Last year we visited the topic of inflation, and wondered if, after a decade of false alarms, the extraordinary dynamics around the pandemic and the policy response to it would finally herald the return of inflation to the forefront of investors list of concerns. That day has now arrived, after April’s above-consensus 4.2% year-over-year headline CPI print, inflation topped by the list of tail risks that worrie
First, the recent numbers. Monthly inflation data exceeded forecasts again in May, with the headline reading rising from 2.6% in March to 5.0% in May, against a median forecast of 4.7%. This followed a large surprise in April, when CPI registered 4.2% against a median forecast of 3.6%. The “core” number, which strips out typically volatile food and energy prices, rose 3.8% year-over-year in May. This was the highest core CPI rate in 29 years. The Fed has told markets that it will look past short-term bouts of inflation that it deems “transitory,” and will instead focus on slack in the whole economy— business and financial conditions, capacity utilization, and chiefly, proximity to full employment—before pulling any tightening levers. It has also indicated that it will tolerate some degree of faster inflation in order to recover ground lost during the recession. Some are urging the central bank to act sooner, to taper its current program of asset purchases before the economy overheats and causes policymakers to truly lose control. Some on the committee appear to be listening and have suggested that a “taper timeline” may be discussed as soon as the June meeting. Antennae will be tuned closely to the Fed’s press conference on the 16th to hear if Jerome Powell is ready to begin to “talk about talking about” tapering.
As we wrote last ye
Housing in particular is in a state of structural undersupply. As the consumer-focused policy response to the pandemic has lowered mortgage rates and buttressed already-healthy household balance sheets, conditions were ripe for home prices to surge by double digits. This
(https://am.jpmorgan.com/us/en/asset-management/institutional/insights/market-insights/eye-on-the-market/inflation-duh/)
We believe the Fed is justified in “looking through” some of the noise in the spikier inflation indicators. We are very much in an unprecedented historical episode; there are bound to be strains and adjustments as the economy recovers its footing. Supply bottlenecks may persist throughout the summer, but
So, why worry? Are market jitters just a natural, healthy reaction to the prospect of a sooner-than-expected shift from extraordinary monetary accommodation to a policy that could be described only as “expansionary”? Market-based measures of inflation compensation have been rising since mid-2020, and the U.S. yield curve has undergone a dramatic bear steepening before moderating in recent months. Inflation-talk and equity market volatility would appear simply to be catching up to the reality that the bond market has been anticipating at least since December. While we think much of the short-run noise will resolve over the course of the year, we believe there are several risks to the long-run inflation outlook that multi-asset investors ought to care about. These have been discussed nicely in recent interviews by Goldman Sachs’ chief U.S. economist David Mericle and they fall generally into three types: wage-price spirals, structural imbalances, and expectations. Let’s address each of these in turn.
There are, broadly, three ways to measure inflation expectations. Market-based measures, as mentioned above, use Treasury Inflation Protected Securities (TIPS) to back out the implied extra inflation protection demanded by investors over nominal bonds. These so-called “breakevens,” measured usually at five- and ten-year horizon, have risen steadily throughout 2020, and formed something of a plateau around 2.5% for 5 and 10-years. Fed chair Powell has said that this sort of expectation is desirable, as it dovetails with expectations for stronger growth that influence firms’ hiring and expansion decisions. Tepid inflation is as self-reinforcing as the brisker kind. Indeed, in the U.S. and globally, we are seeing evidence of the sort of investment and capex-led recovery that has been largely absent throughout the last several cycles. 2.5% is higher than expectations have been for a decade, but that might just be a good thing.
There are other ways to account for inflation expectations than through financial market prices. The Philadelphia Fed compiles a much watched survey of professional forecasters—economists who look at the
Source: Philadelphia Fed 2nd Quarter Survey of Professional Forecasters
(https://www.philadelphiafed.org/surveys-and-data/real-time-data-research/spf-q2-2021)
The third way to look at inflation is surveys of the people actually facing inflation in final goods and services: consumers. The most famous such consumer survey is run by the University of Michigan. This number’s reliability as a gauge of future inflation is debatable, and is used more as an indicator of consumer behavior and purchasing decisions. It reached a high of 5.1% in July 2008, just before the collapse of Lehman Brothers set off several quarters of deflation. One month before that reading, the price of Brent crude had reached $140 per barrel, which underscores an important characteristic of consumer surveys: they tend to reflect not the weighted average price of the basket the consumer actually encounters (financial services and healthcare costs are often hidden, for example). Instead they overweight the most salient items, which in the United States’ car-friendly culture, is often the price of gasoline at the pump. With that noted, the University of Michigan survey in April ticked a 9-year high of 3.4% as gas prices rose on average from under $2.00 a year ago to over $3.00 today. Amid the current climate of rejuvenated global demand and unprecedented OPEC production discipline, these fuel prices will surely be further tested; however, they too will likely moderate by the end of the year.
The risk of self-fulfilling inflation loops is most acute when consumers feel the pinch. Their buying habits, their wage bargaining, and their social interactions determine the psychology underlying a more permanent change in the inflation regime. Right now aggregate expectations are probably where the Fed wants them to be—implying a rapid recovery from a very deep crisis, but remaining anchored close to 2% and showing little sign of significant second-round effects. If the tether stretches further—for example if 4% appears baked into to investors’ or economists’ forecasts for any length of time, the Fed will need to emphasize that it stands ready to reel in its stimulus. This will cause some degree of disruption in stock and bond markets. Many markets are not priced to easily digest a sudden policy shift. This is a near-term risk for investors.
Some clients have asked us if we see a risk of 1970’s style, double-digit inflation. It’s hard to know what can set off such a cycle of positive reinforcing feedbacks, though we refer such questions to our work from last year contrasting the current environment to previous episodes of inflation. To summarize our views, current monetary conditions, expansive as they are, are not alone sufficient to trigger high levels of inflation. Loose monetary policy would need to work in concert with elevated private demand, major supply shocks, tight labor markets, a structural lack of adjustment mechanisms (e.g. substitute goods), and sustained commitments to fiscal spending. While the fiscal center of gravity appears to be shifting away from the deficit hawks, both in Europe and America, the term “sustained” is important. In order to run government demand consistently ahead of supply so as to set off a mechanism of self-reinforcing price rises, governments must seem ready to spend more every year. As long as “stimmie” checks are seen as temporary pandemic relief, their influence is probably short-lived.
Balancing the policy impulse are secular forces that have held down inflation for decades. Among them are the famous three “D’s”: debt, demography, and disruption. We and others have written about these forces before so we won’t elaborate much here. Debt service crimps spending; aging demographics slow productivity gains while inequality lowers aggregate spending; technological disruption results in falling equipment costs and more comparison shopping. Some of these factors may be going into reverse; it is worth thinking about that aging societies will likely draw down savings to spend more on less productive, more inflation-sensitive items like medicine and old-age care. This consumption shift could be inflationary rather than disinflationary. Furthermore, the pandemic has sent globalized supply chains into regional consolidation and has helped fuel shortages (such as for semiconductors, silicon wafers, or the nickel, copper, lithium, and rare-earth minerals that go into much of the “clean” tech needed for decarbonization). For a change, these shortfalls may send the prices of high-tech capital goods up, not down. But near-shoring supply chains and reversing inequality take time, and many of the dislocations caused by Covid-19 will fade. Higher inflation seems probable, but the weight of recent evidence cautions that some disinflationary anchors remain.
So, our answer to the question of if 10%+ inflation is in the cards is “not likely”. That does not mean something scarier than the scenarios outlined above cannot happen. Credible estimates suggest that much higher inflation than is currently estimated are possible. We view a large inflation surprise in 2022 or later as a tail risk. Not a base case, but worth preparing for nevertheless. At the start of this essay we asked two questions: “will it last?” and “what should we do?” Our answer to the former is that inflation is likely to moderate throughout the year as the acceleration of the reopening shifts to deceleration, but that inflation will likely remain above its recent averages for some time. A period of even higher, mid-single-digit inflation rates is an outside risk. This leads to the question of “what should we do?” How do we protect portfolios for a more inflationary future?
Conventional wisdom holds that equities and real estate are good “hedges” of inflation. Stock prices tend to rise with inflation as they are essentially bundles of discounted real earnings. Real estate
High equity valuations have been rationalized in terms of comparisons to bond yields. The trouble is that bond yields appear artificially squeezed by emergency policy. If that policy needs to be reversed earlier or faster than the stock market has anticipated, P/E ratios have lots of room to fall. When compared to the main risk fixed income investors face— inflation—stock market multiples are pricing in, shall we say, heroic rates of earnings growth (or a very abrupt end to inflation). In fact, when Morgan Stanley strategists computed the equity risk premium (the expected return on stocks minus the risk free rate) using inflation break-evens rather than the 10-year Treasury yield, they found it about matched the lowest on record3. That is, the excess compensation derived by equity investors for the risk they take beyond what the could fairly be expected for government bonds is as small as any time since the 1990s tech bubble.
Of unique concern to stock investors today is the ability of busin
One interesting feature of the current recovery that we briefly mentioned above is the high amount of corporate investment that seems to be accompanying it. Perhaps business leaders are responding to expectations of major investments in infrastructure and social safety nets by governments, and the level of demand that will guarantee. Perhaps the mood and the time horizons of chief executives have shifted over the course of the pandemic. Either way, two graphs from Morgan Stanley and the Economist illustrate that capex is running much higher than in previous cycles. The technology sector has often been a leader in investment; this time capital spending is showing more breadth.
What are the implications of an investment- rather than a consumer-led recovery? One is that companies might see lower cash-flow margins in future, though perhaps higher rates of revenue growth. From a macroeconomic perspective, more investment implies GDP growth,
Of course, if stocks and bonds can both fall together, investors will want to consider real assets. We have long been champions of real estate, though with interest rates poised to rise, location and management value-add become even more important. The ability to push through rent increases will be concentrated among the owners of the most in-demand properties. Real (physical) assets such as farmland, timberland, power, transportation and shipping comprise another category, usually called “infrastructure”, which serves a similar function to real estate in providing steady cash income as well as diversifying equity market risk.
There are of course such things as commodities—an asset class some readers may find it strange we have neglected thus far to mention. Our view has been that investments with little or negative intrinsic yield should be used sparingly, foremost as hedges or diversifiers in a balanced portfolio. Over time, through periods of high and low inflation, equity and equity-like investments have been key to growing wealth. Commodities are subject to volatile swings of supply and demand, requiring that investors who place large bets have unique macroeconomic insight or short-term trading prowess. Commodities and currencies can serve as a portfolio hedge, though hedging efficiently and at the right time, takes tremendous skill. Therefore we champion portfolios that seek inflation protection largely through well diversified equity holdings and to limit such macro bets to a small portion of total assets.
We have taken 4,000 words and two dozen charts to make a number of rather simple points. Inflation is running higher as a consequence of an extremely robust economic recovery. That recovery has been aided by substantial policy stimulus, and is increasingly broad based. It is natural to expect some bottlenecks and traffic jams. Asset price volatility always ensues when investors digest rapid change. At present, there is every reason to trust the Federal Reserve when it expects that a period of high inflation will be transitory. But as supply pressures diminish the economy will transit to regime of more fiscal support, a less aggressive monetary reaction function, and perhaps more investment and less inequality. These are generally developments to be welcomed, but which also augur inflation rates higher than those to which we have become accustomed. If policymakers avoid a significant error, and if a major supply shock (likely in the form of industrial and agricultural commodity prices) can be avoided it should be possible to keep inflation expectations contained. With inflation forecast to run a bit hot and then to moderate throughout 2022 and 2023, the Fed may see itself sitting in a sweet spot. Over the next several years, most signs point to inflation moderately but not dramatically greater than two percent. This is a consummation devoutly to be wished. The sweet spot could turn into a hot seat in the span of a quarter or two, and policymakers will need to act to reassure markets. We will prepare for the risks of something worse, and steer clear of assets (for example long-term bonds and mega-growth story stocks) priced for perfection. And we will watch inflation indicators closely as data come in throughout the year. On the whole, however, while cautious around inflation expectations, we view the medium-term outlook fairly optimistically.
1 J.P. Morgan Economic Research, “Global Data Watch.” Research Report. May 21, 2021.
2 “CAGR” = Compound Annual Growth Rate.
3 Morgan Stanley Equity Strategy, “Weekly Warm-up: Supply Shortages Abound; Stick with Quality as Market Narrows Further.” Research Report. May 10, 2021.