As the economy begins to open up, inflation has begun to rear its ugly head. In this commentary, we will highlight why inflation is bad, and why we think that even though inflation pressures will persist, we do not see a return to the large inflationary pressures seen in the 1970’s. We will also discuss how we believe the current round of high inflation is likely to be transitory before returning to a more normal level. Lastly, we will also examine why we think the market will continue to be volatile, but can continue to move higher even though asset prices are at high valuation levels.
Just as a refresher, inflation results when demand exceeds supply in the economy. Inflation has historically been viewed negatively because it raises prices while reducing the standard of living as people need to earn more to consume the same. Inflation also acts as a wealth tax on savings, since savings lose their purchasing power during periods of inflation. Historically, the most favored way of the Federal Reserve Bank to fight inflation is to raise interest rates. By raising interest rates, the cost to consume goods (for example, cars or homes), increases as borrowing costs rise. This in turn causes consumers to consume less and prices eventually fall.
Raising interest rates act as a double hit to the stock market because as sales fall, so do profits. Not only this, as interest rates rise, savings accounts look more attractive, causing investors to more likely place their savings in a bank earning at a guaranteed rate of return, rather than the riskier stock market. So, when rates rise, stock prices tend to fall as earnings of the companies fall, and investors are willing to pay less for stocks because they can earn guaranteed rates of returns from a bank instead. Inflation reports have Wall Street’s attention as news of rising inflation has caused the Dow Jones to lose over 1,500 points in both May and June of this year, followed by quick rallies as subsequent news suggest inflation may only be transitory.
In some regards, rising inflation is to be expected. When the COVID-19 pandemic began, prices collapsed for many goods and services as the economy was shut down. Consumer spending dropped when many stores were closed and savings rates rose dramatically. Moreover, numerous government stimulus programs were put into effect, including several direct check deposits to large segments of the population. This led to a situation where once COVID-19 restrictions were lifted, consumers found themselves in a better cash position than when they entered COVID-19. In fact, YCHARTS (an institutional research firm) estimates that bank deposits are over $1.34 trillion higher in April of this year than they were in April 2020. At the same time, consumers have been pent up in their homes waiting for the chance to get out and start doing things again. So naturally, in April of this year, retail sales showed a 17.9% gain over where they had been in February 2020, pre-COVID. To put this in perspective, that is the fastest gain for any 14-month period since 1978-79 (U.S. Commerce Department). Keep in mind that in 1978, the American economy had double digit inflation, so on a real apple-to-apple comparison the retail sales growth was the strongest in percentage terms since World War II. This current surge in demand has caused a spike in prices throughout the economy as the economy has opened up, but supply chains and production are not fully back up and running.
From a national perspective, this looks to be a timing issue. The total nonfarm payroll labor force was 144.9 million people in May 2021, still down 7.6 million people from February 2020, right before the COVID shutdowns (U.S. Department of Labor). So, demand is way up, but employment is not back yet. This is causing production and capacity delays, which in turn is causing inflation. Throughout the rest of the year, we expect many of those unemployed to reenter the workforce, which will increase production and capacity to meet demand. In addition, we expect that as government programs wind down, demand will go back to more normal levels as consumers “free money from the government” comes to an end.
There are several reasons for why the workforce employment has not returned to pre-pandemic levels, even though the Help Wanted Index is at the highest level in over a decade. First, the federal government is giving a $300 extra weekly benefit to unemployed people in addition to their regular benefits due to COVID-19. Unfortunately, this means that many lower paid employees are actually making more money, or similar amounts as they would be making than if they actually had a job. So, many employees have decided not to work. This program is scheduled to end at the end of September, so this should help businesses later in the year. Twenty-one states have already cancelled the extra government stimulus money, and those states have seen their employment levels rise.
Next, many schools and child care centers remain closed, or are only partially open. This prevents many parents from reentering the workforce. Surveys also show that many workers are afraid to reenter the workforce over fears of contracting COVID-19. As the economy reopens, and as COVID-19 cases continue their downward trend, these constraints should alleviate.
Finally, there is a mismatch between where the jobs are located and where the workers are living. The Wall Street Journal reported that several states that did well during COVID-19, like Idaho, Montana, Utah, Maine, Vermont, Wyoming, Texas and the South, saw an increase in migration and are experiencing higher demand for all goods, but don’t have the labor force, while other areas that were harder hit like Los Angeles and New York, have the labor but not the jobs as they are further behind the reopening curve.[1] In time, this too should self-correct.
The items spiking the most in the CPI (Consumer Price Index) report also lend weight to the argument that the spike in inflation we are seeing will be transitory. According to Liz Ann Sonders, Schwab’s Chief Market Strategist, “52% of the May CPI increase was from used car sales, rental cars, car insurance, lodging, airfare, and food away from home”.[2] These are precisely the industries most affected by COVID-19, and support the notion that as the post impulse buys of COVID-19 fade, and as employees return to work, inflation growth will slow down. Indeed, with new car production slowed due to semiconductor shortages, it only makes sense that people are buying up used vehicles. Once chip foundries can ramp up to meet demand, those prices will fall, and airfares will normalize as airline fleets are returned to service. Rising commodity prices will also likely return to more normal levels for the same reasons. Also encouraging is that all but two of the regional Federal Reserve Banks (Dallas and Philadelphia) saw a downtick in prices in June.
[1] Eric Morath and Stephanie Stamm, Wall Street Journal, “Why It’s So Hard to Fill Jobs in Certain States” May 29, 2021 [2] Liz Ann Sonders, Charles Schwab Chief Market Strategist, “Pressure Drop, Easing Inflation Pressures Ahead” June 28, 2021
As the economy reopens, and people go back to work, some supply issues will naturally course correct. This is already starting to happen with lumber prices, which saw some of the largest jumps in prices this year, as prices went from $775 per 1,000 board feet at the end of 2020 to $1,670.50 in May 2021, an increase of 118% increase in 5 months. Prices have since retreated to $764 in July 2021, but this is still almost double the long-term pre-COVID-19 price. However, the trend and direction of prices still seems to move closer to normal. According to Samuel Burman, Assistant Commodities Economist at Capital Economics, "High prevailing prices have already encouraged lumber mills to boost output, and we anticipate that domestic production will rise even further as labor shortages in the trucking and forestry sector dissipate.”[3] In addition, Samuel notes that the housing industry has curtailed new starts in response to the spiking prices that he estimates added $36,000 to the cost of a new home in May. Demand for lumber is also weakened as the economy is starting to reopen and consumers would rather go on vacation in the summer than do a construction project. So, higher prices are already starting to reduce demand and increase supply. It is also interesting to note that it appears the lumber executives do not believe the high prices of lumber are sustainable either as executives at the large timber firm Weyerhaeuser sold $14.6 million worth of company shares last quarter, the most since the third quarter of 2016, according to InsiderScore, and lumber executives from PotlatchDeltic sold $12.1 million during that time, the most since InsiderScore began keeping track in 2003.
[1] Samuel Burman, Assistant Commodities Economist at Capital Economist, Timberrrrrrrr June 23, 2021
Share Buy Backs and Large Cash Levels Should Help Stock Prices
We expect that as the economy continues to reopen, that earnings will continue to increase to above pre-COVID levels, which should support stock prices. Moreover, due to the expansionary fiscal and monetary policies of the U.S. Government, companies and investors are awash with cash. Ultra-low interest rates have allowed companies to refinance debt to lower interest cost, which has increased cash flow. This increased cash flow is causing companies to increase their stock repurchases to planned record levels, after relatively low buybacks last year.
Investors are also sitting on large levels of cash as measured by money market fund asset levels. Traditionally, money market funds have been a good predictor of future stock prices. High levels of cash means that the money will be invested, and usually that bodes well for positive stock returns as investors look to get better returns on their money. Conversely, low levels of cash usually forecast poor returns as investors are already invested, and are likely to be sellers as normal cash needs arise. The biggest spikes in money market levels usually occur near market bottoms which can be seen in the early 2000’s Tech Bubble, the Financial Crises, and COVID-19 outbreak.
In conclusion, we think the current bout of higher inflation will subside as the year progresses and as the labor force and economy continues to fully reopen. That does not mean prices will come crashing back down in a disinflationary spiral, but rather we do not see the forces for a sustained hyperinflation. In fact, we see inflation at higher levels going forward than it has been in the past few years, but not as high as the last few months. We continue to see increased volatility in the markets as prices are currently at high levels, and the market is pricing in a lot of good news. Any bad news on inflation or earnings will likely cause a quick market sell-off like we saw in the Dow Jones in early May and again in June. However, we think that as the economy picks up speed, earnings will continue to grow. Moreover, we believe that the large amount of cash in money market funds and increasing share buy backs by companies will support stock prices as long as the Federal Reserve continues to keep interest rates near historic low levels. As a result, we continue to think the best course of action is continuing to focus on large capitalization, brand name companies who are not only returning cash to investors, but who are also providing goods and services that consumers need on a daily basis.
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