In our 2021 outlook we talked about preparing for inflation in the back of 2021, and this month the anticipated spike in inflation occurred. Five year breakeven inflation breakeven rates are at their highest level since the 2008 financial crisis, CPI is on the rise, and consumers are feeling the impact of higher goods/services costs. The question is no longer “if” inflation will arrive- instead, it’s how long will it last.
Fed Chair Powell remains adamant that the recent pick-up in inflation is temporary, and that as supply and production bottlenecks loosen into year-end inflation will fall closer to its 2% target. However, expectations matter as well and despite the Fed’s commentary investors continue to expect inflation to pick-up. This dynamic could create a catch-22 scenario with expectations of inflation actually leading to higher inflation.
Which leads to the next question of how long inflation could last. We see evidence that the recent spike in inflation is not transitory, and will last into 2022. Specifically, we think many of the temporary pandemic driven spikes in prices (e.g. auto, housing, food) are likely to have longer-term impacts given, 1) prolonged “ramp-ups” to normalization, and 2) stickiness of many consumer good price hikes. Furthermore, we see additional market events (wage growth, consumer spending) providing further catalysts for higher inflation going forward.
Below we provide thoughts on the drivers of inflation, their potential impact going forward, and the impact of inflation on investment portfolios.
1. Energy (i.e. oil) prices are rebounding and driving inflation, but these headwinds are likely to soften by the end of the year
Oil production scaled back during the COVID shutdown, and now between OPEC+ production cuts and physical supply constraints in the US (e.g. Colonial pipeline hack) oil prices are likely to remain under pressure. Although excluded from core CPI and inflation metrics, higher energy prices are one of the key areas consumers feel the effects of inflation and therefore drive inflation sentiment. While much of the increase right now will likely normalize as production ramps back up and demand imbalances stabilize, in the near-term we think higher energy costs could persist.
2. Spiking raw material prices are driving up input costs to businesses and are starting to get passed on to consumers.
The recent ISM survey indicated that manufacturers have seen average prices paid for inputs jump to levels not experienced since pre-2008. Higher prices are usually able to be absorbed by businesses over short periods of time, but persistently high input cost rises end up getting passed on to customers, which we are starting to see reflected in higher selling prices.
3. Small business average selling prices are on the rise as input costs rise
Persistently higher input costs have reached the point where they can no longer be absorbed by business owners. As the recent NFIB survey indicates, businesses are starting to pass along the higher cost of inputs to customers. In our view these “temporary” spikes in pricing are likely to persist over the intermediate term; while areas such as new car prices should reset as bottlenecks improve, other areas such as housing and food may take longer. In fact, historically spikes in selling prices tend to be sticky, with a macro catalyst (e.g. recession) required to bring them back down.
4. Production bottlenecks are likely to persist into year-end, further adding to price inflation pressures
Consumer goods consumption never declined during the COVID shutdown as government stimulus checks drove consumers to continue spending on durable goods, even as services sector demand (and consumption) plummeted. As the economy reopens factories are working overtime to fill the backlogs caused from persistent consumer demand and limited operational ability during COVID.
Given these dynamics we think supply bottlenecks will persist as factories work to ramp back up, replace inventory, and meet new demand from consumers. And with ongoing shortages, consumer prices will likely remain elevated.
5. The impact of higher wages is not yet being reflected in markets and inflationary measures
Labor market shortages (especially in services sector businesses) are driving an acceleration in wage growth as businesses struggle to re-hire workers. As businesses are forced to spend more on salaries and benefits (e.g. the ongoing push to $15/hr minimum wage) we expect some of the cost to be passed on to consumers, adding to overall inflation drivers.
6. Stimulus money is in the hands of the consumer, and further spending may drive higher velocity and lead to inflation (Monetarist Theory)
Monetarist Theory states that, Money Supply * Velocity (number of times per year the average dollar is spent) = Price of Goods and Services * Quantity of Goods and Services. We think the direct payment of stimulus to consumers, combined with Universal Basic Income (i.e. child tax credit payments) is likely to drive Velocity of Money higher. Given the supply of money is already higher from COVID stimulus, we see this driving upward pressure on the Price of goods and services.
Portfolio Impact: Stretched valuations could start to face reality
On a valuation front, NTM PE multiples have fallen from 23.8 in mid-April to 22.2, but at the same time NTM EPS estimates have risen by nearly 7%, highlighting investors are no longer willing to pay premium multiples.
Growth stock multiples are retracing lower as concerns over rising rates and the end of “cheap money” are weighing on investor optimism. Since inflation started to pick-up the Nasdaq has underperformed the S&P 500 amid investor rotation into more defensive names.
That said, we continue to see opportunity in equities especially as global growth accelerates. However, we suggest re-evaluating factor risk exposures in portfolios, especially to technology and growth names. Real Assets, Infrastructure, and defensive equities can provide inflationary hedges inside portfolios, and with Biden’s proposed infrastructure bill we see additional tailwinds for those assets.
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