Markets in a minute: 5 takes on inflation

This week we had markets reacting to an infrastructure investment bill that passed through Congress, world leaders re-affirmed their commitment to climate change mitigation at COP26, and stocks linked to the Metaverse (or an extension of the physical world into 3-D virtual environments) surged. In China, policymakers paved the way toward an historic third term for President Xi Jinping, while Alibaba’s Singles Day generated record sales. Of course, it wouldn’t be a week in financial markets without some drama from Tesla, and Rivian (a new rival in the electric vehicle space) surged to a $100 billion valuation after its initial public offering (IPO). The company is now the world’s second most valuable automaker.

But all of that was drowned out by the inflation data that was released on Wednesday. We have been writing about inflation all year, but here are five updated takes that hopefully can add some context to the debate.

[1] Any way you slice it, inflation is running hot.

October data showed that consumer prices in the United States rose at a 6.2% pace relative to last year, the fastest pace in 30 years. Food prices are 5% higher than they were last year. Used car prices are up 26%. Energy prices are up 30%. Shelter, one of the most critical sub-categories, has rapidly recovered to its pre-COVID 3.5% pace. The gains are broad based, and seem to be accelerating. Compared to last month, the median component is up almost 60 basis points, the highest reading back to 1983.

[2] Inflation is high because of friction between a booming economy and a continuing pandemic.

The pandemic changed the composition of consumer spending. U.S. consumer spending on goods is more than $700 billion above pre-pandemic trend while spending on services is still $300 billion below pre-pandemic trend. The economy, and especially supply chains, are not equipped to handle this level of spending on goods. The result: price inflation for goods is running at an over 8% pace while services inflation is just 3%.      

[3] Inflation has its costs, but right now they aren’t damaging the broad economy.

Rising prices pressure all spenders, especially those with low disposable incomes. However, only focusing on rising prices ignores important context. Over the last year, the economy has added almost 5.5 million private sector jobs. Aggregate earnings are up 4% annualized over the last two years versus prices up 3.7%. Retail sales are 15% higher than they were a year ago.

Yes, gasoline prices have soared to $3.40 per gallon relative to just $2.10 one year ago. But gas was also $3.40 per gallon in 2014, when incomes were 25% lower than they are now. The only sector that is seeing any demand destruction because of soaring prices and shortages is automobiles.

Economy wide corporate profits (before tax) are 16% higher. S&P 500 profit margins actually expanded in the third quarter despite expectations for a decline. Input and labor costs are surging, but so are sales. For now, inflation just comes with the territory of a booming economy, and a lower inflation environment would likely also be characterized by a weaker labor market and a more tepid jobs recovery.

[4] Markets are looking through it.

There are compelling reasons why stock markets are still close to all-time highs. Third quarter earnings surprised to the upside, global supply chain pressures seem to be getting better, not worse (Vietnamese factory operations are normalizing and shipping costs are falling), and onerous corporate tax hikes seem increasingly unlikely.

Bond markets are a little more stressed, but given the circumstances, they have been relatively tame. Two-year bond yields have moved up by about 30 basis points since the start of October because investors are starting to think that the Federal Reserve will start raising rates soon in an effort to deal with inflation. Meanwhile, 10-year Treasury bonds are yielding just over 1.5%. Why so low? Simply, because bond markets think that this surge in inflation will be temporary. Longer run inflation expectations are still well below where they were from 2000-2014. 

[5] Inflation isn’t the risk to equity markets. The policy response to inflation is.

Inflation has been strong all year and risk assets have hardly blinked. The mega cap tech sector was often cited as the one that was most at risk during an inflationary environment. The Nasdaq 100 is up over 25% this year.

What could change the picture is if the Federal Reserve makes an abrupt turn toward hawkish policy. And we don’t mean something like accelerating the pace of tapering asset purchases. We mean something like what happened in 1994, when the Fed raised rates by 300 basis points cumulatively because they thought they needed to act quickly to snuff out inflation. Even though corporate earnings grew around 20% that year, equity markets ended flat because cash got more and more attractive.

Another longer term risk is that the discourse around inflation is inherently political. Surging inflation now could make it less likely that policymakers opt for powerful fiscal stimulus during future downturns, which could delay economic recovery and be harmful for stocks.

We have outlined our forward looking view of inflation many times this year (most recently last week). The key is that a shift of spending from goods and back towards services, along with expanding labor supply as the pandemic fades, should mean that inflation is declining towards the Fed’s target in the middle of next year, when they will be deciding whether or not they need to raise rates.

For now, we believe that we are in for a strong growth, higher inflation economy. Stocks should keep benefitting, especially relative to bonds and cash.   

All market data from Bloomberg Finance L.P., 11/11/21.