It's Enough to Make Your Head Spin
Making Sense of Market Gyrations
Recent economic and market developments have caused asset values to change dramatically over the past few weeks. What's going on?
During times of market volatility (rapid changes of asset prices), sometimes it rewards attention to review what we know and don't know, and to take a step back and study the full picture. It's a good time to do so now. We'll start with the inflation picture, which we consider the most compelling and most poorly misunderstood.
Briefly, we've been calling for a long and sustained increase in asset values due to the increase in the money supply and economic activity that is the result of the large scale changes in fiscal and monetary policy implemented by the last two congresses and executive administrations to support the US economy during its year of involuntary hibernation. Fiscal and monetary policy have been expansionary, meaning more spending and more money in circulation than would be appropriate for a typical market economy. Some parts of the developed world are emerging from closure (albeit in fits and starts) to extraordinary consumer demand as consumers pivot from forced austerity to hedonistic spending.
A sudden increase in demand, coupled with pandemic-related supply chain constraints, have contributed to an increase in the general price level. These price increases have been concentrated in parts of the economy--airfare, temporary lodging, used cars, fuel and food--associated with doing things consumers couldn't do for the last year. For that reason, these price increases are most likely, in the Federal Reserve's terminology, "transitory", and are not likely to reflect a sustained increase in the general price level.
But data is one thing, and emotion is another. What drives inflation is Inflation Psychology, or the fear that things will be more expensive in future, which causes consumers to pull into the present consumption that they would otherwise delay. The pulling forward of demand can't be met by a commensurate increase in supply, and so the demand/supply mismatch causes prices to increase. When this occurs over a period of time, it can become a self-reinforcing cycle that can be destructive of wealth and earning power. It is for this reason that fighting inflation is considered to be job no. 1 for Central Banks.
And so, Inflation Psychology is really just a fear of scarcity. Accordingly, price increases in staples like food and fuel tend to have a greater impact than that of more discretionary categories like travel and lodging. As of right now, and despite some media hyperventilation, widespread fear of material scarcity is hard to find. (If data emerge that tell a different story, we will adjust our view accordingly.)
Inflation for the months of March, April and May came in at a .6%, .8% and .6% year-over-year change, respectively, which was the largest sustained increase since 1990. For purposes of comparison, rates of inflation were three-to-four times higher in the mid-1970's. In the long view, while these rates are higher than those observed in recent history, they are first of all coming off of the extreme lows of the prior year of forced shutdowns, second of all expected given the reopening of developed economies, and third of all still quite low compared to history.
As the effects of fiscal stimulus wear off, we expect to see the 1-month percent change to hover around .5%. We'll continue to monitor the Personal Consumption Expenditures Index, the Federal Reserve's preferred measure of inflation, the next read of which is due Friday, June 25th. As you can see in the chart below, the most recent readings show a moderation in the steepness of the change, a trend that we anticipate will continue for the next several months as fiscal stimulus works its way through the economy and consumers slake their initial thirst for extra-domestic adventure.
We anticipate the inflation will continue to increase, although at a more moderate pace, for the remainder of the year. In our opinion the price outlook for inflation-sensitive assets such as inflation-protected and nominal bonds, commodities, equities and real estate remains stable. Should the general price level increase at a rate that exceeds productivity growth, we believe that the Federal Reserve maintains the will and policy tools necessary to curtail rampant inflation, as they have indicated both in prepared congressional remarks as well as other public statements.