Unprecedented liquidity provided by the Fed as well as the significant fiscal stimulus passed to date and the Biden administration’s USD 1.9 trillion rescue plan will all but guarantee that headline inflation will be higher in the coming months.
However, this will be more of a mechanical issue than a secular trend. Investors should ignore the noise, follow the Fed and look through it. Rates will be higher as well, and that’s a good thing.
Higher rates imply that Covid is being brought under control, that the economy is reopening, confidence is growing and as a result money will cost more. What’s wrong with that? Consider the alternative: Covid beats the vaccines, lockdowns persist, confidence is lost, deflation and negative UST rates beckon – is that preferable? Of course not.
In our view, the key to investment success in the coming six months is simply this – ignore the inflation/higher rate debate.
There are two important backstories investors need to appreciate when thinking about the US political and economic framework over the coming months and years. The first is that the US and the globe are entering an economic boom the likes of which have not been seen since the 1970s. This will lead to a bear market in long duration US Treasuries, which has not been seen in roughly 40 years. In other words, virtually no one investing today has any experience in the world we are entering into.
Secondly the US political system is exiting a 40-year regime dating back to Ronald Reagan and his famous quote: “The nine most terrifying words in the English language are: I’m from the Government and I’m here to help”. This mentality culminated in the Trump administration’s raison d’etre: “the deconstruction of the administrative state” which left the US supine before Covid. The Biden Admin takes office at a pivot point; the needs are huge: vaccinations, jobs, climate, inequality while the ability to provide that help has never been cheaper. Citizens are crying out for Govt support: the Rescue Plan has over 80% support in recent polling.
Thus the opportunity to deploy lessons learned in the Obama Admin (where virtually all of Biden’s economic team worked) and go big and fast. Winning the Covid battle and generating a robust economic recovery is both good politics and good economics, setting up the Biden Administration to double the amount of time Democrats have controlled both Houses of Congress (only 4 of past 40 years), by doing better than normal in the 2022 mid-term and 2024 Presidential elections.
Amidst these sea changes, it’s important to note the fact that while inflation will run hot in the next few months this does not suggest the US is going from a disinflationary (not deflation) to an inflationary environment. Yes, inflation is almost certain to rise, due mainly to how the Covid-inspired economic collapse led to negative rates of inflation from last March through May. As these numbers disappear from the y/y calculations, headline (not core) inflation will rise sharply, likely leading to higher bond yields as well. However, this inflationary burst will be transitory and will likely fade by fall.
Equity bull markets normally end when labor gains pricing power & the Fed raises rates – both seem quite far away. Prior to the Covid-19 pandemic, the US had enjoyed a long economic expansion culminating in record low unemployment and yet inflation failed to reach worrisome levels. With unemployment at roughly 7%, we are likely a couple of years away before labor inflation (what really matters for the Fed) becomes an issue.
We can also count on increased labor participation, as improvements in the economy bring back the long-term unemployed into the jobs market. Finally, structural changes in the labor market should help keep wages in check. Trade unions have lost significant power and the so called Uberization of the work force makes it very difficult for them to organize. A large output gap and the continued digitalization of the economy are further reasons not to expect a rapid and sustained pick up in US inflation.
US households has USD 2.2 trillion more in cash at the end of 3Q20 than at end of 2019, and that number will likely increase as a result of the Biden fiscal plan. As the pandemic recedes and the economy reopens in the spring, people will spend the additional cash after being constrained for a long time. The pent-up demand for travel and entertainment in general will lead to a rise in services inflation, which the Fed will likely see as temporary, especially given that the jobs market will not have fully recovered yet. What could cause the Fed to change course? If supply – demand imbalances become the norm or if higher inflation becomes engrained in people’s expectations the Fed would likely grow concerned.
Core inflation is now running at 1.4%, well below the Fed’s target of 2%. Should headline inflation rise to 3-4% in the coming months – don’t be overly concerned. The Fed has already mentioned asymmetric inflation targeting (AIT), basically telling us that they will allow even core inflation to run above their target for some time. With the world drowning in debt, some inflation is part of the solution. It’s good news for example that the USD 17T global mountain of negative yielding debt seems to have made a double top and even 10 yr. JGBs now offer a positive yield.
Rising inflation and higher US rates are a sign of recovery – a good thing. At TPW Advisory we have a 1.75-2.0% target for the 10 yr. UST at YE. A gradually rising rate structure should not damage either the economy or the stock market. A rate spike would be more worrisome but here one can look to the very large short position in 10 yr. UST futures as suggesting such a spike is unlikely. It’s more likely that recent market action will continue – better vaccination news, a gradual reopening, higher stock prices and gradually rising rates together. Remember though that rising rates are kryptonite for Big Tech which facilitates the Great Rotation to non-US equity, Cyclical, Value, & Small Cap leadership.
Keep calm and carry on
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