Despite a sharp rise in producer prices for February, stocks rose on Friday while interest rates held steady. Investors have figured out that year-over-year comparisons can play tricks if one compares a booming today with a quarantined world a year ago. That will play out again tomorrow when February consumer prices are reported. As we have noted often, a sharp spike in certain commodities is not likely to be long lasting. Thus, investors sloughed off the apparent bad inflation data, and instead concentrated on accelerating growth that could approach 10% in real terms in the U.S. over the coming quarters.
We are in a true goldilocks environment for stocks at the moment. The economy is surging and that means earnings will accelerate. Indeed, with revenues rising at a much faster than expected pace, most companies will gain operating leverage and achieve even faster earnings growth. All this is occurring while the Federal Reserve continues to buy $120 billion of bonds every month and Congress spends trillions to make the economy move even faster.
Logically, there are no free rides. If there were, Congress could spend trillions more and do away with taxes. But borrowing power isn’t unlimited. Eventually, the laws of supply and demand assert themselves. If demand rises faster than supply persistently, then it would be almost certain that prices would have to rise as well. There is nowhere better to see this happening than in the housing market. Demand is surging while the supply of available homes for sale is at a multi-decade low. The result is higher prices, up 10-15% or more in many markets. Homes that were on the market for months a year or more ago, aching for any bids, now get multiple bids above the asking price within a week of listing. It might seem reasonable that higher prices would bring out more inventory. But sellers need a place to go. To be sure, some will sell and trade down or rent. On the other hand, higher prices are bringing out more buyers. While flipping new homes hasn’t begun in earnest yet, institutional buyers are reentering the housing market, increasing demand even faster than supply.
With that said, inflation doesn’t suddenly erupt. Since the early 1950s there have been two bond cycles. The first started after the Korean War and lasted until the early 1980s. As the baby boomer generation developed (the peak birth year was 1953), inflation and bond yields gradually rose. While the White House and Federal Reserve made occasional efforts to tighten money supply and bring down rates, most efforts were too modest to stop the gradual rise in inflation. Not until Paul Volcker took over the reins at the Fed and crushed inflation did the upcycle end. In the eighties, Volcker’s fiscal partner became Ronald Reagan who introduced us to supply side economics. The net result was a surge in asset prices from 1982 to 2000 with only a brief interruption in 1987. Interest rates continued to fall after Reagan, before reaching what seems to have been a bottom during the pandemic last year. That suggests we are at the cusp of a third cycle, one where rates gradually rise again. But as noted, unlike equity cycles, bond cycles are very long. Inflation rates don’t change overnight. The upcycle that began in the 1950s lasted about a quarter century. The down cycle that followed lasted close to 30 years. Over that great span, earnings, not interest rates, had the dominating impact on stock prices.
If you are looking for inflation, look in two places that matter most. Rents and wages. The costs related to shelter are over a third of the CPI (Consumer Price Index). The cost of a home is not a component of the index. A home is considered an asset purchase, not an expense. Rents or imputed rents are the predominant factor in the CPI. Recently, rents have been stable in many areas while falling in urban centers. There have been recent signs of stability. Certainly, over time, higher home prices will lead to higher rents. But not so far.
Wages are the key input costs. Wage rate increases can be offset by productivity gains. Thus, unit labor costs are more pertinent than wages themselves. But accelerating wages will cause inflation to rise. So far, we haven’t seen much of an increase. But if demand continues to surge, wage rates are certain to follow. There are still close to 8 million fewer Americans working today than before the pandemic. But our economy is likely to add at least 7 million jobs over the next year. Some labor markets are already tight. Others will tighten soon.
At the start of the year, I said that I felt the first half of 2021 would be better for equity investors than the second half. That doesn’t mean stocks have to fall later this year. But it does mean that as the year progresses, the rate of earnings increases will start to slow down while the pressures of inflation will weigh on interest rates. The 10-year Treasury yield has stalled momentarily in the 1.65-1.70% range. But as inflation becomes more evident, even if only modest, rates will rise further. Today’s Treasury yields remain negative in real terms, due to the persistent purchase of bonds by central banks around the world. Fed Chair Jerome Powell has said that the Fed is unlikely to raise rates this year. It may not raise them next year either. But the Fed can’t control the long end of the curve. It will continue to rise, and eventually bond yields will turn positive in real terms. Bond swaps and TIPS spreads suggest that inflation expectations over the next decade center around 2.4%, the highest in many years. Either those expectations are off base and the market is wrong, or Treasury yields are too low. Most, including myself, feel the market is right.
As noted often, 2021 is a battle between higher earnings and higher rates. We are on the cusp of another earnings season, one that should be outstanding. Earnings expectations will rise faster than interest rates. That suggests more upside for stocks. But there will come a time when expectations won’t continue to rise at an accelerated pace and inflation worries increase. They don’t have to increase much. The directional move is what is important. Thus, the second half of 2021 should be a bit bumpier. It doesn’t mean stocks will fall, although they might. It simply means the headwinds of inflation are going to increase, while at some point the tailwind of earnings acceleration will slow.
Today, Claire Danes is 42. David Letterman is 74. Ed O’Neill turns 75. Forget Modern Family, he will always be Al Bundy in my eyes.
James M. Meyer, CFA 610-260-2220