My first firm on “the Street” employed the Chief Economist of The Conference Board, the late Al Sommers. During one recession, from behind a cloud of cigar smoke, Al gravelly-voiced out, “what this economy needs is a little inflation.” And, in our current uncertain economic environment, that advice still holds true. While some inflation will prove an economic positive for equity markets, fixed income markets normally respond with higher long-term interest rates and lower prices.
Forecasting future inflation tripped up many economists over the last decade. The Fed finally threw in the towel in attempting to forecast inflation. They did so when they adopted their flexible average inflation targeting (FAIT) policy. Under the previous framework, forecasts of rising inflation eventually led to rate hikes. Despite these forecasts, inflation remained subdued, leading to policy errors. Rather than depending on economic forecasts, the Fed will now wait until they see inflation rise above 2% for some period before raising rates.
The potential power of the second half snapback and, therefore, the inflationary outlook will depend importantly on two countervailing forces – vaccine rollouts and virus mutations. The United States currently vaccinates about 1.3 million daily, with over 40 million vaccinated at the beginning of February (see Figure 1). Observers estimate it will likely take until the second half of the year to reach herd immunity by vaccinating 80% of the 250-300 million adult Americans. That could prove faster once the one-shot Johnson and Johnson vaccine receives the go-ahead, and rollout experiences lead to improved processing.
Once past the snapback, the moderate inflation view foresees rapidly increasing federal borrowings pulling down economic growth. Research from Hoisington Investment Management shows the slowdown would result from declining marginal productivity of U.S. debt (see Figure 2). If slowing proves the case, then labor market slack will persist – muting wage cost inflationary pressures. Perhaps, Figure 2 also partially answers those who suggest we can continue to enlarge federal deficits without penalty. Finally, continuing to apply new technologies at lower costs will provide major support to this view.
Former Treasury Secretary Larry Summers sees the series of income replacement packages, particularly the current $1.9 trillion proposal, pushing demand above supply, creating inflationary pressures. In his view, the current proposal exceeds the Congressional Budget Office output gap estimate of $670 billion — not a precise Figure. Against that, Goldman Sachs economists argue for a larger output gap and that parts of the package comprise one-off spending.
The two COVID-19 response programs enacted in 2020 plus the $1.9 trillion proposal would total roughly $5 trillion of spending or approximately 25% of GDP. In comparison, the American Recovery and Reinvestment Act of 2009 totaled an estimated $787 billion when enacted, or 5% of GDP. In addition, its greatest impact occurred two years later (Figure 3 compares its relative impact with the 2020 CARES program). Larry Summers also criticized the package for too much short-term spending and not enough long-term investment for growth. The implications of the size and timing difference suggest both a stronger recovery than after the GFC as well as the potential for greater inflationary impacts. The key question – will potential inflation prove transitory or lasting?
Depressed consumer services will likely lead to an economic snapback. With top earners most likely to open up their overflowing piggy banks to experience a broad array of consumer services, inflationary pressures could mount. These pressures will likely prove transitory once consumers satisfy their pent-up demands and savings diminish. Consumer services comprise only six percent of the Consumer Price Index. Therefore, most inflationary pressures mainly arise from other sources such as shelter costs, which comprise over 20% of the price index.
Long-term inflation importantly reflects wage cost trends (see Figure 4). Labor costs typically comprise about 70% of business operating costs. The pandemic’s impact on certain industries exaggerates the unit labor cost impact shown in Figure 4. How quickly the current slack in employment declines will importantly influence wage cost pressures and long-term rates of inflation.
Global supply chains over the last two decades contributed importantly to reducing inflationary pressures. The pandemic revealed the vulnerabilities of single-sourced global supply chains. As a result, less efficient regional supply chains could partially replace global ones leading to higher long-term inflation.
In the first four months of fiscal 2021, beginning last Oct. 1, the federal budget deficit rose 90% to $738 billion. With declining U.S. net savings, funding growing budget deficits will come, indirectly, from increasing trade deficits. This possibility will likely create long-term U.S. dollar weakness. This possible trend leads to rising import prices producing long-term inflationary pressures.
The administration looks to aggressively reduce fracking. If the administration achieves that goal, then increased oil imports at higher prices would likely result.
Financial markets support the outlook for a rising rate of inflation (see Figure 5). Most economists still look for moderate economic growth (2-2.5%) past the snapback. With that, they see long-term inflation not reaching over 2% until at the earliest 2022/23. Of course, most economists do not show a great track record for forecasting inflation.
The Hutchins Center Fiscal Impact Measure (FIM) shows graphically that fiscal policy acted as an economic drag through the first part of the last decade and made no meaningful contribution for the remainder of that decade (see Figure 6). Instead, policies stimulating economic growth fell to the Fed. This will likely shift to increased fiscal policy spending under the new administration. Based on the year-end fiscal package, the Hutchins Center forecasts that fiscal spending will add over 7% to first-quarter growth. In the second quarter, the proposed new COVID-19 package sets the base for a second-half snapback as vaccine rollouts give Americans greater confidence to open up their wallets. Many economists look for economic growth to reach 6% plus this year.
Equity markets in 2020 increased from p/e multiple expansion rather than from earnings growth (see Figure 7).
For 2021, earnings increases rather than multiple expansion will likely prove important in driving equity markets. While tech earnings will continue to improve, the major source of positive earnings surprises will come from consumer services, cyclicals/value, commodities, and small and mid-cap companies. Currently, analysts look for S&P 500 earnings to increase 20-25% this year. Using the unweighted S&P 500 index ETF provides a conservative approach to participating in this broad-based outlook.
The current economic outlook, in our view, will continue to benefit cyclical companies—many of which also fall into the value category. As a caution, periodically the snapback and economic recovery might face regional and local difficulties from variants of the virus.
Stimulative monetary and fiscal spending programs globally joined by the current recovery in China could lead to a synchronous rebirth of global growth later in 2021. This outlook should benefit many hard commodities as well as oil. Underinvestment in production capacity for both groups should prove key to their attractiveness—similar to earlier in this century. A likely slow vaccine rollout in developing countries could throw a temporary spanner into the synchronous rebirth of global growth.
The disruptive pandemic will force many business sectors and companies to reposition themselves to meet this change. These shifts will create opportunities for active managers to differentiate their investment selection skills. These forces may also lead investors to selectively reconsider making greater use of actively managed funds than true over the last decade.
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