Up until March of this year, if you were tuning in for rumblings of inflation, all you got was garbed static – the likes of which is experienced at the ends of the radio dial. Now it seems that all stations are on an endless loop of Casey Kasem’s Inflation Top 40.
It has been over 20 years since the U.S. has seen sustained inflation. However, the combination of massive monetary stimulus, supply chain disruptions and now increased consumer demand have resulted in the “I” word resurfacing.
Inflation has the market spooked. Why?
The worry, in our opinion, centers on that central relationship between stocks and bonds. If prices are rising quickly, bond investors will start to demand more yield to compensate for increased living expenses. If bond yields rise, fixed income starts to look relatively more attractive than riskier stocks – potentially triggering a rotation out of stocks and into bonds.
Asset class rotation is just the outside of the onion, however. When we start peeling it back, there are other layers to consider. If inflation is truly becoming a sustained worry (more to come on that key word in a bit) that means the Fed will have to do an about-face and start tightening monetary policy. Recall that even pre-COVID, the Fed was stimulating the economy. It has been over 5 years since the Fed has embarked on a tightening regime. This could spook stock investors.
The worry over-tightening is twofold. One – many firms have loaded up with debt over the past five years. If rates rise, it will put a strain on refinancing and paying these debts. Two – stocks have been the beneficiaries of an increasing money supply and low-interest rates. If the printing press starts going in reverse, stocks will need to stand on their own two feet. No more borrowing at low rates to buy your own stock. Revenues, profit margins and earnings will rule the day. Investors may adopt a “show me the money” attitude and may not wait for promises of profits 3-5 years hence.
Inflation is here now, but will it linger?
Sticker shock is becoming a daily feeling for most of us. Everything from lumber to used cars to bacon is up well over 10% in price this year. However, taking a step back and asking why can (and in our opinion should) lead one to believe that these high prices are likely transitory not sustainable. In the case of lumber, supply shortages from mill closures are causing higher prices. In the case of used cars, a supply shortage of semiconductor chips for new vehicles is causing a rush to buy used cars.
Simply put, exogenous supply constraints during COVID have created shortages of many goods. At first, producers of goods resorted to lengthening delivery times (Have you tried to buy an appliance recently?), but now producers are feeling more comfortable raising prices as well.
Transitory inflation is not much of a threat to the stock market or bonds. If prices are going to drop right back down once supply chains fully open, the Fed may not be inclined to bump up rates. On the ground level, if a consumer is certain the price of refrigerators will drop back down next year, he or she may just forego the purchase and wait – thereby contributing to a drop in demand.
The Fed has been beating the transitory drum all year. In fact, we have not heard them refer to inflation without using this adjective. We think the bond market may be telling the same story – at least for now. If bond investors really thought inflation was a lasting concern, yields should be higher. Yes, the 10-year treasury quickly rose from a yield of 0.50% to 1.70%, but it has since dropped back to 1.55% – 1.60% and has been stuck in this range since March of this year.
Two Sides of the Inflation Coin
There are compelling arguments for both lasting inflation and transitory inflation. We believe this may be why the bond market and stock market are in an early summer holding pattern.
- Supply chains will fully open and demand will level-off once consumers deplete their stimulus checks.
- The inflation we are seeing is primarily due to base effects. In other words, current prices for most products/services/commodities are being compared to very low prices one year ago during the pandemic.
- While labor costs are going up, the current labor force is still 7 million people less than 2019 pre-COVID levels. Once stimulus checks stop, people should flood back into the workforce driving labor costs lower.
- Technology has created massive efficiencies and cost savings that have resulted in certain profit margins expanding to record levels. This creates a larger buffer for companies to absorb input price increases, rather than passing them on to consumers.
- Nationalism is causing trade relations to suffer. This could potentially increase product costs due to more expensive domestic manufacturing.
- Once the landlord eviction moratorium expires at the end of June, rents will likely ratchet higher to make up for lost rental income. As a reminder, housing expense makes up 41% of the Consumer Price Index (CPI).
- Once companies successfully push through price increases, they will be tempted to keep them at elevated levels.
What is BSW doing regarding inflation, if anything?
The short answer is no big moves. BSW recently ensured client portfolios are in-line with asset allocation targets. We remain diversified across asset classes and geographies. No matter which side the inflation coin lands, we feel our clients are set up for long-term success. Trying to jockey and “play” inflation has historically been extremely hard to execute. Making matters even more difficult today is the fact that the relationship between inflation and classic inflation investments has been weakened due to all the economic stimulus.
At the margin, BSW has kept our liquid bond allocation on the short end – meaning bonds maturing within three years. That way, if continued inflation pushes yields higher, these bonds should retain most of their value and can be redeployed into longer, now higher yielding bonds. If inflation worries bleed into stocks, we believe we are in a good position to harvest our shorter-term bonds and redeploy into cheaper stocks – should that opportunity arise.
Much of the current inflation that we are seeing is a by-product of massive stimulus and COVID related supply shocks. To that end, a whopping 33% of all U.S. income was mailed to citizens over the last year!
Stocks and real estate should do well in an inflationary environment so long as the U.S. does not get 70’s/80’s style uber-inflation. (Note: the current Fed has many tools in its toolbox to fight inflation, so very high, lasting inflation seems like an outlier event at best). Both asset classes have all-important pricing power. Even BSW core, laddered bond portfolios will adjust and be better off in the long run with some inflation. As bonds mature (as they do every year in a ladder), they will be put back to work at more attractive, higher yields.
At the end of the day, you can enjoy turning on and tuning in to the inflation station, but we think that by next year we’ll be dropping out of high inflation.
Thanks for reading. Enjoy early summer and slowly getting back to “normal.” We look forward to seeing you in person soon!
Craig Seidler – Director of Public Investments