The Spin on Inflation - 2nd Quarter – 2021
With the first half of 2021 behind us, we turn our attention to investors’ predominant topic of discussion and cause for concern: inflation. There is no shortage of opinions and often these opinions are supported by data. However, as it is in other areas that compel analysis, such as sports, politics, and science, the data is up for interpretation and may be wielded to suit one’s predisposition.
Additionally, the 2020-2021 pandemic has made forecasting, which is already notoriously challenging, near impossible. On one side, we have decades of historical, official government statistics, and on the other we have miscellaneous, ‘real life’ anecdotes that seem to contradict that data. Both may be accurate.
For the month of May the US Bureau of Labor Statistics reported that Producer Prices (the price of goods leaving the factory) rose 6.6% over the year prior. Stripping out food and energy, which are historically volatile inputs, the index rose 4.8%. Consumer Prices rose slightly less at 5.0% and, when removing food and energy, 3.8% over the same period. These figures are clearly well ahead of policy makers’ desire that inflation rise approximately 2% annually. It is important to note that a year ago these figures were negative, temporarily impacted by Covid.
The goal of the Federal Reserve is to sustain a healthy economy and job market while managing inflation. It has many tools at its disposal. However, interest rates are the most obvious and may be the most effective. The Fed may raise interest rates to slow the economy and drive inflation down. Conversely, it may lower interest rates to stimulate the economy, which may drive inflation higher.
The Fed’s message in recent months has been consistent; current inflation trends appear to be transitory and reacting too quickly to control it would be detrimental to the nascent economic recovery. Still, short-term interest rates remain very low, with nowhere to go but up. This, coupled with a surge in the money supply, as governments around the world continue relief efforts, has historically been a recipe for inflation. One’s time horizon is crucial here. The ‘medicine’ that makes us feel better today may be damaging a year or two from now.
We believe the economy is at an inflection point. The policies of the last fifteen months have succeeded. We have avoided what could have been a dire situation. Our economy is by all accounts stable and, in many areas, growing rapidly (projected at +6% this year), though at present is somewhat constrained by labor shortages and supply chain issues. We expect these constraints, mostly related to the pandemic, to dissipate over time, as does the Fed. Of course, some believe current policy will lead to runaway inflation and others fear any move to increase interest rates will throw the markets into a tailspin.
Interestingly, bond market participants do not share these concerns. Over long periods, the yield on the 10-Year US Treasury has roughly equated to inflation expectations. Today that rate is just 1.5%. This rate is partially justified by the presumption that policy officials will only start to raise interest rates in 2023. Prior to any rate changes, the US Treasury in its effort to support economic activity will stop buying bonds at the current rate $120 billion a month. We expect this activity to wind down over the next year in $10 billion increments per month as economic conditions continue to normalize.
There is an enormous amount of data supporting these decisions and though the stakes for getting it wrong are very high, we have seen this movie before. We are confident that policy officials will return to their dog-eared playbook. Janet Yellen, the current US Secretary of the Treasury, held successive positions with the Federal Reserve from 2004-2018, concluding as Chair. We are fortunate to have tested, independent leaders running these institutions.
Healthy economic conditions do not guarantee robust investment returns, but they do provide fuel to create and sustain them. We expect that equities will continue to compare well from a risk-adjusted standpoint against bonds and alternatives.
Thank you for reading and, as always, please reach out to continue the conversation.
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EPIQ Partners
Daniel Aronson, CFA Bruce Langer, CFA Ben Frey, CTP Rachael Scherer, CFA Julie Ellison