On Friday, I had the privilege of speaking at the annual strategic investment symposium run by the College of Charleston in South Carolina. Sadly, like everything else over the past year, the conference was virtual and so I couldn’t revisit Charleston itself. Just to rub it in, the host let me know that it was sunny day in Charleston, with a high expected in the mid-to-upper 70s.
I can imagine an attendee, after earnestly absorbing the morning’s proceedings, taking advantage of the fine weather and settling into a comfortable chair on his veranda with a cool drink and some easy reading near at hand. But as the afternoon drew to a close, he would have packed up with care, as rain was expected that evening.
Small preparations for a small weather event.
However, the people of Charleston are well aware of nature’s fuller fury and families that have survived the many hurricanes that have battered the city over the generations take more serious long-term precautions. Storm shutters, reinforced roofs and steel doors are standard equipment. Extra care is taken to trim trees and clear gutters. And, as hurricane season approaches, careful attention is paid to the tropical forecast.
For investors, markets last week seemed like a spring day in Charleston, with the stock market drifting up to a new record high and long-term interest rates settling down after a steady rise from August of last year to early March. However, in the short run, investors need to recognize the potential for some headwinds from higher inflation and higher taxes. In addition, while no greater crisis appears imminent today, investors need to be prepared for the risk of a more significant surge in inflation and taxes in the years to come.
Inflation In The Short Run
The week ahead should provide further evidence of a strengthening in near-term inflation pressures. We expect Tuesday’s CPI release for March to show a 0.6% gain overall and 0.2% excluding food and energy. This should boost year-over-year inflation by these measures to 2.6% and 1.5% respectively.
These year-over-year numbers are set to rise further in April, since prices fell sharply in April 2020 as the pandemic took hold. Because of this, inflation, even using the Fed’s preferred consumption deflator measures, is likely to exceed 2% on a year-over-year basis for the rest of 2021.
However, quite apart from base effects, there are some building areas of inflation pressure. Purchasing manager surveys, in both manufacturing and services, show very strong increases in the cost of inputs as bottlenecks restrict supplies. Oil prices have climbed in recent months reflecting both a pickup in global demand and some production discipline on the part of OPEC and Russia. Wage growth could remain relatively healthy in the months ahead as employers, staffing up for improved demand, will have to at least match the income provided to unemployed workers by enhanced unemployment benefits through September. Perhaps most importantly, almost $1.2 trillion in federal spending under the recently passed American Rescue Plan Act should make it easier for companies of all kinds to raise their prices.
Our base case assumption is that widespread vaccinations, along with the immunity acquired by many from contracting Covid-19, allows the pandemic to wind down over the summer, with most normal economic and social activity resuming by the fall. If this occurs, the economy should see a very strong surge in economic growth throughout this year, with unemployment falling to 4% in early 2022. However, beyond that point, barring further fiscal stimulus, growth should slow down and this could allow inflation to settle at the “a little above 2%” level that the Federal Reserve is targeting. Even this, however, should be consistent with long-term interest rates rising further, as the Fed begins to tapper bond purchases early next year. In addition, there is a distinct possibility that inflation could burn a little hotter if further fiscal measures pass Congress aimed at providing additional support to low and middle-income families.
While much of this scenario would be very welcome, these somewhat higher rates would, of course, inflict losses on fixed income investors and could motivate a further rotation from growth to value within the equity market.