INFLATION: NOTHING TO FEAR BUT FEAR ITSELF
Inflation fear seems to be on everyone’s mind these days. Certainly, bond investors appear concerned, while other market pundits are expressing mixed views. So, what is it that the market fears about inflation? And are these fears well-founded? To start, it’s important to emphasize that there are multiple types of inflation. Each affects asset prices in a different way, so distinguishing the types of inflation is important to us as investors. The real questions we need to address are what exactly does the market fear, and how is that affecting prices.
Two of the three types of inflation are related to supply and demand for economic goods. “Pull” inflation is when demand outstrips supply, pushing up prices. That’s what most people think of as inflation. “Push” inflation is when supply falls, but demand remains the same, so that scarcity pushes up prices. The recent pandemic can be thought to influence both.
On the demand side, citizens have been delaying purchases and saving money in aggregate, according to government statistics. The theory goes that when the economy fully reopens, “pent-up demand” will cause a surge in prices. Pent-up demand can drive up prices for a while, but it’s usually temporary. For example, after World Wars I and II, price controls were released and rationing ended, and pent-up demand drove up prices. In 1947, inflation soared to 20%. But this increase is usually just a temporary shock; once the pent-up demand is spent, inflation tends to fall back.
On the supply side, the economic shut-down of early 2020 led to a shortage of many of the goods and materials needed for manufacturing. Global supply lines have also been disrupted by a shortage of workers, causing a further shortage of materials. Now demand for materials is outstripping supplies, causing a rise in input prices for manufacturing. A rise in the cost of materials could also translate to a rise in the price of finished goods, but again, such a rise would likely be temporary, as supply and demand should balance once the economies reopen.
The third type of inflation, monetary inflation, has very different drivers. Monetary inflation is considered the prime cause of hyperinflation and comes from either low interest rates and/or high levels of government debt, at least in theory. Past examples include German hyperinflation of the 1920s and high US inflation of the late 1970s. Critics of current easy money policy and massive fiscal stimulus see similarities to those earlier periods. There is some cause for concern, as this type of inflation tends to be more structural than push or pull inflation, creating a new inflationary regime rather than a temporary shock. On the other hand, the relationship between money supply, deficits and inflation has been quiet for so long that many have dismissed this fear, including Federal Reserve Chairman Powell.
In fact, in recent communications, Chairman Powell has seemed unconcerned about each type of potential inflation, suggesting that any increase in prices will likely be short-lived. Even so, inflation fears in the marketplace are clearly on the rise. The breakeven rate of inflation-linked bonds is increasing. Consumers and analysts also see inflation rising in the coming years, based on survey data. Input and output prices from purchasing managers' surveys are growing at their fastest rate in years. Bonds, accordingly, have been falling, and yields have been rising in anticipation of rising inflation.
So far, realized inflation has yet to meaningfully accelerate, and we can wonder whether this is merely an inflation scare. But as investors, even if inflation does not materialize, the fear itself can have a significant influence on markets, particularly bonds, which we are already observing.
Despite the rapid run up in bond yields in Q1, real yields are far below their long-term averages. Currently, the real yield on the US 10-year bond is approximately 0%, even after a run up of almost 100 basis points in 2021. The average real yield since 1960 has been 2.20%; so for yields to revert to this longer-term mean, prices would have to decline by over 20%, given the current duration of the 10-year T-Note. A more realistic benchmark might be the average real yield since the end of the Global Financial Crisis in 2009, which is a more modest 75 basis points. Even so, reversion to the mean yield would still imply a further 7% decline in bond prices. So either way, if real yields move toward historical averages, the US 10-year can be expected to yield anywhere from 2.45% to 3.95% depending on the scenario.
However, all of this analysis has assumed that the current headline inflation number will stay at 1.75%. In other words, even if inflation does not rise as expected, or does so in a transitory way, the outlook for bonds remains poor unless we have disinflation rather than reflation. If we do start to see an uptick in inflation and the CPI-U rises further, bond returns could be even worse. It appears that we should really fear a normalization of real yields more than a reflationary rise, though both would be bad news.
As consumers, we may be concerned about the type of inflation that could be coming our way. As investors, the type of inflation is not as much a concern as whether or not expectations continue rising. It seems the only inflation fear investors have to fear, is fear itself.
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