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Volume 10, Edition 35 | October 11 – October 15, 2021

The Great “-flation” Debate

Doug Walters, CFA
As inflation looms, there has been a lot of debate amongst investors as to whether we are experiencing reflation or approaching stagflation. What are these terms, and why are they driving investor sentiment?

Contributed by Doug Walters, Max Berkovich

There is much talk these days of “-flation.” If investors are not talking about inflation, they are talking about reflation or stagflation. What are these terms, and why are they driving investor sentiment and the stock market? We will attempt to untangle this conflation of concepts.

Most of us have a good sense of what inflation means. We feel it acutely these days when we go to the butcher or the gas station. Rising prices! But inflation itself is not necessarily a bad thing. The Federal Reserve has been trying to manufacture more inflation for years. So what makes inflation good or bad? To answer this, we need to introduce two other related “-flations”: reflation and stagflation. Investors’ shifting allegiances between these two flavors of inflation have had a lot to do with the market swings of the past few weeks.

Reflation is associated with economic growth. As the economy recovers from the lows of the pandemic, growth is high, as is consumer demand. Increased demand drives up prices (inflation). Companies seek to hire to meet demand, which drives up wages. And this cycle continues until the Fed sees a need to step on the brakes through a rate increase. The rally in cyclical and small-cap stocks we have seen at times during this pandemic are often driven by investors believing in reflation.

Yet over the past few weeks, we have heard more about stagflation, which has been a negative for stocks. Stagflation occurs when you have inflation accompanied by stubbornly low growth. In today’s environment, the concern is that supply chain challenges will be prolonged, which will simultaneously cause inflation (which has already happened), and decrease demand (due to the higher prices).

The Fed is adamant that the current bout of inflation is transient, but investors have not always been convinced, and recent volatility is a testament to that mistrust. Will we have reflation or stagflation? That is a question that can only be answered by the future. As discussed in our recent Perspectives report (Ask the Right Questions), the best approach is preparation (with an intelligently diversified portfolio), not prediction.

80%

Percent of companies surprising to the upside

The Q3 corporate earnings season got off to a strong start, with over 80% of early reporting companies surprising to the upside on revenues and earnings.

Headlines This Week

US stocks ended the week up with a very strong finish. Concerns of stagflation, which have been a headwind in recent weeks, were replaced by optimism regarding economic growth and supply chain challenges.

Encouraging signs

Earnings season kicked off on the right foot this week.

  • While JP Morgan (JPM) failed to impress, 80% of the early reporting companies have surprised to the upside, and year-on-year growth is expected to surpass the big quarterly numbers posted in July.
  • Further helping sentiment was Retail Sales data for September, which significantly beat expectations. Year on year, retail sales are up 13.9%.
  • Inflation is a legitimate concern, but so far, economic growth remains strong.

A Minute for the Fed

The Federal Reserve released its September FOMC minutes.

  • Unsurprisingly, officials said that the process of tapering could begin between mid-November and mid-December. The market was ready for this detail.
  • On rate hikes, there appears to be no rush. Some of the participants commented that they expect economic conditions to justify keeping rates near their lower bound for the next couple of years. So, the Fed is dovish on rates still.

Jolting Employment

We received some additional insight into the jobs market this week with the release of the August JOLTS report.

  • The JOLTS report looks at job openings amongst other measures. Openings fell from July but are still high at 10.4M.
  • Interestingly voluntary “quits” reached an all-time high, likely for two reasons: 1) the rise in concern over the delta variant, and 2) leaving for higher wages as employers try to lure new hires with wage increases.
  • It is a complicated jobs market that we are currently navigating. Job openings are high, with many still choosing or finding it necessary to stay at home. The result is some legitimate wage inflation for the first time in many years.

The Week Ahead

China Losing Momentum

China’s third-quarter GDP numbers are out on Monday amidst growing crises in the property and manufacturing sectors.

  • At the beginning of the year, the Chinese economy was forecasted to grow around 6% year-over-year but is unlikely to reach that target due to multiple setbacks.
  • Forecasts expect 0.5% growth quarter-over-quarter and 5.2% year-over-year, the lowest since Q3 of 2020.
  • Supply chain issues, power outages, new lockdowns, and the fallout from the Evergrande default are all causing the economy to drag.
  • September’s retail sales numbers are also out on Monday, with a meager increase expected.

Inflation Abroad

After the release of America’s inflation data last week, next week will see a host of important international releases.

  • The Eurozone, the UK, and Canada will all be out with their numbers on Wednesday.
  • The Consumer Price Index (CPI) for the Eurozone and the UK are expected to hold steady at 3.4% and 3.2% year-over-year, respectively.
  • The Bank of England expects CPI to reach 4% by the end of the year, with central bank officials hinting that they could soon begin raising interest rates as inflation reaches that level.
  • On the other hand, New Zealand is expecting a strong jump up to 4.1% from last month’s 3.3%, which only increases the likelihood that its central bank will raise rates again in November.
  • Canada is also expecting a slight increase to 4.3% from 4.1%, keeping the Bank of Canada on track to taper again when it meets at the end of the month.

Return of Earnings Season

Earnings season is back in full swing, with several names to look at next week.

  • Things will ramp up on Tuesday, as Netflix (NFLX), Johnson & Johnson (JNJ), and Proctor & Gamble (PG) all report.
  • The highlight of the week will be Tesla (TSLA) on Wednesday.
  • All things seem to be trending in the right direction for the electric car maker as it posted its first profit from car sales without the help from its emission credit sales last quarter.
  • Car deliveries have also risen to a record 241,000 with help from record sales in China with optimism for growth as new factories in Austin and Berlin come online.
  • Rounding out the week will be Intel (INTC) and AT&T (T) on Thursday.

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