The latest reads on inflation have it running at levels not seen in over three decades—CPI at 5.4%, PPI at 7.2% and PCE at 3.9%. One report after another sends the signal that inflation is taking hold. Many economists and even the Federal Reserve (as well as the White House) strongly suggest that this is transitory. That it is the result of the economic reopening and the supply chain disruption. That supply chain disruption, as we understand it now, includes the labor supply. The U.S. seems to be facing a labor shortage in some industries. That has led to wage inflation as well. Wage inflation is usually the last thing to follow price inflation. As we have mentioned before, we feel present-day inflation is the result of the stimulus – the creation of additional dollars by the Federal Reserve. This is also known as monetary inflation.
With inflation and the economy “running hot,” would it not seem to follow that it would 1) put pressure on the value of the dollar (downward) and 2) put pressure on bond yields (upward) and mainly Treasury bond yields? The strange phenomenon occurring, however, is that inflation is rising, yet bond yields are declining. To many that does not seem to make sense. The financial media are full of thoughts as to why this might be occurring. Here are a few thoughts for you.
CNBC recently reported that some (unnamed sources) say that investors and institutions have locked in the significant gains they have seen this year and are selling their stocks and parking those gains and funds into Treasuries. Other reports point to de-risking by investors in anticipation of economic slowdowns due to the spread of the coronavirus. We have been researching other periods of high debt relative to GDP. One thing we take note of is the post WW2 period where the U.S.’ debt to GDP ratio was 108%. A rate many would argue was not sustainable. What happened over the next decade, for several reasons, was that the debt to GDP ratio shrank to 40%. The U.S. inflated its way out of that high debt ratio. In other words, the economic growth far outpaced the debt.
That begs the question: Is that potentially happening again? In other words, is one of the ends in mind is to inflate the country out of the high debt ratio we are currently in? Actions by the Fed – and words from The White House – give us reason to consider that the Fed’s easy monetary policy is likely to continue, and that inflation is real and not transitory. Inflation ran at under 2% for the past generation and a half and now could be running at 50 – 100% higher than that for the foreseeable future. We figure that to make inflation 3-5% over the next few years.
What this means to investors is to look at their holdings in terms of not only risk, time frame and objective, but also in terms of real return. Real return is the rate of return left after the rate of inflation. Current CPI rates would mean an investment returning 5% has a real return of -.4%. That means shrinking vs. growing purchasing power. Higher rates of inflation typically bring higher rates in yields and savers and income investors have yet to see that. That is so because there are more buyers than sellers for bonds, mainly Treasury bonds. The near-term impact (with the caveat that corrections could literally happen any hour of any given trading day) could mean that, along with the tremendous amount of liquidity out there, stocks, real estate and commodities have greater upside potential than downside risk given the strength of the economic recovery and the increased earnings corporations are experiencing. You need to go a step further with stocks and focus on those that are inflation resistant or inflation resilient. Those would be the value stocks and funds like cyclicals, industrials, financials and the like. Real estate could mean buying land, dwellings or perhaps utilizing REITs in the stock market.
Such scenarios have not always favored growth-oriented investments such as technology stocks. Do take note that over the most recent short-term technology has had a strong recovery when considering the 2Q of this year. Investors do not want to ignore the innovation and profitability that technology can bring. We think investors should add to or begin building value-oriented holdings, but not necessarily rotate out of growth-oriented holdings.
Should rates resume their rise again (The U.S. Treasury 10-year note was at 1.77% in March and is at 1.29% at this writing), we believe, based upon historical reactions, that rates would need to rise to 2.75% for investors to begin to see the negative long-term effects that would have on equities (stocks). The 10-year U.S. Treasury note is an often turned to barometer for the stock market as well as for mortgage rates. The 30-year is more associated with inflation.
This, of course, addresses investments as a class vs. looking at certain sectors or segments of the market. We still believe in the words Warren Buffet spoke when he urged investors to focus on buying great businesses vs. just buying investments. We would add to that to be a buy and hold investor until your objectives, risk tolerance and time frame change.
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