Uneven recovery early suggests balance
By Kyle Tetting
As we continue down the road toward the great reopening, we face the opportunities and pitfalls of an economy that continues to navigate its pandemic hangover. Demand — for everything from high-dollar goods like automobiles to services like eating out and travel — seems to be rising. Meanwhile, a variety of factors have led to supply shortages and constraints. The labor market, too, faces unique challenges, leading to persistent unemployment in some areas and labor shortages in others.
What is certain, at least in the recovery to date, is that progress has been asymmetric.
This is not unusual for an economy trying to emerge from the stresses of a recession. However, that asymmetry fuels speculation about fundamental economic shifts that may come more from fear and observations of the early innings of recovery than from any longer-term expectations.
Most notably, predictions about inflation have raged on since the last recession. One often-expressed fear following the financial crisis was that the $800 billion stimulus package intended to stabilize the U.S. economy would lead to runaway inflation. In retrospect, many economists have argued that more could have been spent because inflation stayed muted. It has averaged just 1.6% on a year-over-year basis since 2009.
The May 12 report from the Bureau of Labor Statistics renewed vigor in the inflation conversation. It said that in April, the Consumer Price Index for All Urban Consumers increased 4.2% on an annual basis.
While 4.2% is considerable, and it’s tempting to extrapolate out recent price increases into the future, any single month’s reading includes noise. In April, used car and truck prices rose sharply, aided by chip shortages that have hampered new car production. Similarly, energy prices rose significantly from the pandemic-depressed prices of a year ago.
The challenge is that the very asymmetry at this point in the economic cycle will lead to even more noise in the months ahead. We can’t simply extrapolate out a 4.2% inflation rate in perpetuity. Year-over-year, oil prices needed a 50% increase just to recover to pre-pandemic levels. Car manufacturers will eventually straighten out supply chains, allowing new car production to catch up to demand, offsetting some pressure on vehicle prices.
Even as one problem is solved, others will emerge. For instance, demand for travel is pushing lodging, airfare and car rental prices higher. Such inflationary pressures will capture headlines throughout the summer, but all are what economists call transitory. The real question: After stripping out all the noise of an asymmetric recovery, what’s left?
To answer that, we can look to the two most important factors influencing our long-term view: The Fed and market expectations.
The Federal Reserve, through Chair Jerome Powell and others, has made it clear that it will allow inflation to surpass 2%. Further comments have clarified that the Fed is unlikely to just stand by if inflation far exceeds 2% or if more modest inflation persists for an extended period. With plenty of tools to remove accommodation and combat inflation, the Fed is not leaving much to interpretation.
As a result of the Fed’s communication, market participants have been pricing in an expectation for inflation to exceed 2% over the next five to 10 years. By determining what investors are willing to pay for “inflation insurance” in the form of Treasury Inflation-Protected Securities, we know that investors expect the rate of inflation to average about 2.5% into 2026.” That rate exceeds the Fed’s 2% target, but it’s not as far off as many of the numbers we’re likely to see this summer.
We can reasonably believe that longer-term inflation won’t be as high as what we expect to see in the next few months, but there are reasons for caution. Trillions in stimulus spending has boosted personal savings as consumers had fewer things to spend on. As those savings turn into spending, businesses will be left scrambling to keep up with demand. But, with few capacity constraints at present, the supply of many goods and services is more elastic than in the past. In other words, new and existing businesses will step up to meet demand.
Stocks offset fears of inflation over time, by Kyle Tetting
Be patient holding bonds as rates rise, a Money Talk Video with Steve Giles (from 2016)
Key economic indicators every investor should know, from the Financial Industry Regulatory Authority
For What It’s Worth: Volatility, by Joel Dresang
While the current market expectation is for higher — but not necessarily high — inflation, we must prepare for a broader range of outcomes. Any change to those expectations, and even the noise in month-to-month releases, will likely result in further stock market volatility. Such volatility highlights the importance of the less-volatile assets we include in a balanced portfolio.
Beyond the noise, a transition toward renewed economic growth and the potential for inflation at more typical levels creates meaningful opportunities for investors.
For stocks, rising prices tend to accompany economic growth. Such growth supports a more diverse list of businesses than the few growth names that had been leading markets. For example, more cyclical businesses — with the ability to pass higher prices on to consumers and benefit from continued productivity gains — are likely to see stronger earnings growth.
While bonds may face some short-term pressure as interest rates rise to reflect changing expectations, those higher rates also provide greater income for bond investors. The small near-term increase results in a more favorable outlook for the bond market overall.
As we consider the prospects for inflation, the biggest risk is not the ultimate measure of inflation itself, but how we react to changing expectations. Small adjustments may be called for across a balanced portfolio as expectations evolve, but the very premise of balance is that we prepare for a range of outcomes, recognizing that nothing is certain.
Kyle Tetting is director of research and an investment advisor at Landaas & Company.
(initially posted May 27, 2021)
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