Inflation is an insidious enemy to mission-oriented investors because it chips away at the value of investments, acting as a kind of silent tax, reducing the value of grants, programs, and operating budgets. Inflation also typically leads to higher interest rates in the longer run, which in turn creates a headwind in terms of generating real portfolio returns.
Because of inflation’s important implications for financial markets, investors tend to keep a close eye on it. Unfortunately, inflation expectations are a constantly moving target, making them quite challenging to predict from both short and long-term perspectives. As we noted in our 2021 Capital Markets Forecast, there are a number of factors in play that could push inflation higher over the next decade, including supportive fiscal and monetary policies, pressures on global trade, and costs associated with our response to climate change. Conversely, there are secular factors in play that should keep inflation in check, including changing demographics, technology innovations, and a challenging employment environment.
When we shorten our focus to 2021, there is a ripe environment for debate about the future direction of inflation informed by the many policy scenarios at the fore.
Inflation hawks point to the $1.9 trillion support package on tap from a newly Democrat-controlled Washington. The proposed package contains an extension of enhanced unemployment insurance benefits, rental assistance, increases in food stamps and other forms of hunger relief, and childcare tax credits. Additionally, the proposal includes small business support to prevent bankruptcies and more private-sector layoffs, help for municipalities to alleviate the need for public sector layoffs, support for safe school re-openings, vaccine and protective equipment distribution, and an increase in the federal minimum wage.
The overall package looks to us more of a “relief” bill than a “stimulus” bill since it lacks explicit efforts to stimulate the economy. Ideally, it will be effectively targeted to those who need help to avoid financial hardship, though some are concerned that at least some of this funding will end up in financial markets in the form of savings and investment, as happened with previous COVID relief packages. Because the proposal is geared towards minimizing household and business losses, as opposed to stimulating new investment, we do not expect to see significant inflationary pressure on the economy at large should the package pass.
It is possible that infrastructure investment and other fiscal packages may be proposed later this year with a more stimulative orientation. Whether those will be concerning from an inflation standpoint will depend on their specific characteristics. We have not seen specific proposals yet, though the new administration seems interested to fund major projects such as high-speed rail and a major transformation of our national energy strategy away from fossil fuels. We will be watching any such initiatives carefully for their overall potential impacts on the economy, both positive and negative; for now, however, we are not prepared to speculate that they will bring unwelcome inflationary pressure to the economy.
Inflation hawks also can point to a recent rise in commodity prices as evidence for rising inflationary pressure. Commodity prices would normally indicate or presage whether the global economy is expanding or contracting. While it is true that commodity prices have risen sharply since a multi-year low point in April of 2020, we note that prices have for the moment simply returned to the lower end of a trading range that goes back to the mid-1970’s. We believe that the recent rise in commodity prices is simply an acknowledgement that the global economy did not contract in 2020 as much as people feared it was going to last Spring in the early stages of the pandemic.
Another important barometer of inflation is the 10-year US Treasury Note. Yields on the 10-year note have also risen of late, but again, not to a level that we would consider problematic. The current yield (as of February 16, 2021) sits at 1.29%, still well below the rate of 1.58% we observed one year ago, a level which was not overly concerning from an inflationary standpoint back then before the pandemic slowed the already tepid global economy.
We note that TIPS (Treasury Inflation Protected Securities) have been pricing in higher inflation expectations lately as well. That said, we have found over the past 20 years that TIPS tend to go through cycles of under and over-pricing inflation, which can make them a fine tactical investment, but not an inherently efficient predictor of inflation.
Breakeven inflation expectations based on TIPS are currently in the range of 2.25%. Much of the recent rise in inflation expectations is due to a 7.4% bounce in gasoline prices in January, which is not likely to be sustainable. The Consumer Price Index as a whole was up only 0.3% in January and sits just 1.4% higher than a year ago.
Those less concerned about inflation in the near term would also note that the recent unemployment report from January showed a tepid job market, with job growth of only 49,000. The unemployment rate remains elevated at 6.3%, with 10 million jobs still not replaced since the start of the pandemic. The employment recovery appears to be stalled.
Of additional ongoing concern in the employment market is the high number of long-term unemployed, which is still rising. We believe that inflationary pressure will remain contained in the face of this level of slack in the labor market.
Successful management of the pandemic is widely seen as a key to successfully re-starting the economy. Much of the recent concern about inflation is predicated on the assumption that with vaccines now available, the economy will experience a surge based on returns to full employment and pent-up demand for some of the most damaged sectors of the economy including tourism, restaurants, hospitality, and entertainment.
While we are optimistic that economic growth will be relatively strong in 2021, we’d be more comfortable expressing higher inflation expectations if consumer confidence figures overall were stronger than they are today.
A sustainable “return to normal” will require a smooth rollout of vaccine delivery to the population at large, high percentages of the population willing to take the vaccine when it is made available to them, and successful protection against new “variants” of COVID-19.
Any hiccups in this process hopefully will be mere speedbumps in our recovery. Consumer confidence figures have improved marginally of late, but not enough to be concerning to us from an inflationary perspective, yet.
In the event that inflation pressures become observable in the data, we expect the Federal Reserve to follow up on their recent commitment to err on the side of caution for an extended period before acting to raise rates to stem inflation. As for now, the data does not indicate observable long run inflationary pressure significantly above the Fed’s long-term inflation target of 2%.
While we believe that the economy will continue to recover in 2021 and that certain sectors will have a chance to excel in the current environment, we also note some caution based on a potentially uneven recovery, ongoing geo-political risks, and a divided political environment. Either way, we do not see inflation becoming such a corrosive force that it requires changes in investment strategy. In a world with many socio-economic issues about which to be concerned, inflation does not rise to the top.