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Strategy Update

The Inflation Debate

The economy has come roaring back to life in 2021.  As a majority of people are vaccinated and states have reopened, the pent-up demand for a variety of goods and services has been so strong that the U.S. now faces shortages.  New and used cars are scarce, lumber has become dramatically more expensive, and semiconductor shortages are balling up global supply chains.  Prices on many products have skyrocketed during this squeeze.  The labor market is veering in a similar direction: employers report labor shortages, and wages are beginning to climb in an effort to attract new workers.  All the economic headlines this year speak to a domestic economy that is recovering strongly, and inflation that is quickly climbing in tandem.  We can see the empirical evidence of inflation in more expensive food, gasoline, or housing, but there is also a strong theoretical rationale for inflation to accelerate.  Even as the United States reopens and economic activity recovers, the Federal Reserve and Congress continue to provide an abundance of financial support through direct payments, tax credits and low interest rates.  Stimulus now exceeds $5 trillion since the pandemic broke out last year.  This assistance was critical for so many last year, and is still needed by some.  But delivering so much money into the economy so quickly can have the undesired effect of creating inflation.

For someone who is shopping for a new house, a new car, or simply buying groceries, none of this will come as noteworthy.  We can see signs of inflation all around us.  Yet something quite unusual, and less obvious, is also taking place.  The bond market, typically the best predictor we have of future inflation expectations, is showing no concern about inflation.  One would expect bond yields to rise alongside high inflation, as they did in this country for most of the 1970s and early 1980s.  Instead, yields on Treasury Bonds have fallen, reaching a level that would typically point to investor concern about a pending recession or deflation.  To understand this, one needs to adopt the mindset of a typical bond investor.  Most long-term bond investors seek a rate of interest over and above an expected future rate of inflation.  If inflation is running high, bond investors will demand a high rate of interest.  If inflation is completely absent (as it has been in Japan for decades now), investors may settle for a minimal rate of interest.  Long-term interest rates tend to swing as inflation expectations change.  So as rates fall now, the simplest explanation is that investors’ estimates around future inflation are falling as well.  

This all makes for a confounding moment, for investors and policymakers alike.  Inflation today is accelerating to levels not seen in a generation.  Yet the bond market, which represents the collective wisdom of many, has been dismissive of this trend, and seems to anticipate a future that is quite the opposite: a return to historically low inflation in future years.  The disconnect between current inflation and bond yields is as wide as it has been in decades.  While one can question this logic, it is most notably defended by Jerome Powell, Chair of the Federal Reserve.  His viewpoint, critical to bond investors, is that despite current inflationary data, the economic recovery is still vulnerable.  Employment levels are below where they should be at this stage of a recovery, new Covid variants threaten further lockdowns, and we should fear dipping back into a recession rather than assume a pronounced and lasting economic recovery.  In taking this position, the Federal Reserve needs to remain committed to supporting the economy through policies that historically have also fostered inflation.  But according to Powell, any price increases we see today are only temporary, while long-term inflation is likely to return to its historically low, pre-pandemic trajectory.  High current inflation and low future expectations, implied by the bond market, are not fully incompatible.  Yet the extent of the dichotomy has shuffled investors and economists into two general camps within a debate around the direction of the economy and inflation.

Current Strategy

At Prentiss Smith & Co, we find ourselves leaning towards the inflationary camp, while taking note of the dangers inherent in contradicting the Federal Reserve or doubting the collective wisdom of the bond market.  The empirical evidence for inflation is compelling, and seems to extend well past the range of goods in short supply.  It is convenient to point to spikes in the prices of lumber and used cars and declare them transitory, but evidence of more modest price increases is nearly everywhere.  Most importantly, we believe that $5 trillion in stimulus and low mortgage rates will continue to fuel price increases for everyday goods and housing for some time to come.  Meanwhile, the Federal Reserve points to lower-than-expected employment data to support the notion that this is a still-fragile economic recovery.  But in a country where the memory of last year is still raw and economic assistance is available, we think there are myriad reasons for temporarily remaining outside of the workforce, even as job opportunities abound.  In this unique moment, we don’t believe higher than expected unemployment is necessarily a sign of economic weakness.  To push ahead with low interest rates as a course to remedy unemployment may offer diminishing returns for the Federal Reserve.  But that approach will help stoke the housing market higher and raise general inflation alongside it.

To be a believer in both a lasting economic expansion and ongoing inflation carries significant investment ramifications.  First and foremost, it suggests that today’s bond market is a poor choice for new investment dollars, as long-dated bonds will lose ground in the face of sustained inflation.  We began buying corporate bonds in the late Spring when rates were significantly higher, but have largely given up on that idea as rates have fallen.  At times cash is the more appealing alternative to longer-dated bonds, and we believe that is the case again now.  Anticipating stronger inflation and economic growth, however, does allow for us to be more optimistic investors in stocks.  We have continued to replace stocks that drove returns higher last year in favor of new investments in companies we think stand to benefit from modest inflation and a longer economic recovery.  For years, investors have crowded into the shares of the largest technology companies, avoiding banks, auto manufacturers, industrial equipment companies, and others.  In a full economic recovery, we believe these companies have both good prospects and attractive share valuations after years of investor neglect.