John Gorlow
| Nov 15, 2021
October was a great month for equities. But you might have missed that while frowning at the gas pump, or expressing dismay at grocery prices or restaurant menu pricing. Inflation is on the rise, and that could spell trouble for a recovering economy.
The US stock market, as measured by the S&P 500 Index, returned 7% in October, its strongest showing since November 2020 when stocks jumped 10%. This marked a sharp turnaround from September, when stocks fell amid fears about inflation, labor shortages, shipping delays, bottlenecks, and China’s debt-burdened property market. Investors’ nerves were calmed by low volatility and strong corporate earnings, with some 82% of S&P 500 companies that reported in October beating expectations (FactSet data).
Foreign stock markets, as measured by the MSCI All Country World ex-US Index, also returned to profitability in October, adding 2.39%. The MSCI International Developed Market Benchmark Index returned 2.98% and the MSCI Emerging Market Benchmark index returned 0.99%.
In other markets, Real Estate Securities as measured by the MSCI US Reit index returned 7.74%. Gold shares gained 1.5% and the Bloomberg Commodity Total Return Index returned 2.89%.
Not all October news was rosy. As inflationary pressures spread through the economy, US consumer prices rose at their fastest pace in three decades. The consumer price index (CPI) rose 6.2%, marking the fifth consecutive month that the index exceeded 5%. In fact, October notched the greatest jump in consumer price inflation since July 1982. Driving the surge were cost hikes for energy, housing, food, used cars, trucks and new vehicles. Oil prices closed at $83.22 per barrel, up significantly from last month’s close of $75.27. Gasoline prices ended the month at $3.48 per gallon, the highest in seven years, up from $3.27 in September.
Inflation Raises Alarm
October data reinforces the view that inflationary pressures may be more persistent than many analysts and pundits expected. The Federal Reserve acknowledged the risk that inflation poses when it recently announced plans to begin scaling back its $120 billion-a-month asset purchase program.
Short-dated US government bond yields, which are the most sensitive to changes in monetary policy, surged higher in October to close at 0.48%, up from last month’s 0.28%. Yields on the US Ten-Year Note moved as high as 1.69% before closing at 1.56%, up from last month’s 1.52%.
While some of the pricing pressure stems from reopening bottlenecks, there is more to the story, reports Lisa Beilfuss (15-November Barron’s Magazine). Inflation has run hot for a long time and the Fed knows it, claims Beilfuss. She points to an under-the-radar metric—the Underlying Inflation Gauge, or “UIG”—created by the New York Fed, which provides “a measure of underlying inflation and is defined as the persistent part of the common component of monthly inflation.” Published monthly, the UIG has been soaring since February and stands at a record high 4.3%.
Noting that the Fed’s justification for overshooting on inflation rests on the idea that inflation undershot for a decade, Beilfuss takes a closer look at the UIG’s history. And here she finds that, contrary to conventional wisdom, the Fed’s own gauge shows inflation ran below 2% for only three relatively short stretches over the past decade: March 2012 through April 2014; December 2014 through November 2016; and February 2020 through February 2021. In other words, the UIG does not indicate any sustained period of inflation below 2%.
If prices were higher than advertised in the past decade, then it stands to reason that the current spike in inflation is worse than it appears. And this could spell trouble, says Beilfuss, because “The latest surge in inflation has occurred at a time when debt has ballooned across the economy, making the prospect of higher interest rates particularly problematic. If the Fed is further behind the curve than some observers fear, they may be forced to chase down inflation aggressively. Containing inflation may require tighter financial conditions than are currently priced into the markets.”
The Fed seems to be in no hurry to raise rates, points out Randall Forsyth (15-November Barron’s Magazine). “The Fed is only about to start reducing its $120 billion in monthly securities purchases by just $15 billion a month; at that rate, it will add over $400 billion to its $8.5 trillion balance sheet, which has more than doubled since February 2020, before the pandemic. And the central bank’s federal-funds rate target remains at a rock-bottom 0% to 0.25%.”
While some believe the Fed is acting too slowly after a prolonged period of quantitative easing, chasing down inflation aggressively has risks as well. Beilfuss points to the possibility of the Fed raising rates three times in 2022 and five times in 2023, creating a scenario in which “the yield curve inverts, demand slows, and inventories go from tight to bloated, pushing the economy into recession, or worse, in 2024.”
How to wrestle with rising inflation—and all the other issues created by the global pandemic—is a matter of debate, with sharply differing viewpoints. Some see the Fed’s firehose of monetary stimulus in response to the pandemic as being utterly excessive and a direct contributor to fast-rising inflation. Others are more sanguine, saying we’re simply experiencing the bumpy road back to an economy hungry for goods over services. Add jammed ports, logistics nightmares, Covid flareups around the world, and worker shortages, and a burst of inflation is inevitable. Treasury Secretary Janet Yellen repeatedly points out that many problems won’t be fully alleviated until Covid is under control.
What we are seeing now may be a turning point after decades of low rates, says the Financial Times (The End of the Bond Market Bull Run, 5-November). For more than 40 years, investors have reaped the gains as rates continued to drop. “Yet this time the multi-decade investment trend may really, finally, be coming to an end.” In the current climate, suggests the FT, “the bull case for bonds, now, is the bear case for the rest of the world—shifts in monetary policy reflect a relatively robust recovery from the pandemic.”
For investors, this is a good-news, bad-news story. Like many in the financial media, the FT warns that “if central banks lose control of inflation expectations, interest rates could end up rising without corresponding continued improvement in the global economy, which could put pressure on already richly valued financial markets.” A scenario of higher interest rates, soaring prices and slower growth is enough to make any investor cringe.
As in all financial crises, policymakers have only the past as their guide. The Fed doesn’t always get it right. Inflation is becoming more of a problem, and it may get worse before it gets better. But if you’re looking for a silver lining on this cloud, you may also see an improving economy, strong corporate earnings, and a world working its way back to some semblance of a “new normal.”
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Regards,
John Gorlow
President
Cardiff Park Advisors
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