Despite the Fed reiterating its three pronged message last week that 1) it will not hike rates until 2024, 2) it sees the upcoming rise in inflation as transitory, and 3) that it remains prepared to let inflation exceed its long term 2% target in favor of solidifying the economic recovery and resuscitating the labor market,the bond market last week continued to challenge the Fed’s stance with the US 10-year Treasury yield rising above 1.70% which contributed to further volatility in equity markets.
One factor contributing to inflation fears and concern that the Fed risks being behind the curve is that the US government’s recent Covid-19 stimulus package is overly aggressive, as criticized by several prominent economists. Indeed, outside of World War 2, the US fiscal deficit as a percentage of GDP has never been higher and in the Covid-19 years has significantly exceeded the levels seen during the Great Financial Crisis in 2008/09.
While we do see inflation levels rising over the next few months due to base effects and reflationary forces from the ongoing economic recovery, our base case expectation is that a sustained overshooting of inflation into the end of the year is unlikely.
Since the 1970s, due to the slack in the economy generated by an economic crisis, particularly in the labor market, recessions have always had disinflationary effects. Moreover, since the 1970s the frequency of core inflation above 3% has dramatically fallen due to structural disinflationary forces in play which include 1) a pre-emptive inflation targeting policy by central banks, most prominently the Fed, 2) technological disruption which reduced the cost of goods and services through increased productivity, and 3) demographic factors which drove an increase in labor supply and savings. Most of these structural forces are still in place today.
That said, due to bottleneck pressures related to Covid-19 supply chain issues and base effects, investors should not be surprised to see inflation expectations overshoot over the coming months as inflation fears could continue to escalate.
This will drive a continuation of the equity rotation to cyclicals and value. A historical analysis of asset performance shows that cyclical equity sectors such as energy, materials and agriculture tend to outperform when inflation begins to rise to the 3% to 6% basket.
In addition, during periods of rising inflationary pressures, we tend to see the correlation between commodities and equities decline as mostly clearly shown during the period of high inflation in the 1980s.
This implies that increasing commodity equity exposure can be useful during the anticipated period of rising inflation ahead in view of the challenges faced by investors due to the rising correlation between equity and bonds as interest rate stay near ultra-low levels that we see today.
