By Tim Courtney, Chief Investment Officer
According to this week’s Labor Department report, the Consumer Price Index (CPI) jumped 0.5% in July (on top of a 0.9% increase in June) and is up 5.4% over the last year.1 Back-to-back high readings have been followed by a yawn from markets2, with interest rates actually slightly lower than they were two months ago.3
Many strategists and economists, and more importantly the Federal Reserve, believe this surge is caused by transitory factors and will soon fade.4 While that certainly could happen, it is also fair to note that the Fed has widely underestimated 2021 inflation ― even their updated higher estimates undershot actual inflation.5
At least part of this inflation is being driven by near-term shortages in disparate goods, such as chicken, chlorine, steel, computer chips, cars and even McDonald’s paper bags. However, even if inflation does recede, many economists estimate it will be higher than the 1.7% level we’ve become accustomed to over the last decade.6 This could be exacerbated by a housing crunch, labor shortages, and lots of spending and stimulus flowing through the economy.
This inflation risk is being exacerbated by historically low interest rates. Low rates are great for borrowers looking to refinance debt, but coupled with higher inflation, they are creating a difficult environment with no margin for safety for fixed income investors. Even assuming no defaults, a wide swath of debt investments have negative real yields.
Low interest rates could be telling us to prepare for future growth and inflation so anemic that it rivals the Great Depression. The only 10-year periods with CPI inflation lower than the recent 10-year Treasury yield of 1.25% all occurred during the Depression.7
Another possibility (which we think is more likely) is that current interest rates are not properly accounting for inflation.8 It is difficult to “fight the Fed” while they continue to buy large amounts of bonds each month and help to keep rates lower than they otherwise would be. The basic investor goal of earning a real return (which is becoming increasingly difficult) differs from the Federal Reserve’s set of goals.
We also should note that low rates plus higher inflation is one way to deal with a large debt burden. Receipts to the Treasury reached a record in the first quarter of 2021 and should be helped higher by inflation in future quarters9 while spending on interest is relatively quite low.
Thankfully, stocks and real assets have historically had better success in dealing with elevated levels of inflation.10 Should this persist, we believe a well-diversified portfolio including weights to materials producers and other sectors that could benefit from inflation may be appropriate. If you have any questions about assets or inflation’s effect on your portfolio, please contact your Exencial advisor.
1. Bureau of Labor Statistics (8/11/21) – CPI for all items rises 0.5% in July
2. Yahoo! Finance (7/13/21 – 8/13/21) – S&P 500
3. MarketWatch (6/13/21 – 8/13/21) – U.S. 10 Year Treasury Note
4. The Associated (6/22/21) – Press Fed’s Powell says high inflation temporary, will ‘wane’
5. The Wall Street Journal (7/28/21) – The Federal Reserve’s big inflation miss
6. The Wall Street Journal (7/11/21) – Higher inflation is here to stay for years, economists forecast
7. CPI, DFA Returns 2.0 (12/31/20)
8. MarketWatch (7/18/21) – Does the bond market have it wrong about inflation?
9. St. Louis Fed FRED Data (3/31/21) – Federal Government current tax receipts
10. Investopedia (5/26/21) – 9 assets for protection against inflation
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 9.9 trillion indexed or benchmarked to the index, with indexed assets comprising approximately USD 3.4 trillion of this total. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
The 10-year Treasury note is a debt obligation issued by the United States government with a
maturity of 10 years upon initial issuance. A 10-year Treasury note pays interest at a fixed rate
once every six months and pays the face value to the holder at maturity. The U.S. government
partially funds itself by issuing 10-year Treasury notes.
The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living. The CPI is one of the most frequently used statistics for identifying periods of inflation or deflation.
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