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Mark Simenstad
Chief Investment Strategist

MARKET UPDATE

Inflation – Is it returning or another false alarm?

03/05/2021
By Mark Simenstad, Chief Investment Strategist | 03/05/2021

Inflation has dramatically declined and remained subdued for over three decades since peaking at over 13% in early 1980. Interest rates, which closely follow the path of inflation, have also declined dramatically during this same time span.

Investors have been “looking over their shoulders” ever since then over concerns that the crippling inflation would eventually return.  And, like the boy who cried wolf, highly credentialled economists and market prognosticators have fed these concerns by frequently forecasting higher inflation and interest rates that have not come to pass.

Currently there are many market indicators that are warning of imminent inflation.  Is this the time when the “inflation wolf” is truly at the doorstep after being in the wilderness for so long?

Inflation history and fears – rooted in the 1970s

It is first important to recall why inflation was such a problem during the entire decade of the 1970s.  The U.S. was generating large budget deficits due to funding for the controversial Vietnam war, while also continuing to spend significant sums on domestic programs.

The structure of the U.S. economy was also vastly different than today. During this period the economy was significantly powered by oil, given that manufacturing was such a major portion of the economy.  When oil prices spiked due to the OPEC cartel, these higher prices reverberated through manufacturing supply chains, and ultimately to higher consumer prices.

Finally, ill-conceived monetary policy contributed to the inflation problem with the creation of too many U.S. dollars being created by the Federal Reserve (Fed).  Once inflation took hold, workers and consumers built ever higher inflation expectations into their thinking, leading to a wage/price spiral.

Beginning in 1980, many of the elements that drove inflation started to move in reverse. First, the Fed dramatically altered monetary policy, tightening to such an extent that short-term interest rates spiked, thus leading to a serious recession.

This recession led to a swift and sharp decline in inflation, and eventually to long-term interest rates.  Secular changes to the U.S. economy also began about this time. The service sector of the economy, which requires little energy to produce output, began to grow dramatically faster than the manufacturing sector.  As a result, less oil consumption was needed to deliver economic growth. Oil prices, and OPEC, began its long decline as a major contributor to inflation.

The technology sector, particularly computing power, emerged as a contributor to lower inflation as machines were able to replace labor, thus leading to growing productivity benefits. Finally, globalization, whereby corporations could tap vastly less expensive labor pools across the globe contributed to breaking the wage/cost spiral of the previous decade.

Inflation today – Market indicators flashing yellow

Currently, although reported inflation statistics remain very subdued at approximately 1.5%, many market indicators are flashing signs of the potential for some degree of inflation to emerge.  Since the beginning of the year, long maturity bond yields are up over 60 basis points while short maturity bonds have barely budged due to the continued accommodative policy being pursued by the Fed.

Meanwhile Treasury Inflation Protected Securities (TIPS) have moved from pricing in negligible inflation to now pricing in approximately 2% inflation, higher than currently reported inflation. Commodity prices, especially lumber and other building products, have vaulted in price and agricultural commodities have moved up significantly as well. Bitcoin, the new “digital gold” has risen exponentially.  Although considered a possible inflation barometer, Bitcoin also has a large degree of speculation associated with its price movements.

Finally, the substantial and surprising rise in stock prices and real estate valuation could also be considered a sign of incipient inflation.

Inflation expectations

In the near term, inflation seems poised to move higher for many reasons. First, the Fed has injected a tremendous amount of liquidity into the system, initially to support the economy after the financial crisis, and now in response to the pandemic.

Money in the system relative to the size of the economy is now at levels not seen since after World War II. Second, the pandemic has seriously impacted the supply of goods due to disruptions in global supply chains. There are shortages in many goods, but especially in computer chips, building supplies and consumer products.

Although supply has been diminished during the pandemic, final demand is expected to be significant as pent up consumer savings, built up during the pandemic, is released into the economy. Finally, the surge in wealth created by the amazing increase in stock prices will add further firepower to demand for goods and services. It seems a safe bet that inflation will finally reach the Fed’s long desired goal of 2%. The question is, will inflation stop there at that relatively benign level, or surge higher?

A real inflation problem is caused when labor and consumers begin to build the expectation of inflation into their behaviors causing a wage/price spiral. Currently there are still roughly 10 million people out of work and the economy is growing at a pace that is meaningfully below its potential. It will take at least a few years for employment (and possibly wage demands) to return to pre-pandemic levels. Consequently, in the near term, surging inflation does not seem to be a risk.

Longer term, the outlook is less certain. If the pandemic has permanently altered global supply chain and labor dynamics, it could put pressure on inflation. Also, the extreme monetary policy pursued by the Fed has injected a huge amount of money into the system. Fiscal policy has also injected immense liquidity into the system through trillion-dollar support programs.

Currently this liquidity is relatively latent, sitting in central bank reserves. However, as the economy recovers, these reserves may be released into the system through spending and loans. If there is too much money chasing too few goods and services in an economy that is heating up, prices and wages will rise. Currently the market seems confident in the Fed’s ability to thwart this situation if it arises through tightening monetary policy.

However, the economy has rarely had this amount of money in the system.  The Fed remains in uncharted territory regarding how to set a policy course, responding to impending inflation pressures, after the unprecedented policies that have been pursued for over a decade.

Interest rates and markets

The bond market has already begun to react to the risk of inflation. Longer term interest rates are moving higher while short term interest rates are “locked” due to Fed policy. It is expected that this trend will persist, and that longer-term treasury bond yields could move as high as 2%, particularly if the economy shows continued strong signs of recovery from the pandemic.

Stock prices, especially those of high growth companies, are responding negatively to this prospect.  Investors are responding by rotating into value and smaller capitalization stocks which are less impacted by rising interest rates. After such a long period of these market sectors lagging the high growth sectors, it appears this trend is set up to continue.

Certain secular and demographic forces remain in place that significantly reduce the probability of a substantial upward spiral in inflation and interest rates from occurring. Markets are currently digesting the potential for modestly higher inflation, and that recognition can be messy, particularly when markets are trading at relatively high levels of valuation.

Some change in the dynamics of inflation moving higher, if modest, can be viewed as a positive in that it is evidence that vaccines are working and that the world will be coming out of this dark pandemic period. Economic activity should resume, leading to more sustainable job growth, corporate earnings growth and, longer term, continued wealth creation for patient investors.

However, the Fed’s new inflation policy increases this risk of rising inflation significantly. The Fed has pledged it will allow inflation to overshoot its 2% target to make up for times when it is under this target so that inflation averages 2% over time.  To retain credibility, the Fed needs to show it will allow inflation to run a bit hot.

There is, however, a material risk that the market will eventually come to believe that the Fed will lose control of inflation and interest rates, thus forcing the Fed to pull forward rate increases, which would be bearish for the markets overall.  

 


All information and representations herein are as of 03/05/2021, unless otherwise noted.

The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management, LLC associates. Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

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Recent developments in the economy and markets are now flashing warning signs about the prospect of a return to some higher levels of inflation. How serious are these warnings signs, and how should investors factor that prospect into managing their portfolios?

Recent developments in the economy and markets are now flashing warning signs about the prospect of a return to some higher levels of inflation. How serious are these warnings signs, and how should investors factor that prospect into managing their portfolios?

05/25/2021