That was my question back in February, as stimulus piled up on an already recovering economy. Since then, the questions have become still more urgent—and more complex.
How do we reconcile a disappointing U.S. payrolls report with booming business activity and inflation at 4.2%? Are the inflationary pressures transitory or structural? Is the jump in inflation what everyone seemed to be expecting this spring? Has the vaccine rollout simply brought demand forward a few months, or have we underestimated just how fast prices will be rising come the summer? When Federal Reserve hawks line up with the doves and President Biden to tell us the economy still needs support, is that reassuring, or a worrying sign of groupthink?
For equity and bond markets, we do think inflation is picking up and that surprises mean volatility for the next few months. But could it be enough to end the recovery?
While 266,000 U.S. jobs were created in April rather than the one million expected, that was not for lack of available work. There are currently more than eight million job openings. The “Quits Rate,” which tends to be higher when the jobs market is stronger, is back above pre-pandemic levels. The National Federation of Independent Business’s “Job Openings Hard to Fill” index is at its highest-ever level.
As my fixed income colleague Robert Dishner puts it, it was tough to find people before the pandemic and it’s even tougher now. The logistics of hiring remain difficult in the tail-end of a lockdown. Baby Boomers continue to leave the workforce, and the pandemic may have given some of them a reason to retire early.
An interesting and somewhat confusing element of the jobs report was that, while there are nominally 1.6 million more U.S. jobseekers today than in February 2020, a million of those are not actually looking for work. Some have to sort out new childcare arrangements. Some remain cautious about the virus. And some are staying at home due to the extension of significant benefits distributed as part of the recent stimulus programs.
This labor supply bottleneck, on top of other supply chain constraints, looks inflationary. But many, though not all, of these factors appear transitory.
From a peak of more than eight million jobs lost to the pandemic, the leisure and hospitality sector is now down to 2.8 million. Headline wage inflation is also being skewed by leisure and hospitality, where production and non-supervisory workers’ pay soared by 2.7% just in the past month.
These dynamics fit with the pivot to reopening, as do the underlying drivers of last Wednesday’s U.S. CPI print. Against a consensus forecast of 3.6%, 4.2% was big, but it was dominated by used cars, car and truck rental, public transport, airline fares, recreational services and hotels. Prices for things like housing rent and medical services were essentially flat.
The latest thinking on this from our fixed income team is interesting. Many of their client portfolios have profited from the meaningful run-up in U.S. and European inflation breakevens (as reflected in inflation-adjusted investments such as U.S. TIPS). Now they are reducing exposure to the five- to 10-year part of the curve, while adding at 30 years. Investors have fully priced in high reopening inflation, they suggest, but not the moderate but structural inflation from retiring Boomers and the skills mismatch of an increasingly automated economy.
That puts us close to the Federal Reserve’s position, albeit with less confidence than they are currently expressing. Labor market imbalances, supply chain bottlenecks, commodity and component shortages—these are all real, and could generate more inflation when they hit high summer demand, but they are likely to ease with broader reopening.
Bottom line: We believe inflation has reached an important inflection point, and we expect it to be structurally higher than during the last cycle, but not so high as to create major disruptions in markets. This drives our positive view on risk assets and equities: Demand is robust, and businesses benefit from the growth effect of moderately higher inflation when reporting revenues and earnings in nominal terms.
Reopening and Recovery
So why have signs of inflation caused equity markets to sell off?
First, while moderate inflation can be a tailwind for equities over the medium term, unexpected high inflation is usually just a source of higher interest rates and volatility. Commodities tend to do better in an inflationary environment, which we think could prevail over much of the summer.
This uncertainty is exacerbated by record equity index levels, high valuations, abundant liquidity and talk of aggressive risk-taking. Last week’s broad-based sell-off followed record highs for both the S&P 500 and the European STOXX 600 the week before. Some of the most volatile stocks right now are high-multiple technology growth stocks that are sensitive to interest rates—and which have come to dominate the performance of U.S. large-cap indices like the S&P 500. Adding to this, we have heightened geopolitical tensions, a shift in concern about coronavirus from the U.S. and Europe to Asia and, looking ahead, worries about the debt and tax burdens of today’s stimulus packages.
Market volatility is to be expected in such uncertain times. When it comes from fears about problematically high and sustained levels of inflation, however, we think it will present opportunities to add risk as reopening and a strong recovery broaden out.
In Case You Missed It
- U.S. Consumer Price Index: +0.8% in April month-over-month and +4.2% year-over-year (core CPI increased 0.9% month-over-month and 3.0% year-over-year)
- U.S. Initial Jobless Claims: +473,000 for the week ending May 8
- U.S. Producer Price Index: +0.6% in April month-over-month and +6.2% year-over-year
- U.S. Retail Sales: Unchanged in April month-over-month, but +51.2% year-over-year
What to Watch For
- Monday, May 17:
- NAHB Housing Market Index
- Japan 1Q 2021 GDP (Preliminary)
- Tuesday, May 18:
- Eurozone 1Q 2021 (Second Preliminary)
- U.S. Housing Starts and Building Permits
- Wednesday, May 19:
- FOMC Minutes
- Thursday, May 20:
- U.S. Initial Jobless Claims
- Japan Consumer Price Index
- Japan Purchasing Managers’ Index
- Friday, May 21:
- Eurozone Purchasing Managers’ Index
- U.S. Existing Home Sales
- U.S. Purchasing Managers’ Index
– Andrew White, Investment Strategy Group