Although we are returning to normalcy in our daily routines, resuming travel for summer holidays, and hopefully putting COVID-19 lockdowns behind us, it is worth noting that our current economic recovery is anything but normal. Thankfully, growth in the United States and globally is surging in somewhat of a synchronized manner as we move into the second half of 2021. However, in the U.S., the growth surge and speed of recovery out of recession do not reflect a normal business cycle.
As a result, we are dealing with disruptions in our supply chains which are impacting manufacturing (manufacturing production is down -2.7%) while retail sales are up +51% compared to a year ago coming off a -20% collapse during COVID. If you measure retail sales over a rolling 24-month period, they are up +10% per annum which compares to a normalized growth rate of +3.6% per annum from 2014 – 2018.
Economists are forecasting global GDP growth +6.9% in the second half of 2021 (2H21) up from +4.6% growth in 1H21, with the U.S. contributing +6.7% growth in 2H21 and taking over from China as the real growth engine globally. The macroeconomic picture is one of sustained strong consumer spending, continued robust corporate earnings growth, and a “dovish” Fed intent on keeping rates low for as long as possible.
Accompanying the welcomed, albeit atypical, recovery is an unprecedented early spike in core inflation which is at its highest level since 1972. The key question is whether the rise in consumer prices (+5%) and producer prices (+6.2%) is transitory and temporary versus real and longer term. One economist noted that “a lot of inflation always starts with a little bit of inflation.”
However, if you examine the recent rise in CPI (+5% yr/yr), almost +3% is coming from base effects (the crash in inflation last year due to COVID) which leaves approximately +2% coming from actual non-transitory inflation. The macro-economic landscape does point to a possibility of continuing pressure on energy prices given the low level of capital expenditures in the industry and anti-fossil fuel sentiment from ESG focused investors further complicating strategic CAPEX decisions. In addition, wage growth and the reshoring of industry are likely permanent contributors to inflation.
Fed Chairman Jay Powell insists that the Federal Reserve sees the increases in personal consumption expenditures (PCE) as transitory, though the Fed looks at inflation over a rolling 9-year period and derives an annualized rate of inflation for PCE at about +1.5% since 2012, which is well short of the Fed’s +2% target.
When it comes to the recent unprecedented growth in the money supply (M1 +40%) versus the 2008 Financial Crisis (M1 +20%), the Fed is suggesting that the link between the money supply and inflation has been broken. Yet this narrative sounds a bit self-serving since the Federal Reserve has become the biggest buyer of US Treasuries and US T-bills.
Since 2013 China has reduced its purchases of US Treasuries having adopted a “Belt & Road Strategy” of investing excess foreign reserves into hard assets and infrastructure rather than buying US government debt. Other foreign investors in USD assets have also shifted traditional US Treasury purchases to equities and real estate. Therefore, any dramatic change to Fed bond buying could significantly impact asset values as the price of US Treasuries would fall due to lower demand, thus sending interest rates higher. This risk to market and economic stability requires the Fed to let inflation run hot near-term supporting a narrative of transitory inflation validated by the long-term average measure of PCE remaining below 2%.
Currently, the Fed continues to buy approximately $120 billion/month in US Treasuries and mortgage securities. Most likely by the end of the year, the Fed will announce a gradual reduction in these purchases. In 2013, a slowdown in Fed bond purchases resulted in the yields on US 10-year Treasuries climbing from 1.7% to 3.0% and equity prices dropping in a short period of time. Some economists argue that the next Fed tapering may not result in another “tantrum” due to the current liquidity in the system and the bond market having been through a QE tapering once before. Others, however, would argue that if the largest bond buyer begins to reduce its purchases, it could meaningfully disrupt the market.
Some economists point out that current inflation trends are more akin to 1940’s inflation (fiscally driven) versus 1970’s inflation (bank loan driven). Wise investors should keep an eye on fiscal deficit spending because at some point the perceived return to yield curve normalcy (i.e. a positive shaped curve equal to inflation) will inject market volatility into equity markets.
One final observation which is getting economic press coverage: the Fed has recently increased its overnight reverse repo rate to .05% (reverse repos are used by the FED to manage liquidity in the banking system). While this may seem insignificant, it highlights the amount of excess liquidity in the system. This excess liquidity could create imbalances sparking market dislocation. The dilemma for portfolio construction is an increased correlation between rising bond yields and lower equity prices. Therefore, we are reducing our investment model exposures to longer duration fixed income assets and increasing our allocation to real assets and short-term inflation protected treasuries while maintaining appropriate allocations to equities.
As stated at this outset, the economic recovery – while welcomed – is anything but normal. Our eye is keenly focused on inflation as a key risk factor impacting markets over the next several quarters. We hope the FED has it right and that inflation is more transitory in nature, but we are preparing for it to be real and longer-term.