Time to reflect and reload

Ronald Temple

Lazard Asset Management

The spike in inflation as the United States has emerged from its COVID-19 lockdowns has hardly come as a surprise. Its magnitude, however, has caused economists and investors to wonder whether the low-inflation environment that has prevailed for a generation has finally come to an end—and what it might mean for markets if it has.

The last time the annual rate of inflation, as measured by the index of core personal consumption expenditures, exceeded 3% was 30 years ago, in 1991. And in the decade since the global financial crisis, the rate of inflation has fallen too low, as evidenced by lower rates of real economic growth (Exhibit 1).

Exhibit 1: A Generation without Inflation

As of 30 April 2021

Source: FRED Federal Reserve Database, Haver Analytics

The price of durable goods—cars, homes, washing machines, and the like—kept inflation anchored. Durables prices have stayed about where they landed in the mid-1980s, having peaked in 1996 and declined ever since. The cost of services such as dining out and travel has driven what inflation there has been, rising at a 3.1% annualised rate (Exhibit 2).

Exhibit 2: Goods Stagnation Keeps Services Inflation in Check

As of May 2021

Source: Federal Reserve Bank

Blast from the Past

The pandemic reversed the generation-long experience. As of 30 April, the annual inflation rate of goods accounted for the lion’s share of the hefty overall increase, running more than twice that of services: 7.36% against 3.06%. It figures. Services were mostly not an option during the pandemic, with the possible exception of home delivery. At the same time, a homebound populace stocked up on goods just as factories around the world were going offline due to lockdowns. In other words, the world of goods experienced a simultaneous negative supply shock and a positive demand shock—a classic recipe for inflation.

The unprecedented nature of the past 18 months thus explains much of the inflationary surge. Just how much only the course of the economy over time will tell, but we contend that it accounts for a great deal and that its inflationary impact will fade. Start with base effects. A recovery rebounding from a slump will rack up sizable year-over-year percentage gains—bigger, in fact, than the losses, since the gains are building onto a lower base.

Consensus consumer price index forecasts allowed for such base effects but still failed to anticipate the magnitude of inflation, falling short of the actual outcome in April by 0.6% and in May by 0.3%. The increases were not spread evenly through the economy, however. In fact, we traced much of the overall increase in the two months to three items included in the index: airfares, auto insurance, and used cars (Exhibit 3).

Exhibit 3: Anatomy of an Anomaly

As of 31 May 2021

Source: Federal Reserve Bank

Airfares and auto insurance should go down as prime examples of the post-pandemic power of base effects. At the pandemic’s height in 2020, airlines slashed fares to fill seats and keep planes in the air. But ticket prices soared to pre-pandemic levels and higher as soon as long-grounded passengers felt safe to fly once more. Auto insurance prices, which fell along with miles driven, followed a similar pattern, shooting up as states and localities lifted restrictions. In both cases, we believe prices have either normalised or are close to doing so—provided, in the case of airlines, that jet fuel prices don’t take off.

The increase in used car prices responds in part to that same urge to hit the road, just as the earlier decline reflected the glut in supply when the large auto rental agencies dumped fleets idled by COVID-19 on the market. The used car supply-demand balance may take longer to restore, however, since a shortage of automotive semiconductors lies behind it. The shortage had its origins in the trade hostilities dating back to 2018 between the United States and China, which the pandemic disruptions aggravated. It appears now that the semiconductor supply is coming back and should normalize during 2022.

Beyond Base Effects

The semiconductor shortage highlights the supply-side distortions that are adding to inflationary pressure beyond base effects. The uneven emergence from COVID-19 massively disrupted the flow of raw materials and basic assemblies to Chinese manufacturers and finished goods back to the rest of the world. China opened up and, reacting to the locked-down world’s increased demand for goods, began exporting even as factories and mines elsewhere remained shut. The discrepancy made for shortages up and down the global supply chain and boosted shipping costs as vessels loaded with goods from China had no cargos to cover the expense of the return journey.

Weighing still more heavily in the inflationary calculus is the massive federal relief undertaken to counteract the pandemic’s economic impact. It has amounted to 26% of the entire US GDP since the pandemic’s onset or about 2.5 times the amount of relief provided during the global financial crisis. Among other things, the relief has more than restored household balance sheets with households accumulating over US$2 trillion of excess savings relative to typical levels (Exhibit 4).

Exhibit 4: Priming the Recovery Pump

As of 31 March 2021

Source: Congressional Budget Office, IMF

Expect a substantial chunk of that savings to fuel the demand for out-of-home leisure activities that has built up during the lockdowns. The government will sustain a large portion of its support, and therefore that component of inflation, beyond the transient impact of the lockdowns’ end. Washington will be providing a substantial per child tax credit for two-worker households earning as much as US$150,000 a year. And the infrastructure program currently being hashed out in Congress, we believe, should inject a substantial and enduring stimulus into the economy, no matter what form it finally takes (Exhibit 5).

Exhibit 5: Stimulus Calendar

As of 15 June 2021

Source: American Rescue Plan, Biden Proposal for American Jobs Plan, CNBC, White House May 2021

Wages as the Wild Card

While other cost-of-living components have contributed to structural inflations of the past, wage pressures have been a constant. The economic recovery from COVID-19 will almost certainly involve a hefty increase in employment—in the third and fourth quarters, we estimate, as a growing majority of the labour force becomes vaccinated. Whether this return to work occurs as we expect may well hold the key to how long the current bout of inflation will last and how strong it will be.

At the moment, the labour market is suffering from severe distortions. The official unemployment rate comes in at 5.8%, but adding in people who have temporarily left the workforce for COVID-19 related reasons, such as the need to care for children whose schools have shut down, we get a "real” unemployment rate of 8.6%, a level that compares with the height of the global financial crisis (Exhibit 6).

Exhibit 6: US Unemployment Rate (U3)

As of May 2021

Official unemployment rate accounts for people who are out of work and looking for a job. In April and May 2020, the Bureau of Labor Statistics classified workers that reported being employed, but not at work as “employed.” Had they been classified as unemployed, the unemployment rate would have been 4.8ppts higher in April and 3ppts higher in May. This decreased to <0.5ppts for August–October. The adjusted unemployment rate treats the fall in labour market participation as an unemployed proportion of the total working-age people.
Source: Department of Labor, Haver Analytics

Yet even while unemployment persists, companies have posted a record number of job openings. We attribute this to the simple fact that it is easier to lay off entire groups of workers in a sudden and unexpected downturn than it is to hire the workers back one by one as the recovery starts to pick up. Erstwhile employees may have found other jobs, and new hires may require extensive training to become as productive as the old guard.

Mapping the Mind of the Market

The accelerating recovery, the massive fiscal injections into the economy, and the Federal Reserve’s new flexible average inflation targeting policy framework have obviously had an impact on market expectations and performance, although the exact nature of that impact is still very much in question. Inflation expectations reflected in the breakeven yields of nominal Treasury securities and Treasury Inflation-Protected Securities rose sharply to the middle of May. Since then they have come down a bit as the market debates whether the Fed might fall behind the inflationary curve or slow the recovery as collateral damage in an attempt to tap the brakes on inflation. We believe, to the contrary, that the Fed will let annual inflation run above 2% this year and next in order to restore economic growth to its long-term trend.

If inflation does remain above the Fed’s 2% target through 2022 and then stabilizes at or slightly above 2% thereafter, this would still mark a major turning point for interest rates. The yield on the US 10-year Treasury is highly unlikely to remain around 1.5% if inflation is sustained at or above 2%. A more probable 10-year yield in such a scenario would be 2.5%–3.0%, a significant increase from current levels. Importantly, this jump in long-term rates is not contingent on the Fed "losing control” of inflation. It is contingent on the Fed actually achieving its inflation objective, an outcome that has eluded the central bank for over a decade.

As interest rate dynamics change, so too do equity market dynamics. Starting last fall, with news of effective vaccines, and running into this May, long-ignored value stocks outperformed their growth counterparts, the stars of the past decade. The recent uncertainty about the Fed’s true inflation tolerance has restrained the value rally, but we believe it may herald the dawn of a new market regime for several reasons:

  • The broad-based economic recovery taking shape has given investors seeking companies that can generate growth in both revenues and profits more options.
  • The disparity could become untenable between the nosebleed valuations of the tech companies, which anticipate earnings growth far in the future and have been market favourites for some time, and the bargain-basement valuations of more cyclical companies able to generate solid profits now.
  • Fixed income yield curves have steepened across the globe as central banks continue their accommodation at the short end and inflation jitters deter investors at the long end. Equity discount rates have begun to rise alongside long yields. This works against the valuations of growth stocks dependent on future profitability relative to companies delivering solid profits now.

A recovery that revives value stocks would not come as an unalloyed blessing for fixed income. If the Fed tolerates an elevated level of inflation, as we anticipate, rates will rise and Treasury securities will face the prospect of significant capital loss. Countering that trend to some extent, corporate credit should gain in a growing economy, giving investors a less unattractive income alternative until government debt regains its footing.

As for alternatives to the two major asset classes, commodities have rallied and figure to stay strong in a robust recovery while the unsettled real estate market may present a value opportunity. It has traditionally offered a reliable inflation hedge, and the commercial sector, beaten down but poised to benefit from office and retail re-openings, may well come back. Finally, while private equity has become a crowded asset class, the controversy around special purpose acquisition companies—SPACs—may offer an attractive alternative to that alternative, especially through PIPEs, or private investments in public equity. These vehicles allow investors to conduct deep due diligence on proposed SPAC acquisitions in return for funding that allows a SPAC to complete the acquisition and take a company public.

A Time to Reflect and (Maybe) Reload

All in all, it remains an open question whether the current bout of inflation is merely a glitch response to pent-up demand and the sorting-out of a disrupted supply chain, or whether it will persist and usher out the low-inflation environment to which the markets have long grown accustomed. What is clear with the end of the COVID-19 pandemic in sight is that elevated inflation and economic growth for at least the next two to three years is the likely result in our view. That prospect alone calls for investors to revisit their portfolio allocations sooner rather than later, with an eye toward fortifying inflation defences and capitalising on the opportunities inflation can present.

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Ronald Temple
Chief Market Strategist
Lazard Asset Management

Ronald Temple is the Chief Market Strategist for Lazard’s Financial Advisory and Asset Management businesses. In this role, Ron provides macroeconomic and market perspectives to Lazard’s investment teams on a firmwide basis and works closely with...

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