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Volume 9, Edition 20 | June 7 – June 11, 2021

Inflation Capitulation

Doug Walters, CFA
In the span of a year and a half, concerns of a Japan-esque deflationary spiral in the U.S. have been replaced with fears of runaway inflation. This week’s market moves indicate that those fears may be subsiding.

Contributed by Doug Walters, Max Berkovich

Inflation surprised to the upside this week, but no one was surprised. In fact, bond markets appear to be signaling that inflation fears have peaked. Next week the Fed will have another opportunity to weigh in on the debate.

Inflation fears have been an overhang for investors in recent weeks. Consumers have experienced numerous sticker shocks (gas, lumber, used cars, homes, etc.), and economic data has produced numbers we have not seen in many years. The latest data point was CPI inflation, which came in at 5.0% versus expectations for 4.7% (which itself would have been quite high). Digging into the data shows that it is driven by a couple of factors that are likely to be transitory. The comparison period last year (in the heart of the pandemic) was very weak. This alone accounts for over 1% of the inflation. In addition, there are certain components of the CPI calculation which are significant upside outliers. For that reason, economists and the Fed look at CPI variations like “trimmed-mean CPI” (which omits outliers) and median CPI. Those measures came in at a much more modest 2.6% and 2.1%, respectively.

For much of this year, we have fielded questions from investors about how we are preparing our portfolio strategies for inflation. It was amazing how quickly sentiment had shifted from concerns about a Japan-esque deflationary spiral in the U.S. pre-pandemic to one of runaway inflation. Time will tell, but we have yet to see a credible case for the latter. Fast forward to today, and pundits are already writing off inflation fears. The point is that much of what we have seen are emotional reactions to headlines and sticker shocks and not rational reactions to the data on the ground, which pointed to an inevitable transient spike in inflation. Inflation or not, our portfolio strategies are designed to give investors smart, evidence-based exposure to the market, which we believe will pay off in the long term.

5.0%

Year-on-Year CPI Inflation

Inflation is running hot, but declining bond yields appear to signify that investors are becoming more confident that the increase is transient.

Headlines This Week

Roads and Bridges

  • A group of Democrats and Republicans struck a deal on an infrastructure plan that will not raise taxes.
  • Both sides will need to convince their colleagues in Congress to support the bipartisan plan.
  • In parallel, the Democrats are pursuing a reconciliation approach that would not require Republican support.
  • Both paths will be challenging, putting the White House’s goal of spending about $1 trillion on roads, bridges, and renewable energy in jeopardy.

Rising Prices

  • Inflation, as measured by Consumer Price Index (CPI), rose 5% in May. One of the largest contributors to the figure was used car and truck prices.
  • Some analysts worry that if inflation persists, The Federal Reserve will begin to raise overnight lending rates, which have been near zero since March 2020.
  • While worries over inflation and Fed tapering have been on everyone’s minds, the 10-year U.S. Treasury yields declined this week, which may suggest that market participants are beginning to agree with the Fed that the inflation is transitionary.

Banking on Recovery

  • The European Central Bank (ECB) revised its economic outlook higher but kept its monetary stimulus in place.
  • The Bank of Japan (BOJ) is set to keep monetary stimulus in place and extend a Covid Aid program.
  • The People’s Bank of China (PBOC) stated that inflation is under control and that China will keep its current monetary policy at bay.
  • The Bank of England (BOE) Chief Economist Andy Haldane said on Wednesday that current inflationary forces might force the BOE to taper monetary stimulus. He fears that a wage-price spiral might return to the U.K., much like inflation periods seen in the 1970s and 1980s.

The Week Ahead

Steady Fed

The Federal Reserve will meet next Wednesday for their monthly monetary policy and rate decisions.

  • When the Fed met last month, the central bank acknowledged the recent improvement in U.S. economic data but again reiterated that they are a long way off the goals required to alter their policy stance.
  • It is expected that the theme of stability and keeping the course is likely to be seen again at this month’s meeting.
  • Even though inflation has been accelerating, the Fed has reiterated time and time again that it will be transitory; for now, the markets seem to be giving the central bank the benefit of the doubt.
  • However, it is expected that they will begin to talk about tapering their asset purchase program.

International Data Deluge

A host of key data metrics from around the world is out next week, giving insight into the global recovery from the pandemic.

  • The Eurozone, the United Kingdom, Canada, and Japan will all be releasing their consumer price index numbers (CPI) for May, which will reveal how much inflation is heating up.
  • Canada and the UK will be the two to focus on as they are the first of the central banks to begin winding down their asset purchasing programs.
  • While it is too soon to see the effects of any tapering, these numbers could impact the speed that the banks pull back their programs.
  • The headline CPI for Canada and the UK is expected to come in at 3.5% and 1.8%, respectively.
  • Other international headlines to look out for will be Britain’s jobs numbers on Tuesday and the monthly data dump from China on Wednesday, including retail sales, industrial production, and fixed asset investments.

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