The Vantagepoint Market Perspective: Inflation Awakens from Hibernation

05/14/2021

 

After years of benign readings, inflation reared its head last month. The key question is whether it’s simply a short-term blip or if prices will continue to push higher over the long term.

On Wednesday, data from the Labor Department showed the consumer price index jumped 4.2% in April on a year-over-year basis — the largest gain since September 2008. Excluding food and energy, prices were up 3% from a year ago.

On a monthly basis, inflation rose 0.8%, while core inflation (i.e., excluding food and energy) climbed 0.9%. The latter reading marks the biggest one-month rise since 1981.    

Easy Comparisons

Some of April’s annual price increase stemmed from the fact that a year ago, large portions of the U.S. economy had curtailed or drastically limited operations in an attempt to curb the spread of COVID-19.  As a result, measuring inflation during today’s rebounding economy against prices in last year’s stay-at-home environment — aside from a few exceptions such as consumer staples — is not exactly comparing apples to apples.  

For example, it’s worth remembering that in April 2020, the near-term crude oil futures contract tumbled into negative territory amid an extreme supply-demand disconnect. Meanwhile, large portions of the restaurant and leisure industries were shuttered.

So it’s understandable that the year-over-year price comparisons for both goods and services may be a little off. But whether that’s simply a short-term phenomenon or a trend that will continue into the medium term remains to be seen. Throw in the Fed’s stated intention of letting inflation run a little hot, and we do not believe that Wednesday’s inflation reading is necessarily cause for panic.

Other Factors at Play

Another part of the current economic equation are the shortages, including the one in the labor market. According to the Labor Department’s Job Openings and Labor Turnover Survey, job openings hit a record 8.12 million in March, eclipsing the number of new hires by 2 million (also a record). Separately, the April jobs report, showed payrolls increased just 266,000, presumably amid a dearth of potential employees willing to work or a severe mismatch between job openings and required skills. That was well below the 1 million jobs the consensus expected to be added.  

Some blame the labor shortage on the extension of federal unemployment benefits, which allow some to make more money collecting unemployment than they would in low-paying jobs. But it also may stem from the recent reopening of large parts of the service and leisure industries, which traditionally have paid relatively low wages.

In addition to the labor shortage, supply issues have cropped up in certain segments of the economy. For instance, there’s been a shortage of semiconductors, which has had knock-on effects on a variety of manufacturers. Since both the economy and supply chains are still somewhat unsettled, scarcities in some areas may continue to occur, which may in turn exert upward pressure on prices.

There are also the unexpected wildcards. For instance, during the past week — thanks to a cyberattack on the Colonial Pipeline, which brings fuel to large swaths of the eastern United States — shortages have emerged in the retail gasoline market, leading to long lines at filling stations that are reminiscent of the 1970s. That disruption helped push the average U.S. gas price to over $3.00 a gallon Wednesday, the highest level since November 2014.  

Keeping it in Perspective

Still, it’s worth noting that the nominal 10-year Treasury yield (which is the yield before inflation is factored in) is still well below 2%. While this is good news for borrowers, it means that savers can expect to lose relative to inflation, which is why the 10-year Treasury’s real yield is at negative levels.

The combination of these two rates is seen in the 10-year breakeven inflation rate — which reflects the market’s expectations for inflation over the next decade — and that stood at 2.54% on Wednesday, which is a multi-year high. So, the bond market seems to believe that over the long term, inflation will run materially above the Fed’s stated goal of 2%. 

The Fed Factor

In the fixed income market, there’s an additional dynamic at play due to the fact that the Federal Reserve is still making large bond purchases. If the recent spike in inflation isn’t temporary and instead continues into the third or fourth quarter, it may put pressure on the Fed to either bump up its benchmark fed funds rate or trim its quantitative easing efforts.  

We do not believe the Fed is likely to make any major moves in 2021, no matter what happens on the inflation front. However, if pressure does start to increase on the Fed to change its current policies, the first place it’s likely to show up is in its messaging. That’s why it’s even more important than usual to keep a close eye on the central bank’s statements and its members’ statements and speeches in the months ahead.

Indeed, after yesterday’s inflation numbers were released, Richard Clarida, the Fed’s vice chairman, said that while he was surprised by the jump in prices, he believes the increases will be transitory as the year-over-year comparisons get back to normal after last year’s COVID-19-inspired shutdowns. These types of statements are designed to communicate to the markets that the latest inflation numbers have not caused the Fed to change its policies in any way.

Potential Market Impact

If inflation lingers or accelerates, both the equity and fixed income markets may see some additional volatility as traders adjust both their expectations and security prices accordingly. However, equities may be better positioned to withstand such volatility than fixed income securities during inflationary times.

Therefore, the fixed income market is the one to watch for guidance as to inflation’s impact. Overall, it’s still relatively stable with the 10-year Treasury yield trading substantially below 2%, as previously noted, and still in the same general range that it’s been in for months.

From an economic standpoint, we do not believe that inflation alone will be enough to push the U.S. into a recession. Rather, historically, it’s been the Federal Reserve overshooting on its rate increases that has tended to boost the odds of an economic downturn, or some type of exogenous shock such as oil shortages or geopolitical turmoil.

There will always be heighted uncertainty at various junctures in any market cycle, and during the past year, U.S. investors have certainly seen more than their share. As always, it’s important to differentiate between shorter-term disruptions and longer-term structural concerns.  For those people saving for retirement and investing for the long term, a one-month spike in inflation certainly bears watching but should not obscure long-term objectives and an asset allocation designed to meet those objectives.  

Disclosures:

This information is intended for institutional use only and is not intended for individual investors or the general public. This article includes links to external websites. While we believe this information to be reliable, we cannot guarantee its complete accuracy.

Please note that this content was created as of the date indicated and reflects the authors’ opinions. These opinions are subject to change, without notice, due to market conditions or other factors.

This is not intended as a solicitation nor does it constitute investment, tax, or legal advice. Reference to any fund or asset class is not a recommendation to buy, sell, or hold that fund or asset class. Neither ICMA-RC nor its subsidiaries are responsible for any investment action taken as a result of the information provided herein or the interpretation of such information. Investors should carefully consider their own investment goals, risk tolerance, and liquidity needs before making an investment decision. Investing involves risk, including possible loss of the amount invested. Past performance is no guarantee of future results.

When Funds are marketed to institutional clients by our Investment Only (IO) team, the Funds are offered by ICMA-RC Services, LLC (RC Services), an SEC registered broker-dealer and FINRA member firm. RC Services is a wholly owned subsidiary of ICMA-RC and is an affiliate of VantageTrust Company, LLC and Vantagepoint Investment Advisers, LLC. Learn more at www.vantagepointfunds.org.

Disclosures:

This website is for institutional use only and is not intended for individual investors or the general public.

This information is intended for institutional use only and is not intended for individual investors or the general public.

Please note that this content was created as of the date indicated and reflects the authors’ opinions. These opinions are subject to change, without notice, due to market conditions or other factors.
This is not intended as a solicitation nor does it constitute investment, tax, or legal advice. Reference to any fund or asset class is not a recommendation to buy, sell, or hold that fund or asset class. Neither ICMA-RC nor its subsidiaries are responsible for any investment action taken as a result of the information provided herein or the interpretation of such information. Investors should carefully consider their own investment goals, risk tolerance, and liquidity needs before making an investment decision.

When Funds are marketed to institutional clients by our Investment Only (IO) team, the Funds are offered by ICMA-RC Services, LLC (RC Services), an SEC registered broker-dealer and FINRA member firm. RC Services is a wholly-owned subsidiary of ICMA-RC and is an affiliate of VantageTrust Company, LLC and Vantagepoint Investment Advisers, LLC. Learn more at www.vantagepointfunds.org.