Inflation is one of the biggest long-term threats to wealth generation.
That’s why, for investors, the rise in inflation since February is getting such headlines. As reported last Thursday, core inflation hit an annualized 3.8% in May. That’s the highest in nearly thirty years. It’s also well above the Federal Reserve’s long-term policy target of 2%.
After showing concern during the spring, markets largely shrugged at the headline. The Federal Reserve has been saying for months that rising inflation is temporary, and investors for the moment appear to agree.
Are investors correct? Or is inflation likely to continue to ramp?
EXECUTIVE SUMMARY: OUR KEY MESSAGES
Our own view continues to be:
- Inflation will likely peak this summer but moderate later this year.
- Re-opening combined with historic stimulus are likely to drive higher rates over time.
- Moderate inflation of 3%-4% is most likely over the next few years. Bond markets generally support this view; labor and supplier markets are less clear. We will continue to monitor.
- We would not chase “over-priced” inflation-sensitive investments currently; we would capitalize on better buying opportunities if they emerge later this year.
This note will put the current headlines in broader perspective.
For more on our view of inflation, rising rates, and investment opportunities, see our March Report.
BOND MARKETS: NOT DEEPLY WORRIED ABOUT INFLATION
Bond markets tend to be less speculative than stocks or commodities, so it’s often a good place to start for insight into more consistent expectations about the economy and inflation.
Bond markets are not yet particularly alarmed about the long-term inflation outlook:
- Raising some eyebrows, expected inflation increased rapidly this spring, spiking to its highest point in mid-May. The two-year outlook hit 3.0%, and the five-year nearly 2.8%. The concern was not with the numbers themselves, but with the pace of change from 1.0-1.3% in November.
- Importantly, even with their rise, these inflation expectations fall well below currently reported inflation levels. Whether looking two years, five years, or even ten years out, bond investors evidently don’t expect sustained inflation to match current spikes.
- Note also that the further out you go in bond maturities, the lower the expectations for inflation. If bond holders feared inflation, we would expect to see a ramping in those implied rates over time, not a decline.
- Interestingly, expectations at each year have dropped a bit over the past three weeks, pointing to a possible respite. They are 2.7% and 2.4% for the two-year and five-year, respectively, at June 12.
Similarly, looking at the broader economic outlook, bond investors have been optimistic about the economy, with manageable inflation. Since last fall, the yield curve has generally been steepening. In March, the yield curve hit its steepest point (optimism) in over five years. This is healthy, as long as long-term yields aren’t spiking.
SIDE-BAR COMMENT: Recent Noise in the Bond Market?
Since March, the yield curve has actually dropped a bit, with a faster decline in the past few weeks. This is usually interpreted as a more cautious view about economic growth ahead. Bond yields move down as prices move up, meaning investors are buying long-term bonds.
Has optimism softened, or is there a retreat in the inflation outlook of around 3% in 2022?
We think the decline may be overstated. There is likely some noise in these near-term trends:
- With the run up in stocks, large pension plans may be forced to buy long-term Treasury bonds to lock-in gains and rebalance to allocation targets.
- Plus, some traders made negative bets on the Treasury market, expecting the Fed to raise rates earlier than expected. If the Fed is “winning” the argument that inflation is indeed temporary, those traders may be forced to close those trades, buying long-term Treasury Bonds to limit losses.
All-in, we think bond investors continue to expect recovery to continue, with inflation under control.
WAGES, PRICES, AND SENTIMENT CALL FOR GREATER CONCERN?
It’s well reported in the financial press that consumer prices are up. As the Fed will argue, many are expected to be temporary.
- Prices for air travel, food, hotels, furniture and used cars, for example, are up an annualized 10% or more.
- These sectors were devastated during the pandemic. Surging demand, combined with a cut-back in supply during COVID, is indeed driving prices up.
- Importantly, most prices are still below pre-pandemic levels. Price comparisons later this year should become more reasonable by simple math, and as supply chain shortages improve.
Of greater concern, however: labor markets are tight.
- Some of this may reflect temporary influences (stimulus checks, fear of contagion until vaccinations reach critical mass, challenges with childcare in the summer, etc.). These should reverse as vaccines continue, schools re-open, and government support rolls off.
- Still, employers in retail and certain small businesses are having to raise wages to fill jobs. Wage inflation is at its highest quarterly rate in 18 years, according to the Bureau of Labor Statistics.
- In addition, surveys of businesses show greater concern about the rising cost of inputs to produce goods and services. Commodities, transportation, and labor are all costing more, forcing suppliers to consider raising prices.
THE RISK: EMBEDDED EXPECTATIONS ABOUT INFLATION
The risk to the Fed’s outlook for 2021 is that with higher costs of inputs, a commitment to higher prices tends to stick.
A recent study illustrates this effect (Exhibit). In recent history, as enough firms change prices (the orange line), the core CPI inflation indicator (the yellow line) tends to follow about six months later. The forecast shown in this exhibit stays within reasonable bounds, but the risk is apparent.
It becomes all about expectations, which is difficult to forecast. It could create a self-fulfilling cycle:
- If more and more businesses raise prices, and those prices stay elevated to cover costs, it may be difficult to unwind those commitments.
- If consumers start expecting prices to be higher in the future, they may rush to buy goods and services today, potentially chasing the market.
- This consumer-supplier dynamic creates momentum in higher prices.
Before wrapping this point, we point out that many forces are at work to push or reduce inflation. A major constraint on higher inflation is better productivity. Over the past twenty years, productivity gains due to more global markets and technological innovation have arguably helped keep inflation low. Sustained productivity gains would help keep inflation moderate.
Exhibit: Price Trends and Core Inflation (CPI)
Source: Wall Street Journal and a variety of studies as listed.
We continue to think yields and inflation may ebb and flow as markets digest the pace of re-opening—perhaps creating some fear and confusion—but we don’t expect sustained excessive levels over the next 12 months.
Key developments to monitor this summer are the pace of recovery, pricing trends in supplier inputs, the roll-off of government stimulus programs, and hiring activity in the labor market.
Longer-term issues of government debt levels, deficits, and excess liquidity should become more and more important over time, in our view. We will be monitoring developments closely, as we believe they represent longer-term risk to inflation and rising rates.
Investors—whether in stocks, bonds, commodities, etc.—try to anticipate the future of the economy. Stocks and commodities can be more speculative, introducing excessive noise and volatility. Bonds can show speculation too, but we believe bond markets to be a more reliable indicator of economic outlook. The difficult caveat: even in bonds, predictions arguably get very hazy beyond 12-18 months.
We measure expected inflation in bond markets by comparing yields on Treasury Inflation-Protected Securities to standard Treasury securities for various periods (e.g., two-years, five-years, ten-years out). The different in yields indicates implied inflation expectations.
A steepening yield curve occurs as long-term yields move higher at a faster rate than short-term yields. It tends to represent that investors are more comfortable taking risk longer-term.