Are Inflation Worries Inflated?
Inflation was at the top of investors’ minds for much of February as they tried to parse inflation expectations and its impact on their portfolios. Equities capped off an otherwise strong month with rising volatility in the last week as 10-Year Treasury yields rose swiftly. Stoked by news of shortages of semiconductors, scrap metal, and lumber, investors began to wonder if meaningful inflation was finally back.
Official numbers from the government tell a different story and suggest a far more benign environment. The Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) remained well below the Fed’s 2.0% inflation target. Federal Reserve Chairman Jerome Powell testified last week that it could take more than three years for inflation to reach its target. For that reason, according to the Fed, inflation is not a near-term problem.
Where’s the disconnect?
There is a difference between short-term reflation and longer-term inflation. As the economy restarts, some materials are in short supply as manufacturers race to catch up on lagging production. At the outset of the recovery, we may experience transitory price increases, but they are unlikely to be sustained.
Take lumber, for example. As housing and remodeling boomed throughout the pandemic, producers were unable to keep up with demand causing the price of lumber to soar. Longer-term, however, these higher prices are only justifiable under two circumstances:
- Demand for homebuilding/remodeling continues at the elevated pace of the last year, and
- Supply cannot ramp up to meet the increased demand.
Neither seems likely. While many households traded their vacation for a new deck last year, few will make this tradeoff once virus-containment measures are relaxed. The second assumption is similarly flawed. Lumber supply contracted in 2020 as public health officials’ stay-at-home orders reduced productivity and management anticipated declining demand. There’s little reason to doubt that they will not ramp production back to pre-pandemic levels in 2021 and beyond.
For investors, it is essential to focus on longer-term trends at a macro level. This explains why CPI is one of the most widely tracked measures of inflation in the economy. The CPI measures the change in prices paid by urban consumers for a market basket of consumer goods and services, including food, housing, energy, and commodities. CPI is designed to track the average prices of goods and services most used by consumers, over time. The cost of personal residences, which tend to be relatively stable over the long-term, at a national level, drives one-third of CPI. Other inputs can be more volatile but are relatively smaller in impact.
As would be expected, the largest drags on inflation last year were energy, transportation (including airfare), and recreational services (including sporting and entertainment venue tickets). While each of those may rebound in 2021, their small weights are unlikely to drive broader economic inflation.
Source: Bureau of Labor and Statistics
While CPI can be a decent gauge of overall inflation in the economy, it is less helpful in determining the effect of rising prices for an individual household. Its criticisms include:
- CPI doesn’t adjust for easy substitutions. For example, when the price of pasta goes up, some households may switch to rice.
- CPI lags innovation. For example, the government ignored the price of mobile phones until 1998, after more than 55 million Americans had one. Similarly, “video discs” are still included in the measure.
- CPI is city-centered. While there has been a broad trend toward urbanization in the US over the last several decades, the impact of COVID on remote work may slow or even reverse the move to cities.
The Fed’s preferred inflation measure, PCE, attempts to solve some of these issues. However, there will likely always be a mismatch between an individual’s inflation experience and inflation for the broader economy. For example, those planning to remodel their home or add a deck are certainly feeling the rise in lumber prices. For other households, lower transportation costs drove their personal inflation rate lower. For homeowners with no intention of moving anytime soon, home price inflation has had a positive impact by inflating their net worth. For this reason, we sometimes use different inflation assumptions when developing targeted strategies toward goals like education where the broad inflation measure may be less meaningful.
Impact on the Market
As we saw in February, inflation concerns influence investor behavior. When market participants expect rising inflation, they demand higher yields from their bond portfolios (driving prices lower). Similarly, they begin to evaluate non-income-producing assets more skeptically – from secular growth stocks, to gold and cryptocurrencies.
Rising rates can also signal strength in the broader economy. Over the last several months, we’ve seen equity investors begin to look toward sectors that are leveraged to economic growth, such as smaller companies, financial firms, and energy stocks. However, we caution clients against treating these moves as a zero-sum game by going all-in to perceived winners. Indeed, even after considering this month’s rapid increase, rates have a long way to go before normalizing, and may continue supporting elevated valuations in technology stocks.
Looking forward, we expect economic growth to be more balanced than we experienced throughout most of the last decade. We recommend that investors balance their portfolios accordingly.