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Behind the Inflation Debate
February Market Report

John Gorlow | Mar 18, 2021

Sometimes the investment landscape is radically altered overnight. Such was the case when the US economy was abruptly shuttered in March 2020. A year from now we may look back again, assessing how President Biden’s signature $1.9 billion Covid-19 relief plan affected the economy for better or worse. Meanwhile, we have plenty to unpack this month as markets respond to a tidal wave of money, hopes for recovery, and the threat of inflation.

The benchmark S&P 500 returned 2.8% in February, mostly climbing higher just as it has for months. But a change in market leadership that began six months ago gathered steam as investors began to wake up from a long year of Covid-19 exile. Peloton and Big Tech stumbled as consumers re-evaluated the need for so many new computers, expensive bikes and Amazon deliveries. Meanwhile, last year’s lousy performers continued to perk up as investors turned to more economically vulnerable sectors like banks, energy companies, and heavy equipment makers.

An accelerating shift to value stocks rewarded those who remained diversified through a long and painful decade (that’s right—decade, not year). Over the past six months, the MSCI global value stock index climbed 17% compared to 9% for the tech-heavy MSCI global growth stock index.

For some, the long losing streak of value stocks supports a popular theory that a stock’s price is no longer relevant in forecasting expected returns. These pundits argue that investors should focus on the “intangible value” of internal innovation, including patents, intellectual property and trademarks, things that are not fully reflected on the balance sheet. Innovation is the new currency, they argue. The market seems to disagree with this idea with its recent thumbs-up to value stocks. But as we’ve seen with so many prolonged cycles over stock market history, the timing and extent of value stocks’ comeback can’t be predicted. It remains to be seen whether value’s resurgence is a flash in the pan or has legs to stand on.

In another sign that the tide is turning, February saw renewed love for small cap stocks, which also performed poorly relative to their large-cap counterparts over the past decade. Over the past six months, the MSCI global small cap stock index produced a stellar 30% return compared to 13% for the MSCI large cap stock index.

Both trends—a surge in value stocks and small caps—are continuing into March. Looking now at year-to-date data through March 12th, the MSCI global value index has risen 9% compared to flat line performance for growth companies. This marks a sharp switch from last year’s performance when the same index slumped -1.2% compared to a huge gain of 34% for growth companies. How times have changed. YTD, the MSCI small-cap index has trounced the large cap index, 12% to 5%. Over six months, small caps are beating large caps by 20%. Enthusiasm is even higher for foreign small-cap stocks. Over the past six months, the Morgan Stanley All World Ex US Index outperformed Domestic stocks almost two to one. Here again, foreign value and foreign small stocks outperformed the broader foreign benchmark index by 25%.

What are we to read into these turnarounds? Investors are clearly reacting to the Biden stimulus package, including a huge surge of money about to pour into the economy; smoother, faster vaccine rollouts; and a gradual reopening of major world economies. Despite the horrific death toll and terrifying news of 2020, things have turned out far better than anticipated (so far). One can almost hear a collective sigh of relief. Markets are signaling that a new day is coming, and we’re looking for a new kind of rally. And yet, there is one issue that has investors fretting.

Too Much of a Good Thing?

The stimulus package set high expectations for a robust economic recovery in 2021 and beyond. It also stirred up a hornet’s nest of worry about rising inflation at home and abroad. Torrid growth in the US and across the world could push borrowing costs higher quickly and torpedo global business recovery.

How much growth should we anticipate? Economists at the Organization for Cooperation and Economic Development (OECD) predict the most recent stimulus program will add 1% to global economic growth in 2021, pushing it up to 6%. The OECD also revised expectations for US growth to 6.5% for 2021, up from 3.2% in its November 2020 forecast. Renowned Yale economist Robert Schiller recently told a Blackrock audience that he sees a big rise in employment and some pressure on inflation, but nothing that will move the Fed from its accommodative stance. Schiller suggested that China and the US are probably one or two quarters ahead of where Europe, the UK and most emerging markets will be in 2021. He anticipates rapidly accelerating US and global growth in Q2 and Q3, with US activity returning to a pre-Covid level as soon as Q3. This would be a pace of recovery far beyond anything predicted last year.

That said, Schiller cautions that all the damage that has been done to the supply side of the economy and the services sector will not likely be over by Q3. Rather, he sees a combination of “the good side of the economy” recovering above normal levels along with some recovery in services. While his forecast for Q3 2021 exceeds that of (pre-pandemic) Q4 2019, it is predicated on strong control over the spread of Covid-19 and new virus variants. As we know, the best-informed predictions can be derailed by unforeseen events.

One of the most vocal critics of the new $1.9 billion stimulus package is Former Treasury Secretary Larry Summers, who argues that a strong recovery coupled with last year’s $900 billion stimulus will overheat the economy and ignite inflation. It’s just too much money flowing into an already recovering economy, he says, noting that the size of the spending package equals about 9% of pre-pandemic national income, far exceeding what was lost during the pandemic. An inflationary scenario is easy to imagine, pumped up by loose monetary policy, freely-spending Democrats in control in Washington, falling unemployment, and pent-up demand by consumers who have been saving and are ready to spend. We already see signs that recovery may be happening faster than manufacturing and service workers can handle it, with supply chain bottlenecks pushing up prices.

Concerns that aggressive monetary and fiscal policy will reignite inflationary pressures rattled the global bond market in February and led to a wave of selling that sent prices down 1.8%. The selloff culminated in the worst start to a year for the bond market since 2015. The higher yields have driven unexpected strength in the dollar since early January. And yet, if bond prices are a good indicator, most investors, including Dan Ivascyn, chief investment officer at Pimco, don’t appear to be overly alarmed about long-term inflation. But, he added "the bond market may not come to that same conclusion in the near term" (Financial Times, 26-February, 2021). Traders tend to overshoot to the downside, so the selloff could be a taste of further volatility to come. Still, the US break even curve, which tracks investors forecast for inflation, has flipped upside down with short-term measures eclipsing their long-term counterparts. The two-year breakeven rate, which is derived from US inflation protected securities, hovers at 2.7% while the five-year gauge recently hit 2.5%. The ten-year rate has lagged slightly behind at 2.3%. Rather, the market seems to share the views of Fed Chairman Jerome Powell and Treasury Secretary Janet Yellen, both of whom expect any jump in inflation to be temporary. Gregory Daco, chief US economist at Oxford Economics, also anticipates that inflationary pressures will soon subside. “The most likely outcome is that after a spring peak, inflation will fall back while remaining above two per cent for longer than at any other time over the past decade,” he said. “By longer-run historical standards, inflation is still set to remain relatively muted and a long way from spiraling out of control” (Financial Times, 11-March 2021).

But perhaps these views are too shortsighted. With all the money surging through the economy, Robert Schiller speculates higher inflation could come from some combination of excess saving, household balance sheets coming back faster than anticipated, and passage of a big infrastructure bill. While massive infrastructure spending wouldn’t flow into the economy right away, by 2023, 2024, or 2025 it could join a surge of very strong consumer spending and an economy buzzing along at full employment. In that scenario, Schiller sees the potential for higher inflation. “I just don't think everything is in place at this point. And I'm certainly not looking for a once-in-a-generation return to the 70s-style inflation outcome,” he told a Blackrock audience in February.

Schiller isn’t the only one to hearken back to the 1970s, when inflation reached 10% and interest rates soared to 20%, a 20th-century record. No one wants to repeat that era. But that was then and this is now, writes Binyamin Applebaum (New York Times, 16-February 2021). “The threat of inflation has been invoked repeatedly as the justification for placing limits on federal spending, for restraining the pursuit of full employment and for limiting the economic power of workers. It is a tired refrain that seems to be sung mostly by those whose views were forged during the ‘stagflationary’ 1970s. But we live in an era of anemic inflation, and changes in the economic landscape since the ’70s have significantly reduced the chances of a revival, including the watchfulness of the Federal Reserve, workers’ loss of bargaining power and the effects of globalization.” Applebaum points to the huge wealth gap that has widened even more during the pandemic, and is hopeful that the Biden stimulus package will plug holes and lift the boats of those who have suffered the most.

Problematic Questions

Other policy experts have different concerns, namely that the magnitude of the Biden relief bill subtracts from resources needed to invest in other urgent needs going forward, including infrastructure, sustainable jobs, green technologies, nationwide broadband support and other forms of spending that support growth. “What is the highest use of our dollar?” asked Raghuram Rajan in a February DFA-sponsored webinar. Currently a distinguished professor at the University of Chicago Booth School of Business, Rajan served as Chief Economist and Director of Research at the International Monetary Fund between 2003 and 2006.

His questions are practical and also troubling for those totaling up our future debt. If, in the span of a couple of years, we're spending something like 20% to 25% of GDP and debt levels are around 130% of GDP, what are the consequences? If the spending is not generating assets in terms of human capital or physical infrastructure that will repay in the long run, are we simply helping people now only to create a large debt load that will hurt us in the future?

Rajan points to a startling number of crises in our recent past—all of which consumed significant resources. We’ve now had two “once in a century” financial crises in about 12 years (the financial crisis and now the pandemic; he doesn’t include the dot-com bust). And in Texas, we’ve seen the consequences of failing to prepare for potential climate change. “If we have more disasters [due to fixable reasons that we have neglected], we need to be able to spend at that time in the same way as we spend now. So to some extent, we shouldn't be exhausting our capacity to spend in one go because recovering our ability to spend again will take time.”

This perspective puts the Biden relief plan in a different light. “The kind of money we're spending now is the kind of money that's been [spent] in decades, not in a few years. So it's really important to preserve the capacity to deal with future emergencies. It's also important to preserve the capacity to deal with investment we need if we want a more sustainable economy.” Rajan concludes that for all these reasons “We have to be much more careful, even though there's no chance of us defaulting on the debt in the very short run.”

In Conclusion: Good News and Worries

Alan Blinder, Professor of Economics and Public Affairs at Princeton and Vice Chairman of the Federal Reserve from 1994 to 1996, concludes that “We are not likely to see inflation rates that any reasonable person would call high soon.” The outlook for the rest of the year, starting in Q1 and building up toward the end of the year, is that we will see increasing levels of economic activity, stronger growth, and lower unemployment. We will see a strong rebound, and this year will look unlike any in our recent past. Higher inflation may occur but many believe it will be temporary. There is no need for most investors to worry about it.

Longer term, we will be better able to evaluate the results—good and bad—of the $1.9 billion stimulus plan. Some believe it will begin to address a severe financial crisis for millions of Americans and the imbalances of a lopsided playing field. Others foresee a dangerous debt load and inability to satisfy future needs. Most economists do not foresee a return to the 1970s-era inflation. But one thing is certain: we did not see ourselves at this juncture a year ago when the global economy went into lockdown. And a year from now everything will be different again.

So how should investors approach these new risks? I encourage you to remain diversified, gear equity exposure towards a strong cyclical recovery and maintain allocations in line with your targeted long-term goals.

Do you have questions or concerns? Call me, I am here to help.


John Gorlow
Cardiff Park Advisors
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