a simple way to equate the VIX to expected daily returns. Divide the VIX by the square root of the number of annual trading days in the year (e.g., 252). A VIX reading of 30 implies daily moves of +/- 1.9%, but the daily expected range is only +/- 1.1% at today’s level. For detailed asset class performance information, click on the table below.
Re- or In- “flation”. We’re getting an inflated number of inflation questions (ok, that’s a horrible pun, but I just wanted to see if you’re paying attention), which makes sense given reports of product shortages and delayed delivery times for everything from automobiles to dishwashers. Last week’s release of the March Producer Price Index report raised more questions as it showed a 1% surge in prices, twice the expected increase of 0.5%. The answer to the question of “are we entering a period of higher inflation” is yes. We expect inflation to rise above 2% in the short run, but that forecast shouldn’t be confused with runaway 1970s-style inflation. However, that’s not to say that investors won’t extrapolate forthcoming inflationary data into the future by selling bonds and pushing up market interest rates, especially in the next couple of months as economic data heats up.
While inflation is the “buzzword,” it would seem that reflation is a more accurate depiction of what’s taking place in the economy. Reflation is when the economy is growing, and prices are rising, but the economy is not yet at full capacity. On the other hand, inflation is characterized by rising prices when the economy is at full capacity, which gives rise to even higher prices. As we’ll see in a moment, even when the economy runs at full capacity, it’s an insufficient condition for generating excessive inflation. Moreover, inflation is a global phenomenon, and the U.S. economy is at a more advanced stage of reopening than most other countries, which I’ll touch on a little later.
Although there’s a definitional difference between reflation and inflation, prices are rising. Several economists we track forecast that core inflation (excluding energy and food prices) will peak in the next couple of months in the 2.3% – 2.5% range. That level will seem quite high as Core CPI averaged only 1.5% in January and February. One reason for the impending rise in inflation is the base effect – annual inflation starting in April will include the depressed pricing of the Great Lockdown, a period of extraordinary demand destruction, and associated price declines for most goods and services. Another reason economists are anticipating higher inflation is that by the end of the year, economic output is expected to exceed the economy’s potential output. The so-called “output gap” has been a reliable predictor of the direction of inflation.
Source: FHN Financial
Since 1985, actual economic output has exceeded potential output on four occasions, illustrated above whenever the blue line has crossed above 0.0% (right axis). On each of those occasions, inflation rose either concurrently with the direction of the output gap trend or shortly after it broke into positive territory. Yet, while the relationship between the two measures is strong directionally, the output gap has been a lousy predictor of the level of inflation. Indeed, since 1985, the only time core inflation was above 2% is when it was coming down from extraordinary levels of the late 1970s. Said differently, core inflation has been well below the Fed’s target 2% rate for more than 25 years.
Last week, the Producer Price Index (PPI) for March showed a steep rise of 1%. Isn’t this the start of runaway inflation? Maybe, but probably not. As the economy began opening back up and government stimulus worked its way into the system, order backlogs, mainly for goods, started rising. Demand for goods was less impacted than demand for services given the nature of social distancing – e.g., restaurant closures, fewer flights, and little interest in hotels and cruises. Meanwhile, goods producing firms face staffing complexities and a disrupted global supply chain making parts and products more expensive to produce. Firms are passing on some, but not all, of the costs to their customers, which is placing upward pressure on pricing.
Source: FHN Financial
Firms participating in the ISM surveys report that they expect the supply chain and labor issues will be temporary. Hence, while they are currently raising prices, both manufacturing and services firms reported that they expect price increases to be temporary. In addition to stressing the temporary nature of the price increases, firms are also showing constraint in the amount of increases they’re putting in place. While Economics 101 teaches that prices should rise until demand equals supply, after a rough year, firms are instead taking orders at lower than “optimal” pricing to improve cash flow and increase backlogs. That’s not to say they expect to lose money on the orders. Instead, the firms anticipate supply constraints to ease in the intermediate timeframe while demand remains steady on the back of sustained global economic growth, enabling firms to get back to business at reasonable profit margins.
Rising prices in the short term are not the same as the type of inflation that concerns central bankers. Central bankers get concerned when high realized inflation rates lead to sustained higher inflation expectations. When that transition occurs, consumers try to buy more today because they believe that prices will be much higher in the future. This, in turn, creates a positive feedback loop that increases demand above supply and prices spiral ever higher. But identifying that inflection point is difficult. Inflation is a mysterious force that no economist nor central banker can reliably predict. Arguments that excess government stimulus must result in higher inflation are met with counterarguments that high government debt levels crowd out the private sector and result in slower economic growth and lower interest rates. Japan’s situation offers support to this latter argument. In the last 20 years, Japan’s average inflation level has been 0.1%, and the yield on its 10-year bond has been less than 1%.
The investment implications for reflation vs. inflation are multifold and involve game theory of estimating how other investors will react to rising near-term inflation rates. Longer-term, the Fed wants inflation sustainably above 2% and is willing to let the economy run hot before removing accommodation. Sooner or later, the Fed is likely to get what it wants. Yet, the pace of inflation will depend not just on the U.S. economy reopening but also on other countries’ progress, as inflation is a global phenomenon. At this point, outside of China, the U.S. is the only major economy growing rapidly enough to engender inflation close to its central bank’s target, which means there’s an excess of global productive capacity that will weigh on prices. All of this to say, the 20+ year era of disinflation appears to have concluded, and we’ve entered into a new reflationary phase. Can reflation turn into problematic inflation? Yes. And although that doesn’t appear to be a near-term concern, as we’ve said before, the risk of a bout of nasty inflation is higher than it’s been in 20 years, which in and of itself has important investment implications.