Stocks rose slightly yesterday in a mixed session. Tech stocks continued to exhibit weakness as investors continued to rotate into more cyclical names, a sign of optimism about the economy.
Over the past several months I have viewed looking forward as a clash between the tailwind of rising earnings versus the headwinds of rising inflation expectations and interest rates. The improved earnings outlook is based on an expectation that the current Covid-19 surge will run its course over the next month or so, and that vaccines will accelerate herd immunity. I am reasonably confident in the accuracy of that statement, but the slope and timing of that improvement are open to some debate.
As for inflation expectations, waiting for inflation to kick in has been akin to waiting for Godot. For almost 40 years, it has yet to appear. In the interim, we have witnessed recessions, a financial crisis, an Internet bubble on Wall Street, several valuation-related crashes in the stock market, and a boom/bust in the housing market. Yet over that entire period, inflation has rarely reached 2%.
The reasons are clear. For four decades we have experienced a steady drop in capacity utilization rates and declines in monetary velocity. Everyone learns in Economics 101 that when supply overwhelms demand, the result is price weakness. Over much of that period, and certainly over the past decade, central banks around the world have undertaken policies that overwhelm financial markets with liquidity. With so much excess physical capacity, pricing power has persistently stayed in the buyer’s hands. The invention of the Internet has enhanced price discovery, giving buyers even greater advantages.
The Fed wants inflation of about 2%. It is there around the edges. Commodity prices are spiking in many places, including lumber, copper, and oil. But commodity input prices, overall, are a small part of input costs. By far, the biggest component is labor. Thanks to the pandemic, there are few labor shortages, certainly not enough to push wages higher in any meaningful way. With over 700,000 unemployment claims still being filed every week, more than 3 times the level pre-pandemic, wage pressures aren’t going to rise very soon.
Squelching inflation is painful but not that difficult. If the Fed raises the cost of money enough, economic activity slows and demand drops. Less demand ultimately means lower prices. But the Fed has less power to create demand. It can make borrowing costs zero, but it can’t make you borrow. Think of the toilet paper scare this past spring. Once supply caught up with demand, was there a need to buy two more 36-roll packages at Costco? Once you have a year’s supply stuffed into every nook and cranny of your closets, what incentive do you have to buy more? With so much of our economy shut down, why would you buy a new suit or an evening gown? That expensive vacation is on hiatus. In short, as long as the pandemic is with us, demand is going to be curtailed and inflation will remain absent.
But suppose the virus starts to disappear by summer. Suppose we all rush to the airport at the same time, or otherwise catch up on what we have been missing for months. Sure, there will be a surge and there could be a short-term spike in some prices as a result. But soon we will get back to normal, a new normal. More working from home. Less business travel. Plenty of empty retail space. Inflation will show up, but only in isolation. Housing prices are rising and that may be one economic sector where inflation appears. Millennials moving from cities to suburbs will buy cars, but there is plenty of car building capacity to meet demand. Technology will continue to drive down unit costs. That will allow profits to rise even if prices don’t, the ultimate secret to keeping inflation at bay.
Of course, if the Fed continues to add money to the system robustly, eventually it will create inflation. Indeed, that appears to be its tactic. When the pandemic hit and economic activity froze, the Fed and Congress stepped in to provide both liquidity and a safety net. But the worst of last spring isn’t being replicated today, even as the virus surges to new heights. Soon this surge will end, and the Fed will still be pumping money. When will it stop? Chairman Powell has already told us. It will stop when it sees inflation persistently above 2%. That is unlikely to happen this year. We could see signs by the end of the year, or it could wait until next year. Or the year after.
Waiting for Godot can be very unsatisfying economically. You don’t make a dime sitting and waiting. You watch the world go by and don’t participate. Perhaps the better answer is to go on with your daily life while keeping one eye open waiting for Godot (or inflation) to appear.
For investors that means watching the bond market. We have seen an uptick in rates over the last several months, and some acceleration in recent weeks. But that acceleration seems to be losing steam. While our rates are super low, they are actually higher than in the rest of the world. If U.S. rates rise too quickly, more money will flow into our markets, creating a headwind for future increases.
Ultimately, if the Fed keeps pumping and the Biden administration keeps spending, inflation will reappear. But when and how much are open questions. In the meantime, earnings are likely to surge, increasing economic values. There are recent signs of investor euphoria. The recent weakness in technology shares suggests that valuation does matter. There remain pockets of speculation in electric vehicles, hydrogen, cryptocurrencies, and SPACs. But overall, the speculation hasn’t spread enough to infect all markets. It could, however, and that would lead to a sharp temporary correction that would purge such euphoria, if only for a short time. Many new investors who get their “news” from Tik Tok and Robin Hood need a spanking with enough pain to deter them from reckless abandon in the future. The one assurance I can offer is that it will happen. When, I don’t know. But when it happens, it will be painful enough to deter an immediate repeat.
In conclusion, the economy is starting to percolate and 2021 will be one of the best years in terms of earnings growth. Inflation pressures are rising, but as long as real interest rates are negative, they are not cause for immediate concern. Watching for inflation should not be a full-time focus. It could be a long frustrating wait. A better course is to read the bond market and react to its message when delivered. Finally, play at the speculative fringes at your own peril. There is nothing more economically appealing about Bitcoin at $40,000 than there was about Bitcoin at $4,000. Or $400. Or $400,000. You still can’t do anything with it, and it provides no income. It’s unstable, hackable, and unregulated. It’s only worth what the next guy will pay you for it. It is the Dutch tulip bulb reincarnated. It is what happens when there is too much money looking for a place to park in an environment where cash earns nothing.
Today, Orlando Bloom is 44. Julia Louis-Dreyfus turns 60.
James M. Meyer, CFA 610-260-2220