Have we reached peak economy?

Roger Montgomery

Montgomery Investment Management

As world economies start to bounce back after their COVID-19 lockdowns, inflation is back on the agenda. US Federal Reserve Chairman, Jerome Powell, thinks the current spike is transitory. Time will tell if he’s right. But whether it’s transitory or persistent, inflation will impact stock market returns.

Quite simply, persistent inflation will mean central banks will have to apply brakes to their economies. And that means a tapering of the fiscal stimulus, monetary stimulus and low interest rates that have fuelled the stock market boom.

In recent weeks we have talked about an expected jump in inflation as economies reopen, labour is re-employed, and vaccines are rolled out.

Indeed, on 28 April, Fed Chairman Powell commented:

In the United States, fiscal and monetary policy continue to provide strong support.

Vaccinations are now widespread, and the economy is beginning to move ahead with real momentum. During this time of reopening, we are likely to see some upward pressure on prices…But those pressures are likely to be temporary as they are associated with the reopening process. In an episode of one-time price increases, as the economy reopens, is not the same thing as, and is not likely to lead to persistently higher year-over-year inflation into the future – inflation at levels that are not consistent with our goal of 2% inflation over time.”

The anticipated jump is now underway and there are two primary reasons.

The first and most obvious is what’s called the base effect. The typical 12-month measures of inflation will move well above the US Fed’s 2% target over the next few months simply because the very low inflation readings from March and April 2020 drop off the comparison calculations.

Similarly, once these spikes in inflation are compared later, the rising rates of inflation should prove transitory. Deflation is the picture that is then expected to emerge by central bankers.

The second reason we will see a spike in inflation is because of commodity price rises.

Table 1 reveals the spikes in commodity prices since the March 2020 lows as well as the more important changes in prices since compared to the pre-pandemic highs.

Table 1. Commodity price changes are dramatic to 25 February 2021

Of course, these price rises are already being passed on, where possible, by companies. By way of example, we have successfully invested in the shares of push-to-connect plumbing fittings supplier Reliance Worldwide. Many of the company’s products are made of copper and Reliance recently noted it had passed on the rising cost of copper materials to customers.

The pivotal question for inflation watchers is whether these commodity price rises are themselves transitory. The US central bank currently believes so.

Powell believes the spikes in most of these commodity prices is due to “bottlenecks” in the supply chain, as emphasised in his late April Q&A:

… we’re in close touch with all of these industries. You know, the Fed has a network of contacts that is unequalled in businesses and in non-profits for that matter, too. So, what do we mean by a bottleneck? A bottleneck really is a temporary blockage or restriction in the supply chain for a particular good or goods, something that slows down the process of producing goods and delivering them to the market. We think of bottlenecks as things that, in their nature, will be resolved as workers and businesses adapt and we think of them as not calling for a change in monetary policy since they’re temporary and expected to resolve themselves…It’s much harder to predict with confidence the amount of time it will take to resolve the bottlenecks, or for that matter, the temporary effects that they will have on prices in the meantime.”

And that’s the key question. How long will it take for supply chains to resolve the bottlenecks that are constraining supply and delivery? And what of the price of oil? A strong US economy is itself the driver of higher prices. Only another price/production war within and beyond OPEC countries is likely to crimp rising prices. This is not a bottleneck issue and while oil prices are removed from Core Inflation, consumers consider the purchase of gasoline ‘core’ to their daily lives.

Inflation isn't a concern and the economy’s booming

Higher interest rates are anathema to equities, particularly highly-priced profitless companies. And while central banks might hold off raising rates, believing rising rates of inflation to be transitory, the fact is that inflation expectations and concerns that central banks are ‘behind the curve’ are all that is needed for bond rates to rise again.

If bond rates continue to rise, they will act like gravity on the prices of profitless growth equities.

And let’s not forget Powell’s veiled warning: “If, contrary to expectations, inflation were to move persistently and materially above 2% in a manner that threatened to move longer-term inflation expectations materially above 2%, we would use our tools to bring inflation and expectations down to mandate consistent levels.”

To date, the stock market is generally sanguine about inflation and instead has been rising on evidence of both a strong recovery in the economy and in company profits.

Previously unimaginable fiscal and monetary stimulus, pent up demand, and a return to normal social and economic activity, thanks to successful vaccinations, have fuelled strengthening economic data, which in turn has buoyed investors.

What about the economic boom?

In both the US and here in Australia, economic growth and employment forecasts are being comfortably exceeded, spurring economists to further upgrade their forecasts. Since the end of February both US and Australian consensus economic growth forecasts have been upgraded by 1.6 per cent and 0.7 per cent respectively.

In Australia, the Reserve Bank concluded its May policy meeting with rates firmly locked at 0.1 per cent. The RBA also reiterated a hike was unlikely until 2024. More interestingly however, this commitment remains despite our central bank upgrading some of its own economic predictions. The RBA now sees unemployment falling to 4.5% by the end of next year. This is down a one full percentage point from its previous forecast and much closer to full employment.

The end of JobKeeper in Australia was feared by many to be a significant adverse milestone for our economic prospects. But instead, employment grew as the unemployed were forced to take jobs to earn a wage. Of course, there are plenty of jobs, because immigration has virtually ceased. Meanwhile, Australians are unable to spend any of their income overseas, ensuring robust reports from a wide variety of businesses, from building supplies to car dealerships.

Continued economic strength could result in the RBA also upgrading its own forecasts for GDP growth. While the central bank may allay market concerns about inflation’s impact on interest rates, it could nevertheless stop the RBA from rolling its three-year bond target forward beyond April 2024. Indeed, at its latest meeting the RBA said it would decide at its July 2021 meeting whether it would roll over its three-year bond target from the April 2024 tranche to the November 2024 bond.

The end of the RBA’s three-year bond target would coincide with the end of the Term Funding Facility in mid 2021, which has allowed banks to borrow at ultra-low rates for the purposes of lending for mortgages.

Those two events alone may be enough to spell at least the end of the irrational exuberance that is responsible for the profitless prosperity of 2020 and early 2021.

Interestingly, the NASDAQ and the Russell 2000 are each down between 4 and 5% from recent peaks. The Russell 2000 is trading near its most overvalued level on record. While the trailing PE ratio seems reasonable at 21.2-times earnings, the ratio excludes companies with negative earnings. When these companies are included, the index’s trailing earnings are negative.

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Roger Montgomery
Founder and Chairman
Montgomery Investment Management

Roger Montgomery founded Montgomery Investment Management, www.montinvest.com in 2010. Roger has than three decades of experience in investing, financial markets and analysis. Roger also authored the best-selling investment book, Value.able.

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