CIO Update: Inflation Fears in Focus
With massive stimulus just passed in Washington, it’s not surprising that the market is reacting to these significant fiscal policy moves. In this week’s CIO Update, Shannon Saccocia puts potential inflation risk into perspective. Listen now.
Hello and welcome to Boston Private perspectives.
I'm Shannon Saccoccia, chief investment officer at Boston, private.
Thanks again for joining me today.
As we noted in our piece last week, written by a member of our fixed income team.
The equity markets have been buffeted by the sharp increase in bond yields.
Over the last several weeks.
And we can attribute these moves higher to the fears of inflation.
So let's talk a little bit about what's driving these fears.
It's really a combination of factors, but it's important to understand why they're all coming together now to create this short term volatility, and this rapid increase from a relative standpoint in.
First and foremost, monetary policy the Fed has continued to be incredibly accommodative over the course of the last year. So if we go back to the great financial crisis of 2008 and 2009.
A number of the measures that the Fed put in place in order to provide needed liquidity to the financial system were sort of never before seen programs, and many of these programs persisted for several years following the recession and the Fed only started to tighten monetary policy.
Over the last couple of years prior to the pandemic, and so a lot of the things that the Fed has done this year or in this last 12 months and through early 2021 have really been a continuation of some of the programs that they utilized in the great financial crisis.
As well as some.
New programs that were added that.
Or more specifically, geared towards the pandemic crisis that we were facing last year, but the magnitude of the amount of stimulus is significantly higher than it was previously and so one of the.
Arguments that are being made by economists is that although we were anticipating inflation given the Fed's quantitative easing programs after the GFC were more likely to get it from this particular period just because of the sheer magnitude of the intervention from the Fed, and that intervention is unlikely.
To change meaningfully over the course of the next 12 to 18 months, there is likely to be a tapering of bond purchases, and as you remember, if you go back to 2013 and we talk about the taper tantrum, that was really what created a lot of concern in the equity market about, you know the potential pullback of the punch bowl from a liquidity perspective when.
The Fed stopped buying or threatened to stop buying bonds in the open market.
We could start to see that taper as as soon as the end of this year, but we do not anticipate that there will be a significant increase in interest rates and so therefore this so.
We have free money or cheap money paradigm is going to persist at least for the foreseeable future.
Another factor that economists and market pundits are pointing to as a driver of inflation is the savings, right here in the United States so.
With the changing spending patterns as a result of the pandemic, for many people who were able to keep their jobs work from home, and you know, sort of continue their normalized earnings.
In this environment, without potentially spending as much just given, particularly the shift to lifestyle spend that we've experienced here in the United States over the last several years, and the fact that a lot of our spending is services based spending, there is a significant amount of cash that has been built upon consumer balance sheet.
If you go back to.
Again 2008 2009. It was a very different environment where homeowners were utilizing their houses to lever up to take out debt, to purchase other things, and so a lot of the consumer spend came ahead of that recession and so post recession.
American consumers really used those several years, in fact, to build up their savings, and so the unleash of consumer demand from an improving economy took several years.
Today we're sitting on the precipice of reopening and states that are not reopen now, and just you know, wider.
Normalization of the economy here in the US and that is anticipated to increase the amount of consumer spending essentially overnight in the back half of this year, leading to some inflationary pressures.
The final aspect of you know what's driving these inflationary fears?
And probably the most notable one is the massive amount of fiscal stimulus that's been poured into the economy over the last 12 months.
If we go back, we had.
We've had several packages, most notably the CARES Act, but also the supplemental package in December and now coming down with.
You know, at $1.9 trillion package from Washington, much more.
Then was what what was initially anticipated or expected this. This bill was really expected to be narrowed significantly. You know, if we go back to sort of the beginning of the negotiations on this on this particular COVID-19 package, it is anticipated that the Republican.
Caucus was coming to the table with somewhere around 500 to 600 billion that they would. We would probably end up somewhere in the middle. The reality is, is that you know this is such a significant stimulus, and really a lot of it is in the form of cash payments to American consumers.
As well as continued support for the unemployed, which creates some insulation in terms of any residual pressure on consumer spending, at least over the next couple of months.
An so you couple that with this really high savings rate already an you think about this infusion of cash directly into the economy, essentially at the tipping point where consumers are going to have the opportunity to go out and spend that money.
And it certainly speaks to not only you know inflationary pressures in terms of goods and services.
But you also start to think about things like acid inflation in the equity markets, for instance, so.
Again, going back to, you know the comparison to 2008 and 2009. I think this fiscal stimulus aspect is probably the most important thing, so if we go back over the last decade, we never ended up seeing the inflation that everyone feared coming out of the GFC.
We didn't see inflation that was caused by the feds injection and and not just the Fed.
Mind you, the Bank of England, European Central Bank, the Bank of Japan.
Where you where you actually did see inflation was in China, and you know that's a that's a story for another day, but what you did not see post GFC which you did not see a massive fiscal stimulus package.
Treasury Secretary Janet Yellen seems incredibly keyed in on this particular aspect because it is the view of many economy.
Is that the slow pace of the recovery here in the United States was.
Holy or at least largely in part to the fact that we did not have meaningful fiscal stimulus to supplement or complement the monetary stimulus that we had in 2009, and so that is why, you know, perhaps there's this view that it's different this time.
Because we do have this fiscal stimulus because we have this very high savings rate because there is the opportunity for unleashing him.
Can we add?
So that's all the case that.
Sounds like a really big case for why we could see higher than anticipated inflation over the next couple of years.
So why does the Fed continue to caution that this effect is transitory?
And there are two three main topics that you want to you know point to number one demographic.
If we go back a couple of years, we were really much more concerned here in the United States about deflation than inflation, and we've seen the effect of demographics in a country like Japan.
The overall graying of the world population is considered to be.
Mary and you've seen that amongst in Japan, because demographically, it's a much older country.
And so as we see the baby boomers retiring, there is just kind of less money going into consumer spending because they tend to live on a fixed income and don't have as much of that discretionary spend that that fuels a lot of the.
The services economy here in the United States.
Another thing to think about is commodity prices.
So if we go back to 2004 and 2005 and into 2006.
We would have been sitting here talking about you know what does oil get to? Does it get to $200 a barrel? You know copper? Other industrial metals, precious metals.
All of those commodities were experiencing meaningful or were in the midst of meaningful bull market over the course of time due in part both to demand but also into in the difficulty of obtaining supply.
One of the biggest changes that we've seen over the last decade was.
The NRG Renaissance here in the United States and we've talked.
About that really.
The NRG Renaissance was based in in technology and the ability to extract natural gas and oil reserves in ways that were not available 20 or 30 years ago, or at least not at scale.
So with that as the as the backdrop and with some of the competitive aspects of the commodities markets changing, if you think about the basket that the Fed looks at from an inflationary standpoint, that basket includes commodity prices and input prices.
Those are likely not to increase.
In price significantly apart from sort of a near term revival of demand, the one caveat to that is that we are seeing a strengthening in the manufacturing economy globally, but particularly here in the United States and so there could be perhaps some near term inflation related to this pickup and manufacturing activity that.
Was more subdued in 2018 in 2019, based on the trade war with China. And so you know again, that sort of speaks to the feds comments on on this being transitory.
The last thing is technology, so one of the main.
Areas of inflation that the Fed focuses on, and frankly probably the one that affects most businesses or businesses the most, because it's it's consistent, is wage inflation.
And so you know, productivity has continued to increase through the use of technology.
The which really reduces labor costs in general.
It reduces the number of people that you need the move from on site or brick and mortar to e-commerce even for a portion of a business is sales certainly decreases the number of people.
So wage inflation, despite the fact that we were at historically low levels of unemployment.
Prior to the pandemic really didn't feel that it was being pressured higher, and while we have seen an improvement in the employment market over the last six months in particular.
We still stand at close to six per a little over 6% unemployment an in the services industry. You know that's well North of 10 or 12% depending on the particular sub industry that you're looking at, so it's going to take awhile for the employment market to improve to a point where we're worried about wage inflation again.
An because wage inflation is that sort of consistent cost for businesses.
You know it.
Speaks to the fact that there perhaps won't be as much pressure on you.
Know these kind of inflationary pressure as part of the back.
Ask it because if companies aren't forced and businesses you know whether they're small or large or not forced to pay significantly more in wages, they're not forced to raise their prices to maintain their margins.
In order to do that.
And so there is a meaningful transmission in Ripple effect to wage inflation that.
That is is worth.
The other thing that we want to talk about or just mention at least is that we have been experiencing inflation for some time.
It's just not in this basket.
Education and health care, for instance, have experienced significant inflation over the last 15 years, and that doesn't seem to be changing.
Although you know with some of the.
Focus on limiting drug price increases and creating a more efficient health care system as well as.
Limiting potentially, you know, cost increases that in state universities and and things like that there there are some efforts being made to combat that inflation, but it's certainly not like we can sit here and say prices haven't moved higher over the course of the last 10 years, 'cause they have in certain areas.
But in this basket.
Based on those factors that I just mentioned, we haven't seen the increases that we would normally have have expected given the monetary stimulus.
After the great financial crisis.
So the overall effect of all this is that.
Yes, rates are moving higher.
They're moving higher for good reason.
Economic growth and inflation and inflation expectations based on that economic growth are positive reason for rates to be moving higher.
But we also you know are looking at nominal GDP, trying it somewhere around 3 1/2% and so. Therefore that implies that rates could rise from, you know where they sit today at around 2 1/2% in the corporate you.
Of another, you know 50 or 60 basis points without really hindering the economy, at least according to you know economists.
Any upside on GDP?
For these, you know, based on these expectations could support higher yields as well, and so we are in agreement with the Fed.
Our view is that rising rates will continue to pressure equities in the short term and we could see some of this.
Dislocation that's occurring, not just because of rates, but because of the push and pull of this reflationary rebound that we're experiencing from a sector rotation standpoint.
But we do think that these that inflation and interest rates will be normalizing into 2022, and therefore if we're anticipating improving economic growth, we you know, we believe that an overweight position to equities, even though it might seem challenging at certain periods over the course of the next.
Month or so in particular as rates move around, we.
Still think that that's.
The appropriate positioning for investors with a long term time horizon.
Thanks again for listening to this weeks podcast.
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