Q: Kevin, from a fixed income investor’s perspective, what is your inflation outlook and how do you think the Fed will play its hand in the coming quarters?
A: Continued aggressive monetary policy and increased fiscal spending will likely drive growth rates to be well above normal in the near term. The increased demand, combined with tighter supply chains, has put upward pressure on prices. Recent economic data has shown a significant uptick in inflation with CPI rising 4.2% year-over-year and 0.8% month-over-month in April.
All the “easy money” is putting fixed income investors on edge over inflation. Last year, the Federal Reserve adopted a new policy of “average inflation targeting,” meaning it will allow inflation to drift above 2% after periods of below 2% inflation. We are now clearly in the phase where the Central Bank is allowing it to drift higher. To date, the Fed believes the recent inflation data is transitory in nature and we will start to see these numbers subside in the coming months. Market participants are not as certain about this as the Fed is.
We believe that modestly higher inflation is likely here for a more extended period. In our view, this will force the Fed to begin taking their foot off the accommodative gas pedal sooner than they anticipate. As of now, members of the Fed do not anticipate a rate hike until early 2023. Although they have started with baby steps, we expect the Fed to begin to taper its monthly bond purchases potentially more earnestly by the end of 2021, with additional tapering to begin in the coming months. We do not anticipate any rate hikes in the near term, but if inflation remains elevated that could be the catalyst that forces the Fed to raise rates before mid-2022.
Q: Paul, there is a lot of discussion if inflation is transitory or more secular, what is your opinion on this topic? Are there pockets of inflation where you think the answer is different?
A: This depends on your definition of transitory but, in my opinion, inflation pressure will last more than just a few months and may even last a couple years. Eventually, innovation, which is deflationary, supply improvements and policy adjustments will kick in and erase upward pressure on prices.
Let me give you a specific example which highlights this scenario – take a meat processing plant. The plant is designed to process various cuts of meat, some of which are sold to grocery stores while others are sold to restaurants. The plant will have designated lines to process and package the cuts to meet the end users’ specifications. When COVID-19 hit, the demand mostly shifted to grocery end-markets versus restaurants, exceeding the plant’s capacity for grocery while shuttering its restaurant capacity. In addition to the shift in demand, labor constraints slowed throughput. Plants couldn’t reconfigure processing lines to compensate for the shift in demand, not to mention the capital investment that would require. As the economy reopens, industries are still reeling with labor issues at a time when demand is increasing at an accelerating rate, but eventually market forces will balance supply and demand.
This example transcends across a multitude of industries right now – labor is still an issue and manufacturing plants, or more generally supply chains, were never designed to meet a rapidly changing demand picture.
Furthermore, if you think about commodity-intensive industries, there has been a dearth of capital investments over the past decade due to low prices and poor margins. So, when it comes to answering how long inflationary pressures will last, I think its twofold. First, how long does it take for capacity to recover or even expand, and second, is the demand we are seeing a permanent shift higher, or just a short-term phenomenon due to the reopening of the economy. It is difficult to answer these questions, but it is going to take more than a few months to realign the supply and demand curves, in my opinion, and therefore what we are experiencing isn’t transitory if we define it by that time horizon.
Q: Kevin, how does your inflation outlook impact asset allocation and the role of fixed income in portfolios?
A: We believe that Treasury yields will gradually move higher as investors adjust to higher growth rates and increased inflation. Short-term yields will likely remain muted as the Fed continues to support the economy. This makes for an extremely challenging environment for fixed income investors as bond prices move in the opposite direction of yields. In addition, corporate credit spreads are near all-time tight levels, adding to the difficulty in finding value in the fixed income markets. Our view is that, while fixed income should remain an important part of a portfolio, we believe better value can be found in other asset classes that have low correlations to equities, such as commodities, strategic income (preferred stocks and real estate) and alternatives. We believe that investors with long time horizons and the willingness to take on a bit more risk in the form of market volatility should be underweight fixed income as we expect returns to be muted for the foreseeable future.
Q: Paul, commodities have historically been an attractive way to hedge against inflation. Any reason to think it will be different this time?
A: No, I don’t think this time will be different. In fact, commodities have performed well over the past several months as inflation expectations have crept higher. And, since we are still in the early stages, I suspect the general trend will still be higher across the board, like in previous cycles.
However, as the inflation theme matures over the medium-term, I think we could see a decoupling within the asset class over that time frame, different than in previous cycles. In other words, I think the inflationary pressures will last longer in certain segments of the economy than in others and there will be a trickle-down effect to the individual commodity markets with some outperforming others. As one example, the green energy wave could result in deflationary pressures for fossil fuels while producing inflationary pressures for other inputs.
Q: Kevin & Paul, what is something non-consensus or a derivative of the inflation outlook that you believe the market might be overlooking?
A – Kevin: While we are making progress towards the end of the pandemic, I believe that the market is pricing in very little chance that we have any significant setbacks in the United States during the fall or winter. Any possibility of additional closures of the U.S. economy are not priced into the markets. Should we get a scenario where this happens, a flight to quality is likely to ensue, pushing Treasury yields significantly lower.
A – Paul: There seems to be this general belief that consumer habits will slowly shift back to pre-pandemic preferences. For example, consumer spending on travel and entertainment will increase as we reopen, which probably occurs at the expense of in-home spending (i.e., home projects). What happens if this shift does not occur? I think that will continue to constrain supply chains, exacerbating the current situation.
Another question I would raise is how quickly can capacity recover? As unemployment benefits expire, will labor capacity recover quicker than we think? Everyone seemed surprised at how fast capacity was taken offline during the pandemic, so will the same be true on the upside as we emerge? We live in a very innovative society and I think a quick recovery in capacity, or throughput, is something that could derail the inflation bulls’ thesis.