On Wednesday, after a much higher than expected increase in consumer prices reported for April, stocks fell sharply with the Dow Industrials falling over 700 points. On a percentage basis, small cap and NASDAQ stocks fell even more. Higher inflation, should it persist, would mean higher interest rates and lower P/E ratios for equities. But on Thursday and Friday, with no contradictory news, stocks recovered their entire loss of Wednesday.
What happened? For one, while the rise in consumer prices was scary, it didn’t make much of an impact in the bond market. Either investors were sold on the Fed’s conclusion that inflation was transitory and would dissipate in the months ahead, or other factors kept rates down. At any rate, with increasing bond yields, there was no serious headwind for stock valuations.
But let us not forget the basics. Stock prices, like all prices, are subject to the laws of supply and demand. The supply side hasn’t changed a whole lot in recent weeks. Dissipating interest in new SPAC and IPO offerings are no longer diverting money from traditional equities. A modest increase in bond yields still leaves real rates in negative territory. To be sure, other asset classes, like homes, are experiencing soaring values and diverting some money. But the big gorilla in the room remains the Federal Reserve buying $120 billion of securities every month. At the same time, the Federal government has been handing out $2,000 in stimulus checks in two tranches this year to every man, woman and child below a certain income level. Most qualify. With bank deposits already swollen, savings rates above 20%, and money supply growing at an even faster rate, demand for all sorts of investments, especially stocks, continues to grow. As the fervor over SPACs and IPOs fades, as bitcoin stops going up every day, and as bonds remain unattractive, money flows into stocks. Supply and demand sends equity prices higher.
Can this continue forever? Democrats in Congress talk about $4 trillion more in spending on top of an economy growing close to 10% annualized in real terms. While all of that won’t pass, a good chunk might. Note that I use the word might without much conviction. It is still too early to sharpen pencils and make any meaningful prediction. Certainly, what might have been needed a year ago during campaign season isn’t all necessary today. A lot of observers argue that the ongoing $300 additional unemployment benefits are incentivizing workers to stay home and collect roughly $15 per hour rather than rejoin the work force despite close to 8 million job openings.
The real questions today are (1) might the current wave of inflation be more persistent than the Fed believes, and (2) how long is it prudent for the Fed to inject $120 billion per month into the economy?
There is little question that much of the current spike in prices is a result of post-pandemic demand rising much faster that supply. It has been unexpectedly so, probably as a result of the very rapid distribution of effective vaccines. Again going back to supply and demand, when demand spikes and supply can’t keep up, you get both shortages and higher prices. Higher prices bring more supply to the market in short order, and balance is restored. But not all price increases are transient. If they are, the “transient” period may last years. Housing could be an example. There is very little inventory of existing homes for sale. While higher prices could elicit more sellers, it could be several years before it becomes a buyer’s market again. As millennials move from rental units to suburban homes, it is unlikely that builders can fill the gap anytime soon. Local townships want to control the pace of new families moving in so that local infrastructure, notably school capacity, isn’t overwhelmed.
Besides housing, there is one other commodity that can’t be increased rapidly, namely labor. While unemployment is still close to 6%, given the number of job openings and the pace of new job creation over the past several months, most observers, including government and Fed officials, believe full employment will be reached by the end of 2022. Already shortages are causing spikes in wages. Restaurants and retailers are being forced to increase compensation to entice workers to return. McDonald’s just raised wages 10%, for instance.
Indeed, the two biggest factors contributing to inflation are labor costs and interest rates. Higher rates should follow inflation expectations but have been held down by the huge amount of government borrowing all around the world. Supply is enormous. What is preventing rates from going lower is corporate demand (trying to lock in low rates) and home buyers seeking mortgages.
With all this said, inflation expectations are rising. Central banks can buy bonds for a long time, but they can’t buy them indefinitely. With savings rates and money supply growth near record levels, further buying at a time with all that excess money sloshing around risks creating monumental bubbles that would inevitably burst.
Thus, the Fed remains in a bind. Perhaps it is right and much of the inflation pressure of the moment will dissipate, but all of it won’t. Even the Fed forecasts inflation of 2-3% persistently over the next several years. History isn’t kind when it comes to Fed forecasting. Almost always, the Fed has overstayed its welcome, remained accommodative too long, allowed inflation pressures to build beyond expectations, and, ultimately be forced to step on the brakes.
But that time isn’t now. That is why short term 3-5% corrections simply haven’t lasted. Maybe some time between June and September, the Fed will lay out a roadmap for tapering the pace of bond purchases. The likelihood is that the pace will be slow although subject to changing economic data. Any actual increase in rates is well over a year away, maybe even two.
I have said several times that I thought 2021 would be a good year for stocks but the easier gains would come early in the year. Both sequential and year-over-year earnings gains will start to slow in the second half while inflation pressures will continue to rise as the economy gets closer to full employment. I also expect that at some point in the second half of the year, the Fed will, at a minimum, suggest a schedule to taper bond purchases, not a message equity investors want to hear.
That doesn’t mean the end of the bull market. It comes down to the pace of earnings growth versus the rate of increased inflation. There is no recession in sight, confidence is building, and there are enormous amounts of available cash and pent-up demand. At the same time we know that anything too good to be true probably isn’t true. Growth can be sustained without taxing inflation only as long as demand growth doesn’t outstrip population growth plus productivity gains persistently. At the early stages of a business cycle, high growth is possible until the gap between existing and potential growth closes. As noted, that time isn’t now, but government must be proactive to prevent overheating. History says that won’t be easy.
Today, Enya is 60. The most likely time to hear her music today is during a massage. Bob Saget is 65.
James M. Meyer, CFA 610-260-2220