I have finally started to begin to return to life as I once knew it. I just took my first business trip in a long time and used many of those services that were so battered down when the economy came to a screeching halt, such as hotels, airlines and even a car rental. It felt good to start seeing what life will look like after COVID-19. The combination of the successful distribution of vaccines and government stimulus is helping us see the light at the end of this pandemic – at least in the U.S.
Not surprisingly, Americans who have been hibernating in some form or another for the last 15 months are anxious to reengage in aspects of their pre-pandemic life. But as the economy has come roaring back, so too have prices. Now many worry if the strength of the recovery will cause the economy to overheat. The concern of whether inflation is just temporary or will stay around for a longer period of time is by far the most common question I received on my latest trip and during my many recent Zoom calls.
Let’s look at the latest measures of inflation and why we believe they are likely transitory, how the Federal Reserve might react, how various asset classes perform under different inflation environments, and address our current portfolio positioning.
Inflation has Arrived but Likely Temporary
Inflation is defined as too much money chasing too few goods, or demand outstripping supply. While it has been easy to bring back demand for goods and services after the abrupt shutdown of the economy a year ago March, it is much more challenging to supply those goods, as evidenced by the latest inflation readings.
Consumer prices for May accelerated at their fastest pace since the summer of 2008, with the headline Consumer Price Index (CPI) up 0.6% from April’s levels. Core inflation, which strips out the more volatile food and energy components, soared 0.7%. From a year ago, headline CPI was up 5% in May and core inflation increased 3.8%. Unsurprisingly, some of the biggest year-over-year reflationary trends were in areas most distressed during the pandemic, such as energy prices (+54.5%), food away from home (+4%), transportation services (+11.2%) and apparel (+5.6%). Meanwhile supply constraints for items such as semiconductor chips have stalled car production and in turn pushed up prices of used cars and trucks (+29.7%).
Similarly, underlying producer prices remain elevated as strengthening domestic demand pushes against supply constraints. The Producer Price Index (PPI) rose 0.8% in May and is up 6.6% versus the same period a year ago. Excluding food and energy, PPI is up 0.7% in May and 5.3% from a year ago. Keep in mind that year-over-year inflation readings are elevated because of the “base effect” of comparing them to the lows hit during the worst months of the pandemic last year.
Exhibit 1: U.S. CPI Components
The base effect, the surge in pent-up demand, and supply-chain bottlenecks are among the reasons why we believe the rise in inflation will likely be temporary – although investors should be prepared for prices to remain elevated over the summer months. There are also longer-term deflationary forces still in play: aging demographics, improving technology, higher productivity, and even our lowered dependence on foreign energy sources (which leads to a lower probability of a spike in oil prices). Most or all of these trends have helped keep inflation at bay for the past several decades and should continue to do so in the years ahead.
Policy Reaction is What will Matter
At its June policy meeting, the Federal Reserve acknowledged the strengthening economic recovery but Chairman Jerome Powell also stated that he believes it will still be “some time” before “substantial further progress” is made toward full employment and its 2% inflation target. The Fed made no changes to its monetary policy. However, they accelerated the timeframe of when they may begin raising rates as well as the amount of increases needed. For 2021, the central bank also adjusted its real GDP forecast to an annual rate of 7% (up from 6.5% in March) and raised its core inflation forecast to 3% (up from 2.2% in March). Their inflation expectations for 2022 and 2023 remain stable at 2.1%. This suggests the Fed continues to believe inflation will be temporary and moderate over the next few years.
The bond market tends to agree with the Fed that inflation is only transitory. Treasury Inflation-Protected Securities (TIPS) breakeven rates declined after the Fed announcement, with the 5-year breakeven rate falling to 2.40%, suggesting that the bond market believes the central bank will not allow for excessive inflationary pressures. The last thing the Fed wants to do is stifle this economy as it continues to recover. We believe they will continue to closely monitor the data and take the appropriate steps needed if they suspect inflation could become more sinister or long lasting.
Asset Class Performance
When assessing how various asset classes perform under different inflation regimes, history paints a clear picture. When inflation is below 4%, stocks have historically had the upper hand, and there seems to be a high inverse correlation between the level of inflation and stocks’ dominance over commodities, gold and real estate. In high inflationary environments – defined as annualized headline CPI rate over 4% – asset classes, including a broad basket of commodities, gold and even real estate, appear to do relatively well as investors seem to feel tangible assets are more likely to hold their value when inflation is eroding the dollar’s purchasing power.
We analyzed asset class returns in high inflationary environments over a 50-year period ending April 30, 2021 and found nine periods when headline CPI was above 4%, lasting an average of 24 months. One exceptional period was the energy super-cycle of the 1970s, when inflation was in the double-digits amidst oil price shocks and political instability. Gold significantly benefitted during this inflationary period. However, if you exclude this one time in the 1970s, gold and stocks on average performed roughly the same during high inflationary periods.
So, therein lies the conundrum of positioning a client portfolio for a high inflationary environment. If your assumption about high inflation proves to be wrong, the portfolio historically suffers in opportunity cost, (and it may actually result in losses as commodities have exhibited negative returns with inflation between 0% and 2%).
History might suggest a shift to real assets in one’s portfolio during an expected period of high inflation but reducing or eliminating equities to fund this allocation doesn’t seem appropriate given equities have outperformed real assets in many high inflationary periods. Perhaps fixed income or other sources of funds should be used, as these assets would be directly hurt by higher interest rates brought on by higher inflation.
Commodities also have a very subpar long-term return profile. In our work done for clients last summer, when we updated our neutral allocations, commodities were reduced significantly as they have been dominated by most other asset classes over multiple business cycles. In other words, commodities seem to be only occasionally a good sprinter in one’s portfolio but seem to serve little purpose as a strategic allocation.
Stocks, meanwhile, seem to serve as one of the best inflation hedges over long periods of time, because of their tendency to produce strong returns when inflation is low. In doing so they build up a buffer of gains which can be used to maintain purchasing power for long periods of time, even as inflation regimes change. Stocks even have the ability to occasionally produce solid returns during higher inflation backdrops.
Positioned for a Broad Expansion
In anticipation of a broad, V-shaped recovery we have been positioning portfolios for an expected rebound in growth, earnings, and consumer spending. With that said, we are keeping a very close eye on inflation and inflation expectations as we move through 2021. Even though we are seeing a pick-up in inflation in the near term – and will likely see this continue over the coming months – we still don’t believe that inflation is sustainable.
While we have increased exposure to more economically sensitive areas of the market that can benefit from the reopening, such as small cap stocks and emerging market equities, we have not yet recommended allocating more of our clients’ portfolios to commodities or real assets. As I book more business travel and increase my in-person client meetings, we will continue to monitor wage growth, employment, velocity of money, bank lending and interest rates. These and other variables will give us more information on the most likely path of inflation as this economic expansion continues, and the corresponding portfolio positioning that would be consistent with this view.