Jon Burckett-St. Laurent, Senior Portfolio Manager
Over the last few weeks, financial media have featured a string of pundits predicting inflation. Indeed, inflation expectations and nominal rates have both risen sharply over the last few months, taking markets by surprise, and leading to an acceleration of the ongoing rotation out of large-cap/growth/tech stocks and into small-caps / value / cyclical. As an increasing percentage of the population are vaccinated, workplaces reopen and the global economy begins to normalize, we will undoubtedly see an uptick in most measures of inflation as we will be comparing current levels to the depths of the crisis last year. Further, the shift from heavy reliance on monetary stimulus or “quantitative easing” towards greater use of fiscal policy via stimulus checks, proposed infrastructure spending, mortgage forbearance, and other measures may well lead to an increase in consumption and economic activity. Ongoing supply-chain issues and bottlenecks could compound this post-Covid reflationary boom. Investors have begun to worry whether debt-fueled government spending and “free money” could lead to a sustained rise in inflation or worse a hyperinflationary scenario where purchasing power is rapidly lost.
The risk of hyperinflation or even sustained inflation above 2% remains low at present. Since the Global Financial Crisis, the world economy has been mired in a prolonged period of low economic growth and recurring bouts of deflation. Despite the huge pileup of debt, inflation has consistently undershot estimates for over a decade. The velocity of money has declined, and bank lending has stagnated, offsetting the increase in the money supply. There are several causes for this phenomenon including government policy, demographics, globalization, technology, and income inequality. The current period of rising rates and inflation is best viewed now as a “return to normal” rather than a definite change of regime. Indeed, the Fed’s view is that inflationary pressures that crop up over the next few months will be transitory.
Household balance sheets on average are in excellent shape due to the combined impact of the fiscal stimulus along with decreased spending during Covid lockdowns. There is a risk that the large size of the latest stimulus package plus future government spending will compound with a surge in consumption as people exit lockdown and begin to spend some portion of their accumulated savings. Inflation is caused as much by aggregate consumers’ expectations and decisions about delaying or accelerating spending as it is by government policy, so there is a risk of a sea-change. After 30 years of steadily declining interest rates, we may have seen the low. However, it is also possible that the reflation narrative may be running ahead of reality.
In general, consumers tend to save windfalls or gains seen as temporary, such as those stemming from stimulus checks. Indeed, recent surveys suggest that a large proportion of the upcoming distributions will be channeled directly into financial assets rather than real-world consumption. It is rising wages and employment that tend to lead to sustained inflation, and thus far the recovery has been uneven. The USA has weathered the Covid storm remarkably well, but Europe and other regions are further behind in their recovery. As we do not exist in a vacuum, low growth and low-interest rates elsewhere in the world should help to keep a lid on the trajectory of inflation. Should the rise in rates begin to get out of hand, the Fed may implement a policy such as Operation Twist 3.0, extending the maturity of the securities they purchase to prevent a rapid rise in long-term rates.
Investors who heed the latest market narrative, make drastic changes to their portfolios, and go “all-in” on small-caps, cyclical sectors or value-focused funds at this stage could find themselves disappointed. Momentum-based strategies have begun to pick up an increasing weight to these groups after chasing SPACs, EV stocks, and social media darlings over the last few months, to disastrous results. Unusually low starting valuations in certain sectors provide a wonderful tailwind, so there could be fuel left in the tank. Nonetheless, performance-chasing has repeatedly landed investors in hot water and a better approach is to maintain a well-diversified portfolio and rebalance it assiduously as asset prices shift relative to one another. Investors with a growth or tech focus need not despair and purge their portfolios. Both consumers and businesses alike have in the last few years shifted their spending away from physical goods, plants, and equipment and towards tech, software, and services. Should the economic recovery continue to gain momentum, the same market leaders of the last few years may well be among the prime beneficiaries.
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