- Commodity prices and CPI subcomponents continue to flag an increased risk of inflation.
- Corporates and the Fed, on the other side, continue to behave as if inflation will only be transient.
- Inflation or not, the market should be much more able to digest tapering (i.e. slowdown in bond purchases by Central Banks).
Commodities, CPI, and Labor
A couple weeks ago, very few people were contemplating a tapering of bond purchases by the Fed, but that changed after US CPI data exceeded expectations and the most recent FOMC minutes indicated that tapering-related discussions have already begun.
Ground zero for the inflation narrative tends to focus on the surge in commodity prices:
- The year-on-year change in the Refinitiv Core Commodity Total Return Index is at its highest level in 25 years.
- As Jason Goepfert from Sentiment Trader said: “When we look at major commodity contracts and measure the percentage of them with a 252-day rate of change of 50% or more, we can see that the percentage has reached the highest level since the 1970s. Never before in the past 50 years have more than half of them jumped by 50% in a year.”
- Copper, iron ore, and lumber have all made record highs.
- Agricultural commodities have also been sucked into the vortex, with the rise in US corn prices in the highest year-on-year change since the early 1970s.
Commodity prices are mainly considered inflationary as they’re input prices for major products (higher grain prices makes raising cattle more expensive, leading to higher meat prices), but in terms of short-term direct impact, few commodities have a meaningful impact on CPI outside of oil (via gasoline) given the time lag between, for example, grain consumption and protein manufacturing.
Many of the CPI subcomponents, which have a more noticeable impact on headline inflation numbers, however, are prone to short term gyrations:
- The used autos component has seen its largest bounce ever, fueled by a shortfall in new cars.
- Acute bottlenecks are in play today in the semiconductors market.
- There is solid demand in the housing markets of North America and the UK, with increases starting to match the boom of the noughties (that’s how Brits refer to the 2000s FYI…).
Inflation is also starting to creep into wage data. The paradox here is that companies are trying to hire but they can’t find employees, not because there is a shortage of labor, but because of a skills mismatch.
Many parents are unable to re-enter the labor market because they can’t find child support, whilst others who lost their jobs in the ‘old’ economy don’t have sufficient skills to transition directly into technology-based roles.
The mismatch paradox between supply and demand of labor only grows larger given:
- Furloughed staff have not been in a rush to look for a job given the generous support programs and,
- Cheap overseas labor is facing travel restrictions that prevent them from returning to fill the lower-wage positions.
Job Openings, a proxy for job availability, now stands at a record level of 8.1 million, but the unemployment rate is still double what it was pre-pandemic.
A shortfall in labor, at a time when fiscal measures continue to support consumption, carries a number of consequences.
- Consumer demand is elevated, but production operates at a level that is insufficient to meet that demand, creating scarcity, potentially leading to higher prices.
- In order to increase production, companies have to attract more labor likely through higher wages (automation will offset some of this), which either squeezes companies’ margins or increases prices to the end consumer.
The arguments for higher inflation continue to be very reasonable, at least in the short term. Let’s see how the reopening impacts all of this, as we still believe inflation is less permanent and more transitory than what consensus thinks.
What does the Fed Think?
- The Fed wants the economy to overshoot. They have moved to an average inflation target of 2%, which gives them leeway to let inflation exceed their target for an unspecified amount of time.
- Policymakers consider the significant shortfall in total employment as a sign of economic slack. When the US unemployment rate was under 4%, inflation was benign, but with the current unemployment rate nearly double that figure, the Fed believes more work is needed.
- But some argue that today’s higher level of unemployment is misleading because one needs to take into account (1) those who are not working simply because they’re making more under the furlough scheme, (2) those who will quickly return into the workforce once travel restrictions are eased.
- This increases the risk of higher prices, especially as the economy reopens. With CEOs saying that they will be passing these price rises on to consumers, it will be the lower-income groups that suffer the most.
- Food price rises were influential in the Arab Spring uprisings a decade ago. Persistent food price rises today will also be felt by many consumers in North American and European markets.
How Are Corporates Reacting to Inflation Risks?
Inflation mentioned in quarterly reports increased by 800% Q-on-Q.
That said, the actions of the corporate sector tell a different story:
- Q1 2021 US Capex is only annualizing at a faster pace than 2020 due to a massive increase by Verizon ($49 billion compared to around $20bn for FY 2020). Stripping that out, Capex is below the pace of 2020.
- According to Goldman Sachs, YTD share buybacks, however, are at their fastest pace in 22 years.
If corporates believed in the permanence of the price hikes, then they would be investing in growth, not shares. Diverting capital to buybacks helped undermine productivity over the last decade, and this apparently continues to be the case for the 20s as well.
Additionally, commercial bank loan growth has just dipped back into negative territory.
Whilst part of this is due to the base effect after last year’s surge in emergency loans, it continues to signal that commercial banks (which drive the real supply of money available to the consumer) still don’t want to lend and that corporates don’t want to borrow.
Inflation beyond bottlenecks and base effects will be fleeting if the corporate and financial sectors show little interest in embracing growth.
Reactions to Tapering
Although some of the current levels of pricing pressure are historically commensurate with rising interest rates, the decision to taper or to tighten should be treated as two distinct and sequential decisions.
Policymakers will first taper (begin to reduce their bond purchases as the Fed did in 2014) before they tighten interest rates (as the Fed did in 2015).
Taper without a Tantrum? It’s the key question for markets.
- When Ben Bernanke announced their intention to taper in 2013, the sell-off in the US bond market dragged global yields higher.
- The US equity market shrugged off the move in yields, but emerging markets saw significant outflows from both bonds and equities.
The taper also set off a chain of events that caught policymakers by surprise.
- The ECB and BOJ stepped into the breach with increased bond purchases of their own. The monetary policy differential led the Euro and Yen to a rapid fall against the US dollar, which undermined global commodity markets (mainly priced in US dollars) and led to a global industrial profit recession.
Policymakers have learned from those lessons.
The current setup seems to imply that nominal bond yields may have already adjusted to the expectation of a taper, but the rise in inflation expectations has kept real yields depressed at the levels where the Fed announced its taper in 2013 (as a reminder: Real Rates = Nominal Rates – Inflation).
When thinking about the risks of higher rates, it’s important to stress that investors and policymakers are far more aware of the bond yield versus growth dynamic today than they were in 2013:
- Investors are acutely aware that the Fed has other tools at its disposal, such as yield curve control.
- They could announce a taper of QE bond purchases and at the same time float the idea that they would still purchase bonds in order to cap yields.
- An explicit threat could be enough to prevent yields from ever reaching their target.
A taper announcement today should therefore be far easier to digest given the policy toolbox, the market’s experience in this theme, and the willingness of governments and central banks to keep the economy and markets at support levels. This all means that higher nominal yields are a smaller threat.
Realistically, a tightening of monetary policy may even help relieve some of the current inflation expectations that have started to unsettle financial assets.
For all the hate they get, one needs to acknowledge how policymakers’ don’t have it easy at this point:
- Loose fiscal and loose monetary policy is good for risk assets but will stoke inflation. High input prices have often preceded some of the major market tops of the last 20 years, which, if they were to materialize, would require even looser policy to support risk assets.
- Loose fiscal and tight monetary policy could see the dollar surge again. That was bad for global markets in 2014-2015 and would be so again.
- No one is considering tightening fiscal AND monetary policy at this stage, but the US may be compelled to ease its fiscal support in order to reign in the supply/demand bottlenecks that are at the heart of today’s inflationary imbalances.
Whilst it’s unclear what lies ahead of us, we do believe that markets should be able to digest a taper today far better than they did in 2013. Whilst the biggest risk remains inflation, prices could stabilize permanently higher if policymakers remain loose on both fronts.