What to make of the inflation debate
There are some signs that pressures may be easing. Are markets listening?
Our Top Market Takeaways for May 28, 2021.
Markets in a minute
The inflation debate continues to rage. This week, Larry Summers, the Director of the National Economic Council under President Obama, warned that “inflation risk is real” in a Washington Post op-ed. We agree with Mr. Summers that price pressures are present right now, but we are less concerned that the Federal Reserve will have to abruptly pivot to prevent an overheating economy.
There are some tentative signs that inflationary pressures could be easing. Recent data releases from the housing market, such as new and existing home sales, housing starts and building permits, have all disappointed relative to expectations. If the housing market comes off the boil, it would ease some inflationary fears. Further, the backlog of ships waiting to offload goods at the Port of Los Angeles/Long Beach has been cut in half from peaks in February, and the golf clubs I ordered in March are getting delivered next week! We expect these supply chain issues to continue to be resolved as the economy normalizes.
Markets could be noticing. Corn prices are down 10% from recent highs, and lumber prices are down over 20%. Five-year inflation breakevens, which tell you where the bond market thinks inflation will average over the next five years, are below their highs and unchanged from early March. What are the best-performing S&P 500 equity sectors since the hottest consumer price inflation data release in a decade? Communication services and information technology, which had previously been labeled by most investors (including us) as places to avoid if inflation surprises to the upside. Perhaps most importantly, short-term interest rate futures suggest almost no chance of a rate hike next summer, and have priced out around 25 basis points of hikes for the summer of 2023.
Our view is that inflation is peaking in the near term. However, inflation through this cycle will probably be stronger than inflation during the last cycle. This has important implications for equity portfolios (balancing “growth” stocks with “cyclical” and “value” stocks, and the U.S. markets with other regions). It also argues for allocating to real assets such as infrastructure and real estate, holding an underweight to core fixed income relative to other asset classes, a short duration stance within fixed income, and locking out longer-term interest rates on the liability side of your balance sheet.
We wouldn’t worry too much about inflation. One of the goals of our industry is to achieve returns that exceed inflation so that wealth maintains its purchasing power. The best way to protect against inflation is to get invested. Our view is for a relatively more inflationary environment, but not one that will disrupt the economy or markets either by itself or because it entices the Fed to raise interest rates. There are important implications for portfolios, but staying in excess cash is probably the worst thing you can do.
Fun for the weekend
The Memorial Day Stock Index
Memorial Day is on Monday, and we wanted to take the opportunity to thank the men and women who have sacrificed their lives in service of our country. As we enjoy the first few days of summer this weekend, we’ll take pause for a moment of gratitude for those who have served.
Last year, when Memorial Day looked very different, given COVID-19 restrictions, we created an index that tracks home improvement stores, boat makers, cooler purveyors, RV companies and brewers. It had been outperforming at the time, and it gave us solace that we could still enjoy some of the summer activities we loved even while being cautious about COVID.
Well, some things change: Memorial Day will be much more social this year. But some things stay the same: Our “Memorial Day” index has continued to outperform.
Here’s to a bright summer.
All market and economic data as of May 2021 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.
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