Written by Vibhav Das
With U.S. unemployment hovering around all-time highs, a recent resurgence in COVID-19 cases, and the largest quarterly decline in GDP on record, most investors are eager for signs of stability and improvement in the economy. Therefore, it’s relatively easy to overlook current data points indicating potential inflationary pressures to the economy. And with markets pricing in a CPI remaining under the Fed’s target rate of two percent through 2050, elevated inflation may be the last worry on anyone’s mind. However, investors and economists alike would be prudent to note important implications for the capital markets and economy with a rise in inflation.
At 22%, the current money supply growth represents the largest uptick on a year-over-year basis by more than 1000 basis points (Wilson, 2020). Money supply growth is arguably the most powerful leading indicator of inflation, and although there wasn’t meaningful change to inflation from the monetary policy support provided by the Fed during the Great Recession, this policy response differed in key ways, according to Mike Wilson, Chief Equity Strategist at Morgan Stanley. For starters, the Fed went ‘all-in’ from the onset of the pandemic, pumping trillions of liquidity into clogged credit markets, showing no hesitation to backstop the markets and the economy. More importantly, fiscal support has dramatically changed. Congress made the move to guarantee commercially-backed mortgages and offered forbearance to rent payments, in addition to approving an unprecedented level of stimulus aimed directly at individual Americans (Wilson, 2020). In essence, the government – instead of the central bank – assumed control of money supply. Why would this be a problem? Won’t this money supply growth help fuel aggregate demand and nominal GDP growth?Things become tricky when political agendas become intertwined with government-backed financial support. Stimulus programs are popular amongst Americans, and “popular programs are what politicians run on,” Wilson asserts. What’s stopping Congress from approving trillions more in federal aid if it means its constituents may remain in office for years to come? And herein lies the problem. What was originally a central bank agenda has been taken over by a legislative body, and the consequences for continual funding and support for citizens are not being given their due diligence. Hence, potentially inflationary programs. As Milton Friedman so eloquently put it: “Nothing [is] so permanent as a temporary government programme.”
Besides money supply growth, there are also hidden dynamics within the supply and demand sides of the economy that convey inflationary momentum. Look no further than the huge run on toilet paper in April. According to data compiled by market-research firm IRI, weekly stock availability for paper products bottomed at around 40%, and it still hasn’t recovered to normal levels. What’s more, these supply shocks are met with considerable price hikes; prices for paper products have ratcheted up nearly 9% from last year, and overall store prices are roughly 5% higher on average than a year ago (Gasparro and Stamm, 2020). This phenomenon can be seen in numerous other areas of the economy, from used-car sales to barbershop markets (Lee, 2020 and Sheets, 2020). To put all this in economic terms: supply curves have shifted left while demand curves simultaneously moved right. Pent-up demand at any given price with contemporaneous supply-side shocks (permanent closures, restrictions on capacity to prevent spread, etc.) point to higher prices, which generally brings inflationary pressure. While this is not necessarily grim news, current market expectations completely overlook this, and mispricings in various asset classes may soon begin to correct as the consensus regarding inflation expectations begins to change.
Despite the disconnect with overall expectations, some areas in the markets are indicating potential inflationary strength. Utilities have long been seen as an inverse leading indicator for inflation and volatility. Various exchange-traded funds tracking utilities are down 5-10% YTD, while the broader S&P 500 and NASDAQ indices have roared back to all-time highs since bottoming in March. The S&P is up almost 4% YTD, while the NASDAQ has seen nearly 28% YTD growth (FactSet, 2020). What’s more, fixed-income markets may already be digesting the possibility of elevated inflation in the coming years. The 30-year Treasury auction that took place earlier this month experienced muted demand with a weak bid-to-cover ratio (TreasuryDirect.gov, 2020). This makes sense, as durations for longer maturity bonds, like 30-year Treasuries, tend to be very high – indicating a sharp price sensitivity to changes in interest rates and inflation. Since bond prices fall when yields rise, inflation tends to hurt bond markets in an outsized manner.
Although market pricings of select asset classes and sectors indicate growing inflationary sentiment, current market and economic expectations do not seem to address key leading indicators for inflation. Those who take advantage of these mispricings may see unrivaled portfolio strength in the quarters to come – meaning investment-grade credit, commodities, financials, and other beneficiaries of the growth in inflation.
Citations:
Gasparro, A., & Stamm, S. (2020, August 10). Why Are Some Groceries Still So Hard to Find During Covid? Retrieved from https://www.wsj.com/articles/why-are-some-groceries-still-so-hard-to-find-during-covid-11597069761?mod=searchresults&page=1&pos=4
Lee, J. (2020, August 22). Secondhand Sellers Have Problems, but Demand Isn’t One of Them. Retrieved from https://www.wsj.com/articles/secondhand-sellers-have-problems-but-demand-isnt-one-of-them-11598104981
Bureau of the Fiscal Service, Treasury Auctions. (2020, August 13). 30-Year Treasury Bond Auction Results[Press release]. Retrieved August 30, 2020, from https://www.treasurydirect.gov/instit/annceresult/press/preanre/2020/R_20200813_3.pdf
Wilson, M. (Host). (2020, August 17). The Case for Higher Long-Term Interest Rates [Audio blog post]. In Thoughts on the Market. New York City, New York: Morgan Stanley.
Wilson, A. (Host). (2020, August 21). What Can a Haircut Tell Us About Inflation? [Audio blog post]. In Thoughts on the Market. New York City, New York: Morgan Stanley.
Wilson, M. (Host). (2020, August 3). Who’s Driving The Growth in U.S. Money Supply? [Audio blog post]. In Thoughts on the Market. New York City, New York: Morgan Stanley.
FactSet Research Systems. (n.d.). NASDAQ, S&P 500, Various Exchange Traded Funds.: Monthly and quarterly performance. Retrieved August 30, 2020, from FactSet database.