Inflation roars, will it be transitory?
US consumer price index (CPI) posts sharpest increase month over month since 1981
- US consumer price index (CPI) jumps 0.8% in April vs 0.3% expected.
- CPI increased 4.2% in April on a perhaps less meaningful due year-over-year basis as lockdowns were widespread in April 2020. Inflation was unusually low during this time.
How are markets responding?
- Technology and growth stocks are under pressure
- On Tuesday, the yield on 10-year U.S. Treasury notes climbed from 1.623% to 1.670%. Yields rise as bond prices fall.
- The volatility index is up 40% for the week.
Inflation is everywhere, caused by economies reopening faster than supply chains can meet demand
We could be at a generational turning point for global finance. Politics, economics, international relations, demography, and labor are all shifting to support inflation. After more than 40 years of policies that gave priority to the fight against rising prices and lower interest rates, investor and consumer friendly solutions are becoming less fashionable, not only in the U.S. but in much of the world.
The consumer price index (CPI) measures what consumers pay for goods and services including clothes, groceries, restaurant meals, recreational activities, and vehicles. Areas that drove the increase are as follows:
- Higher prices for used autos surged 10% in April compared with the prior month, the largest monthly increase on record. That accounted for more than a third of the increase, the Labor Department said. The global chip/semiconductor shortage is largely to blame.
- The average price paid for a used car exceeded $25,000 in April for the first time in the history of research firm J.D. Power’s tracking.
- Lumber prices alone have risen 124% in 2021 amid persistent demand for building materials.
- Copper, often seen as a proxy for economic activity, has jumped nearly 36%.
- Energy prices overall jumped 25% from a year earlier, including a 49.6% increase for gasoline and 37.3% for fuel oil.
Wages are starting to increase as there appears to be a labor shortage
Drive around your local main street and you will likely see “help wanted” signs on nearly every restaurant. The service industry desperately needs workers, however individuals aren’t quite ready to get back to work.
Many are blaming a $300 supplement to weekly unemployment benefits.
The U.S. economy added 266,000 jobs in April, much weaker than the 1 million expected. The April jobs report has led to outcry in some circles that the COVID-19 unemployment benefits are fueling a labor shortage. The extra aid offers an incentive for laid-off workers to stay home, making it hard for businesses to hire.
Others think factors like a shortage in child care as schools still remain in hybrid mode and COVID-19 fears also play a role in hiring difficulties. But the truth is likely somewhere in the middle, according to economists.
We have seen companies start to increase wages in an attempt to motivate people back to work. The Biden administration is pushing a national $15 minimum wage and large tax increase. Chipotle said it will increase restaurant wages resulting in a $15 average hourly wage by the end of June, as it looks to bring on 20,000 workers. If this trend of wage inflation continues, this could be dangerous and lead to inflation that is not as transitory as the Fed leads us to believe.
There are signs that this labor shortage may correct itself in the not so distant future as additional unemployment benefits won’t last forever and many schools are expected to be fully reopened in the fall as children and teens can now begin to receive the COVID-19 vaccine.
Fed holding the line when calling inflation increases “transitory”
In a speech prepared for delivery to the National Association for Business Economics International Symposium, Richard Clarida, the Fed’s vice chairman said, “These one-time increases in prices are likely to have only transitory effects on underlying inflation, and I expect inflation to return to—or perhaps run somewhat above—our 2% longer-run goal in 2022 and 2023.”
That quote may sound extremely familiar, as it seems anyone at the Fed regurgitates the exact same prepared line. The Fed seems to be very fearful of deviating from their script of referring to the increase in inflation as “transitory”.
There is concern in the market that the Fed is not paying enough attention to inflation and is behind the curve when it comes to being proactive to combat rising inflation.
Excerpt from WSJ opinion piece by Stanley Druckenmiller, “The Fed is Playing With Fire”,
“The American economy is back to pre-recession levels of gross domestic product and the unemployment rate has recovered 70% of the initial pandemic hit in only six months, four times as fast as in a typical recession. Normally at this stage of a recovery, the Fed would be planning its first rate hike. This time the Fed is telling markets that the first hike will happen in 32 months, 2½ years later than normal. In addition, the Fed continues to buy $40 billion a month in mortgages even as housing is clearly running out of supply. And the central bank still isn’t even thinking about ending $120 billion a month of bond purchases.”
5 years of retail demand has been force fed into the market
Retail sales have shot way past the trend line and have seen a five year demand be force fed into the market due to COVID-19 stimulus. Many say that the last $1.9 trillion stimulus from the Biden administration was a step too far and could have negative impacts on the reopening. We are starting to see that in inflation numbers and the spike in retail sales will surely slow and likely return to the trend line.
Is inflation actually “transitory”
Simply put, it’s too early to tell, but there are a few factors that say yes. However there are significant concerns pointing towards inflation could be longer term if the Fed does not deviate from it’s easy money policy.
- Lumber and commodity prices appear to be significantly overbought and might be rolling over. See lumber price chart below.
- Additional unemployment benefits will end at some point.
- Supply chains should be able to become more productive as global economies start to open.
What tools does the Fed have to combat inflation?
With Covid uncertainty receding fast and several quarters deep into the strongest recovery from any post war recession, the Federal Reserve’s guidance continues to be the most accommodative on record, by a mile. Keeping emergency settings after the emergency has passed carries bigger risks for the Fed than missing its inflation target by a few decimal points. It’s time for a change.
We believe that the Fed needs to realize that the economy is roaring back quicker than expected and reevaluate its monetary policy. Interest rates might need to be hiked in order to tame inflation. We think this would be healthy for the market.
Tech is not broken, focus on companies that actually have earnings.
- FANG+Microsoft is under pressure, but long-term, these are extremely strong companies with quality earnings.
- Software companies and other growth companies with no earnings are feeling the most pain.
- Tech investors should focus on companies that we can put a price to earnings multiple on rather than companies with no earnings that have to resort to price to sales multiples.
Outlook
We have no reason to be overly concerned that inflation is not transitory right now. However, investors should be diversifying their portfolios in the off chance that inflation is more long-term. We recommend starting to trim exposure to overall commodities as prices seem to be stretched and unsustainable at these levels.
We have been pairing technology holdings in client accounts from overweight to market weight since the back end of 2020 and rotating into industrials, financials, and infrastructure.
We believe that investors should continue to pair back overweight technology allocations and focus these funds in gold, financials, and industrials that should outperform when interest rates and inflation ticks up.
For investors with a strong risk appetite and long-term investing horizon, technology could look attractive at oversold levels. Again, investors should focus on companies with valuations tied to earnings over sales.
We expect a similar year in equity markets as 2016 where equity market growth was moderate. Volatility will likely continue to be a story throughout the year and investors should maintain discipline to a diversified, medium to long-term approach.
Thank you for your interest.
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