A Break in the Calm

March 5, 2021
A break in the calm

A break in the calm is starting to happen within the financial outlook. Many respected economists, on both sides of the political fence are now starting to think and talk about the risks of rising inflationary pressures this year and spilling into 2022. Until recently, most economists viewed building inflationary pressure as something remote, and were focusing primarily on the building risks of deflationary trends, rather than inflationary trends. This trend, or calm, may be changing.

I recently saw a comment from Paul Ashworth, chief U.S. economist, at the globally respected economic research firm Capital Economics. He said, “We wouldn’t be foolish enough to claim another massive fiscal stimulus would make a bout of higher inflation unavoidable. But it does increase the risks considerably at a time when other factors were already pointing to a rebound.”

This statement is enough for many, including myself, to think about the potential ramifications of an upward push in inflationary pressure, irrespective of the magnitude of the move. The world’s businesses, governments and investors have one thing in common – most mainline thinkers believe inflation is dead and buried. But what if they are wrong? These kinds of surprises are the stuff from which market volatility is born. 

The Importance of Inflation Risks

It behooves investors to understand pressures in both inflationary and deflationary trends. In his work, “Deep Risks: How History Informs Portfolio Design,” William Bernstein stated that all investors are faced with four major, deep risks which have the potential of affecting not just the return on their capital, but the very survival of the capital itself. These four deep risks are:

  1. Deflation
  2. Inflation
  3. Confiscation
  4. Destruction

As noted above, two of the four deep risks Bernstein highlights have to do with pricing trends/pressure.  In the past, during times of rising inflationary pressure, financial asset’s returns tend to be muted, and in the case of longer-term fixed income assets, returns tend to be negative. Stock prices are also negatively impacted as valuation levels (P/E ratios) contract. The simple table below shows historical periods when inflation trends were rising and the impact on some fundamental factors. 

Data for Inflation Interest Rates and P/E ratios
  1. Data shown for inflation, interest rates and P/E ratios are as of the year indicated. S&P 500 price change data is annualized for the decade noted (all data is per St. Louis Federal Reserve and MacroTrends) 
  2. As can be seen from the above:
    • Inflation (CPI) was at 1.46% in 1960 and at 13.55% in 1980 
    • Over this rising inflationary period, interest rates on the 10-year U.S. Treasury rose from 4.72% to 10.5%
    • The P/E ratio on the S&P 500 fell from 16.5x to 7.2x
    • The average yearly price change of the S&P 500 was a mere 3% per year
  3. Additionally:
    • Inflation was at 10.5% in 1980, falling to 1.80% in 2020
    • Over this period of falling inflation, interest rates on the 10-year U.S. Treasury fell from 10.50% to 1.88%
    • The P/E ratio on the S&P 500 rose from 7.2x earnings to 23.3x earnings 
    • The average yearly price change of the S&P 500 was 8.88%
  4. The U.S. market is now priced at 21x+ earnings (expected), and the 10-year yield is around 1.3%, after being as low as 0.5% earlier in 2020
  5. Note that in all periods, the 10-year Treasury yielded more than inflation except for the period of high inflation of the late 1970’s and early 1980’s 
    • Currently, the 10-year Treasury yields less than inflation, a condition which, unless Karl Marx was correct in his view that capital has now value, shall not persist; either inflation will eventually collapse to lower than 1% on a sustainable basis, or interest rates will continue to rise
  6. Stock market pricing, on a decade-long basis, is up an average of 6.9% per year from 1960 through 2020
    • Stock price change averaged well below normal during the two decades when inflation and interest rates were rising (1960’s and 1970’s)
  7. Basically, periods of rising and high inflation lead to high interest rates and lower stock market P/E ratios…this happens because as rates rise, bonds become stronger competition for investor inflows than when they are low

So, the question we ask is “Will inflation rise, and if so, by how much?”

Current Picture

Inflation has been a thing of the past, as noted above. The Federal Reserve has stated they aren’t particularly concerned about rising inflationary pressures, as the long-standing 2% target rate of inflation has recently been changed to an acceptable range. In other words, the Fed is expected to let monetary policies run hot even if inflation reaches their previous 2% target. 

According to the St. Louis Fed, over the last 12 months, inflation (Consumer Price Index or CPI) has risen by 1.4%, reflecting the decline in demand which accompanied the economic recession of last year. However, as the economy has recovered, inflation pressures appear to be building, as the CPI has risen by an annualized rate of 2.72% over the last three months. Prices of many goods and services are starting to show an upward tilt. 

Additionally, a case can be made that inflation has recently been understated. Housing costs represent 42% of the calculation of the CPI, and 32% weight of the Personal Consumption Expenditure (PCE) index – the Fed’s preferred inflation gauge, the largest weighted factor of both indexes. The next highest factor is transportation expenses, at 17% of each index. 

When computing inflation indexes, housing values and mortgage rates are not the primary drivers, but rents are. National residential rents have declined by 0.5% over the last 12 months, as reported by rentcafe.com. At the same time, home values have pushed upwards by 10.4% according to the Case/Shiller index. In addition, mortgage rates are now starting to move upwards as the average 30-year fixed mortgage rate is 3.18%, compared to 2.74% earlier last year. Folks need to take this disparity in consideration.    

Changing Landscape – Back to the Past? 

If asked, most people probably believe over the long term, inflation has been reasonably high. People are surprised when they discover the longer-term inflation rate in the U.S. has been 3.23% (1913 – 2020 per the Bureau of Labor Statistics). Not that high, but much higher than we have seen for quite some time. 

We haven’t seen 3.2% inflation in 14 years according to the St. Louis Fed. And, we haven’t seen that historically normal level of inflation, on a sustained basis, since 1990-1992 (3%+ inflation for three years straight). So, the last time investors were justifiably concerned about inflation was 30 years ago. A full generation of investors has been mentally groomed to think inflation is gone, dead and buried. Maybe. But perhaps not. Think of the following data points:

  • The world is coming out of an economic shock driven by COVID. Demand for many consumer services (hotel, restaurant, travel, group events and gatherings) fell significantly over a very short period last year. That collapse in demand was met by a contraction in supply, as many businesses which cater to these services shuttered their doors and dismissed their employees, many for good. For example, in New York City, around 5,000 restaurants have closed and 500,000 people have lost their jobs while tens of thousands of small businesses have gone away, according to the Partnership for New York City. These numbers are for just one city. Take those numbers and multiply by hundreds of cities and towns. You get the picture. The supply of many consumer services has shrunk on a national scale. The national workforce is still almost 10 million workers smaller than in early 2020. 
  • On the demand side, consumer’s balance sheets are flush with cash. The Commerce Department reported that personal income shot up by a seasonally adjusted 10% in January from December – a 10% increase in personal income in just one month. This level of increase typically takes years to accomplish. Consumers spent 2.4% of that 10% increase, while the other 7.6% went into savings, much of which will be spent later. This money primarily came to consumers through government-sponsored stimulus checks. 
  • Fed figures show that as of the end of the third quarter 2020, households had $2.2 trillion more in cash than at the end of 2019. That was before the original stimulus check was mailed. As vaccines are more widely distributed throughout this year, and people feel freer to leave their homes, expect to see a major surge in consumer spending.

Will the supply of many products and services be increasing as rapidly as the thirst to spend money as the economy reopens? I suggest the table is set to see a surge in consumer spending in a way we haven’t seen in quite some time. Will supply of goods and services ramp upwards rapidly enough to absorb the upward push in demand?   

I suggest this is the kind of scenario which may lead to an upward push in demand/pull inflation during late 2021 and into 2022. Our early economic studies in college told us that when demand for a good or service rises more rapidly than the growth in supply to meet that demand, pricing tends to rise. That is the short-term picture.    

Will inflation return? 

Will inflation, the likes of what we saw in the late 1970’s – early 1980’s come back? I don’t think so. I don’t believe the world has the capacity, or tolerance, of that kind of problem returning. But could inflation rise to the long-term average of 3.2% sometime over the next few years? Without much problem, in my mind. 

There is an old saying that in economics, there aren’t any solutions, only trade-offs. With record-setting deficit spending coupled with extraordinarily easy monetary policies being applied, we should take the view that government actions will lead to a very rapid increase in final demand this year. The actual cost of that increase in final demand may be a rise in general prices. 

The S&P 500 Index is a market-value weighted index provided by Standard & Poor’s and is comprised of 500 companies chosen for market size and industry group representation.

10-year U.S. Treasury yield curve rates: Yields are interpolated by the Treasury from the daily yield curve. This curve, which relates the yield on a security to its time to maturity is based on the closing market bid yields on actively traded Treasury securities in the over-the-counter market.

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