With inflation in the U.S. running at a multi-year high, investors should stay vigilant and take inventory of how rising prices can impact monetary policy, economic growth and the prospects for financial markets.
- The future path of inflation will largely depend upon whether supply and demand dynamics in the economy can reach a stable, post-pandemic equilibrium.
- Bond markets are especially attentive to rising inflation and whether the Federal Reserve must pull forward plans to raise interest rates.
- With policy options limited, the likelihood has increased that real interest rates will rise, which would have meaningful consequences for financial market returns and cross-asset diversification.
For much of 2021, inflation has been on the forefront of investors’ minds, and rightfully so. The trajectory of prices paid by consumers and businesses has a profound impact on the economy, monetary policy and financial markets. With the global economy having yet to fully emerge from the COVID-19 pandemic, the presence of what appears to be persistently rising prices has injected a new source of uncertainty that investors and policy makers must account for.
While inflation is sometimes bandied about in the most sinister terms, we believe the investment community would be better served by recognizing what this bout of inflation is, what it isn’t and what it possibly could still become. Furthermore, an explanation of how inflation can influence monetary policy and the prospects for financial assets should provide perspective as the current situation surrounding accelerating prices continues to unfold.
A Long Time Coming
Given 2020’s pandemic-induced lockdowns, the current spike in year-over-year inflation was well telegraphed. Not only has that come to pass due to low base effects and a resumption of economic activity, but also an array of supply-chain disruptions – themselves a function of the pandemic – has led to prices increasing far higher and lasting much longer than most forecasts anticipated.
Year-over-year headline U.S. consumer price inflation (CPI) rose 6.2% in October. When stripping out volatile food and energy – a measure known as “core” inflation – it gained 4.6%. October marked the sixth consecutive month that headline inflation crested 5.0% and represented inflation’s fastest annual pace since 1990. This stands in stark contrast to recent history. In the 15 years leading up to 2008’s Global Financial Crisis (GFC), headline and core inflation averaged 2.7% and 2.4%, respectively. This period was known as “the great moderation,” meaning economies could expand at a healthy pace without igniting runaway inflation.
Year-Over-Year PPI and Headline and Core CPI
Source: Bloomberg, as of 31 October 2021.
The specter of inflation diminished even further between the onset of the GFC and last year’s pandemic, averaging 1.6% over the period. A primary objective of the extraordinary monetary policy that was a hallmark of this era was to nudge inflation higher to catalyze economic activity and stave off a potential deflationary spiral. While deflation never materialized, neither did above-trend economic growth as annualized quarterly U.S. gross domestic product grew at a pedestrian 2.2% over the decade ending in December 2019.
More Than One Source
Economists and policy makers are mindful of the deleterious effects of inflation as it erodes the purchasing power of consumers and distorts the pricing signals that would otherwise set an equilibrium in the economy. Typifying these phenomena are inflation pulling forward certain purchases as consumers anticipate continued rising prices, which can lead to a self-fulfilling prophecy, and the curtailment of other – typically discretionary – purchases as households must prioritize expenditures.
Top Contributors by Segment to October’s 6.2% Year-Over-Year Rise in Headline CPI
Source: Bureau of Labor Statistics, as of 31 October 2021.
Much rhetoric has been focused on whether the current inflationary environment is transient or longer lasting. In recent weeks, the Federal Reserve (Fed) hedged its position, believing that a period of elevated prices could last into 2022. Several drivers of inflation could lose steam as more economic capacity comes online. Others, however, may prove more challenging. The semiconductor shortage has not only hit the automotive industry, resulting in significantly higher prices for new and used cars, but also has permeated other sectors given the proliferation of microchips in the 21st century economy. Similarly, this year’s spike in energy prices cannot be solved overnight and typically energy is one of the last segments households and businesses can scrimp on, with them preferring instead to cut back on other expenses. This takes on special relevance as the colder months in the northern hemisphere approach.
Wages play a complex role in inflation, especially in a service economy like that of the U.S. Broad-based economic growth can result in demand-driven inflation as workers have the confidence to increase spending and pay higher prices. But in the current environment with the U.S. labor force participation rate still well below its pre-pandemic level, employers have had to bid up wages to attract workers. This has resulted in a cost-push inflationary dynamic where higher labor costs are passed along to customers. This can lead to an upward spiral in prices. The upshot is annual wage gains having averaged 3.8% over the course of 2021. Rising wages, it should be noted, are a sticky form of inflation as once pay is increased, it typically cannot be dialed back.
A “Healthy” Recovery
Recessions induced by natural disasters tend to be short-lived and followed by rebounds mirroring the trajectory of the contraction. This has largely been the case with the COVID-19 pandemic.
With the exception of the period impacted by the emergence of the Delta variant, economic growth in the U.S. quickly recovered lost ground. Purchasing manager indices remain strong as do household consumption data, which have largely exceeded consensus estimates over the course of this year.
Purchasing Manager Indices Signal Strength
Source: Bloomberg, as of 31 October 2021.
A recovery in demand has occurred during a period in which global economic capacity cannot match consumer appetite. The result is inflation being driven by both “demand-pull” and “cost-push” factors. While the Fed is likely hesitant to tamp down on the former, given its preference for allowing the economy to continue to heal, monetary policy tends to be less effective in dealing with the latter. Looking forward, the ability of policy makers to not “fall behind the curve” may depend upon which source of inflation proves dominant in coming quarters.
The One-Two Policy Punch
An additional – and important – ingredient for accelerating inflation is monetary policy, which remains highly accommodative. Since the onset of the pandemic, assets on the Fed’s balance sheet have more than doubled to $8.7 trillion. And while plans to taper monthly asset purchases have been announced, we can expect the liquidity injected into the economy to remain for some time.
Current and Projected Total Assets on Federal Reserve Balance Sheet
Source: Bloomberg, as of 10 November 2021.
Evidence of this liquidity is seen in the “broad” money supply in the U.S. economy having risen by 37% since the pandemic’s onset. For this liquidity to become kindling for inflation, its circulation through the economy must increase. Thus far, that has not occurred as the velocity of broad money remains a miniscule 1.1%, well below its long-term average. An overlooked risk is that with broad money in such abundance it could take only a modest uptick in velocity to further fuel inflation. Yet, throughout the post-GFC era, concerns about an expanded Fed balance sheet leading to inflation never materialized.
The pandemic has also compelled Congress to answer the Fed’s call to increase fiscal accommodation to complement a decade’s worth of dovish monetary policy. In addition to fiscal measures aimed at supporting household finances and key industries during the height of the pandemic, a $1 trillion infrastructure bill has just been signed into law and other legislative initiatives await.
Treading Carefully in Fixed Income
The U.S. bond market has been particularly sensitive to the recent spike in inflation. Initially, longer-dated Treasuries sold off, resulting in a steeper yield curve as Fed officials maintained a dovish stance despite a rapidly recovering economy. More recently, short-dated interest rates have risen in anticipation of the Fed being compelled to pull rate hikes forward. The futures market now predicts at least two rate hikes in 2022, and while a survey of Fed officials is less aggressive, even that hints at an initial hike next year in contrast to earlier predictions of them holding fast through 2023.
U.S. Treasuries Yield Curve Has Risen across nearly all Maturities in 2021
Source: Bloomberg, as of 22 November 2021.
With both the front end and long end of the yield curve in play, we believe investors must pay close attention to duration management, especially in securities with a higher sensitivity to interest rate swings. Should the economic recovery continue at a measured pace, credit securities with sufficient cushion to absorb modestly higher rates appear well positioned. If, however, inflation continues at a torrid rate, bonds could come under pressure as investors demand deeper discounts to account for potential erosion in coupon and principal payments.
Cautiously Optimistic Equities Markets
An inflationary backdrop is less dire for equities, but not one without risks. Typically, the economic growth that is the source of demand-driven inflation can be beneficial to stocks as it allows companies to raise prices and boost earnings. Uncontrollable inflation, on the other hand, can have the opposite effect, leading to demand destruction as consumers are unable to bear the costs of higher prices.
If inflation appears transitory, corporations are sometimes willing to absorb higher input costs to protect market share. Should rising costs appear permanent, however, they opt for passing them onto customers to maintain margins and earnings growth. With the year-over-year change in the Producer Price Index having accelerated to nearly 12%, corporate managers may soon face tough choices as they decide between protecting market share or prioritizing margins. Those with the pricing power to pass along higher costs have largely done so, as a trip down the grocery aisle or gas station will indicate. But with consumer demand having proven resilient during this stretch of inflation, optimism prevails in equities markets. Since January, consensus estimates for S&P 500 Index EPS for both this year and next have climbed by double digits. Overt concerns about imminent margin compression would likely not have resulted in such a bullish view.
2022 S&P 500 Index Consensus Earnings Per Share Estimates
Source: Bloomberg, as of 22 November 2021
If persistently high inflation continues to put upward pressure on interest rates, the growth stocks that have led markets higher for the past few years may come under pressure. These stocks’ valuations are more reliant upon prospective earnings streams several years out. Consequently, a higher discount rate would lower their present value. Conversely, the broadening growth that results in tolerable levels of inflation could be the catalyst needed for market leadership to rotate toward value stocks after a long delay.
One Way or Another: Anticipating Higher Real Rates
The Fed has navigated a delicate path in supporting the U.S. economy as it emerges from recession. This policy course has gotten more difficult in the wake of persistently high inflation as the risk of policy error has increased regardless of what it chooses to do next.
Throughout the post-GFC era, the level of real interest rates has been a telling barometer of accommodation. With still accommodative policy keeping a lid on nominal interest rates – for now – the current bout of inflation has kept real rates deep in negative territory. We doubt this can last, and over the past few weeks alone the real yield on the 10-year Treasury has risen from -1.21% to -0.94%.
Nominal and Real Yield on the 10-year U.S. Treasury
Source: Bloomberg, as of 29 October 2021
When given a choice, the Fed has tended err on the side of dovishness. If it holds true to its “guided” pace of measured rate hikes in the face of inflation remaining well above its 2.0% target, nominal rates could continue their march higher, pulling real rates toward positive territory. But if the Fed pivots and raises rates more aggressively than anticipated – tamping down on inflation in the process – real rates would also probably increase as inflation would be less of a scourge. In either case, real rates are likely to rise, which would have meaningful consequences on financial assets as they all could come under pressure. Not only would this act as a headwind for returns across financial markets, but it would also increase the correlation between stocks and bonds, thus reducing the benefits of diversification.
A third scenario is the Fed stands pat as inflation reverts to a lower level. This stasis, whether driven by slowing demand or the resolution of supply-chain issues, could result in real rates staying negative, thus buying more time for the economy to heal.