You’ve most likely heard all the buzzing in the news recently about inflation. Here’s an update to let you know what we’re keeping an eye on and what we believe you can expect.

Will Inflation Be Transitory or Sustained?

This is the big question that the Federal Reserve has been asking: Will recent inflation pressures be transitory in nature (around 6 to 9 months) or is a higher, more sustained inflation regime about to begin? But the Fed isn’t the only one asking that question: You likely are, as well. The macro-economic implications and the impact on your portfolio that the inflation story has will be important to monitor going forward.

The June Consumer Price Index (CPI)—which is the most widely used measure of inflation—came in at a blistering 5.4% YoY, bringing the 6-month annualized rate of change to 7.3%, a level that rivals the 6.8% annualized rate during the 1970s.

We do believe that these extraordinarily hot inflation readings will be transitory in nature for three major reasons:

#1 An Economic Phenomenon Known as the “Base Effect”: Typical of other recessions, the COVID-19 shock that rocked the economy in 2020 was disinflationary in nature, meaning prices dropped from previous year’s levels. Therefore, when you compare 2021 to 2020 prices, YoY readings are artificially inflated due to what is known as the base effect.

An acute example of this phenomenon is airline fares, which dropped 27% in June of 2020 from 2019 levels. In June of 2021, airline fares are up 25% relative to June 2020 levels, but are still down 9% from 2019 levels. As the 2020 data washes out of YoY readings, inflation numbers will, strictly from a mathematical perspective, drop.

#2 Constraints in the Supply Chain: The 2010s were a deflationary environment and a lot of that can be attributed to the globalization of supply chains. While this globalization phenomena helped keep a lid on inflation over the last 10 years, it has been a contributor to the top blowing off recent inflation numbers.

When COVID restrictions forced Taiwan Semiconductor, the manufacturer of more than 60% of microcontrollers used in cars, to reduce capacity, the supply of new cars was constrained due to limited supply of the necessary chips used in production. As a result, consumers turned to used cars which have risen 45% over the last 12 months.

This is certainly not a phenomenon unique to microchips, and as global supply chains recover, we fully expect that supply-demand imbalances should ease and inflation should moderate.

#3 A Return to Normal Consumer Spending Behavior: At the onset of the pandemic retail companies suspended new orders and factories cut manufacturing with the expectation that consumer finances would be hurt, as they have been in previous recessions.

On the contrary, the government more than filled the employment void and consumers— stuck at home and flush with stimulus cash—shifted their spending from services, such as dining out and flying, to goods, like home improvements. This created a massive supply-demand imbalance, which drove the prices of physical goods up.

As the economy has reopened and consumers once again shift from physical goods to services consumption, it has once again created a supply-demand imbalance. One example: There are only so many available seats at sporting events and concerts. We expect that as this pent-up demand and stimulus funds continue to dissipate through the economy, these “COVID-sensitive” sectors will start to look more normal in terms of inflation signals.


Factors Influencing Sustained Inflation

The recent spike in inflation is due to these more cyclical factors, and we expect these factors will subside as we move through the end of 2021 and into 2022. But while this cyclical bounce is expected to end, there are some more structural things at play that could lead to sustained inflation in the 2-4% range.

Here some things we believe may contribute to a more sustained inflation rate above 2%:

Fiscal Stimulus: The 2010s were characterized by fiscal austerity and loose monetary policy. The low interest rates of the 2010s, as we know, did not lead to substantial inflation; rather, this easy money tended to flow into financial assets.

Congress appears to be in the midst of passing a $1T stimulus bill that focuses on domestic infrastructure. Additionally, we expect that the social infrastructure bill, or some variation of the $3.5T currently proposed, is more likely than not to pass via the budget reconciliation process.

This bill will put more hands in the money of consumers, who will then be more likely to spend, which will drive inflation. Unlike the COVID relief spending, these bills are not intended to be a “shot in the arm” and will have a more lasting impact on inflation readings moving forward.

Liquidity: Inflation occurs when there are too many dollars chasing too few goods. At this moment, the U.S. financial system is awash in cash; however, this is sitting in people’s bank accounts or going into financial assets and not being spent on goods and services.

If consumers expect higher inflation to be more sustained, they will spend more now because they know that their dollars will be worth less tomorrow. Consumer expectations for inflation can be somewhat of a self-fulfilling prophecy because of this phenomenon and the amount of liquidity in the financial system raises the risk that spending will shift from purchasing financial assets to goods and services. This has the effect of driving inflation up and asset prices down.

De – Globalization: The globalization of supply chains, as we talked about earlier, has been a contributor to the low inflation environment of the last 10 years. Companies were focused on cheap labor and efficiency in lieu of stability. The COVID crisis shined a bright light on the vulnerability of supply chains, and we expect some of the globalization trends of the last 10 years to reverse as companies focus more on supply chain durability.

Rising Wages: When the pandemic began, service providers furloughed millions of employees and now that the economy has re-opened, many are finding it difficult to bring workers back onto the payroll. In some instances, companies are even offering bonuses for simply showing up to an interview.

What this labor supply-demand mismatch has led to is the fastest two-year annualized wage growth since 1983. Wages represent the largest cost of doing business for most companies. When wages rise, in order to avoid squeezing of profit margins, companies tend to raise prices. Rising wages are especially potent to inflation because as wages rise, so does consumer buying power, increasing the probability that they will simply pay the higher price for a good or service rather than forgo the purchase.

What We Expect to See

Although we expect this 2-4% sustained inflation rate, we by no means expect a stagflation environment of high inflation and slowing economic growth, like the 1970s. The trends of the 2010s that kept inflation muted are likely to reverse some, but they are not going to make a complete 180, in our view.

An inflation rate of 2-4% is consistent with a moderate overshoot of how the GDP is trending and we don’t expect the Federal Reserve to tighten policy as a way to restrict demand if we do see this level of inflation.

From a markets perspective, we expect interest rates to rise as the fears of the Delta variant are alleviated and the bond market begins pricing in more inflation risk. We also expect the dollar to decline, because inflation reduces the buying power of the dollar.

We also expect the dollar to decline, because inflation reduces the buying power of the dollar.

These current views and expectations are subject to change based on changing data.

How We’re Managing Risk

We understand there are abundant risks in the market at this moment and have placed an even greater emphasis on risk management moving through the second half of the year.

  • We favor short-dated bonds as they will be less negatively impacted by rising interest rates.
  • We favor cyclical equities that should perform well while we are in this period of above-trend economic growth.
  • We also favor international equities over domestic at this time due to valuation discounts relative to the U.S. and the added return tailwind provided by the declining U.S. dollar.

We will be watching wage growth very closely over the next year in addition to the impact of the money supply on inflation, as measured by the velocity of money. The Federal Reserve is likely to begin reducing its abundant monetary stimulus in 2022 and we have prepared our portfolios for this to occur.

How can we help you during this time? We’re here to keep you on track to reaching your wealth goals and to provide you with the perspective you need to feel confident in your plan. Contact us to set up an appointment today.