Don't Dismiss the Risks of Inflation for Investors
Posted by: Doug Gerlach 6/22/2021 12:17:12 PM

Will higher-than-anticipated inflation result from a strengthening economy and the Fed’s easy monetary stance?

A strengthening economy combined with the Fed’s easy monetary stance have led to a robust debate over whether this will result in persistent, higher-than-anticipated inflation. The May Consumer Price Index (CPI) data reflected a 5% increase in prices over the past year. This represented the largest increase since 2008 and was an acceleration from April. After removing volatile food and energy, the May reading rose 3.8%. This is well ahead of the Federal Reserve’s 2% target, though current readings are elevated partially as a result of supply chain bottlenecks that are expected to ease over time. For example, used cars and trucks alone accounted for one third of May’s increase after surging nearly 30% over the past year. Used car prices have shot higher amid a semiconductor shortage that has hit car production, a pressure that is likely to fade over time. It is worth noting that the CPI rose at an annualized rate of 2.5% versus May 2019. While this is a more reasonable figure, it still represents a multi-year high.

The Fed’s preferred measure of inflation, the core price index for personal-consumption expenditures (PCE), increased 3.1% for April, the date of its most recent release. Regardless of the measurement, the takeaway is recent inflation readings have been running ahead of the Fed’s target and are expected to continue to do so for some time. For its part, the Fed has said it anticipates higher inflation readings in the near term given the recovering economy and supply chain bottlenecks, but it has consistently reiterated its belief these price pressures are transitory. This belief, combined with a more flexible inflation targeting objective adopted last year, suggests the Fed is currently more concerned with the full employment component of its dual mandate, though this could change.

The bond market of late has been dismissive of inflation fears. In a sign the market is generally in agreement with the Fed’s “transitory” view, 10-year treasury yields have dropped in recent weeks even as inflation data has shown higher price increases than expected. Treasury yields recently achieved their lowest levels since early March, and at about 1.50% are down meaningfully from the recent highs of 1.75%.

If inflation continues to run hotter than expected, the fear is that the Federal Reserve will have to tighten policy more abruptly than investors currently expect. The first step in what is widely anticipated to be a gradual tightening process is expected to be a tapering of its $120 billion monthly purchases of mortgage and government bonds. As recently as April, Fed Chairman Jerome Powell insisted the Fed was not even thinking about a discussion on tapering, but more recently Fed Vice Chairman Randal Quarles and other top central bank officials have called for talks about trimming its bond purchases. The current market expectation is that tapering begins at some point in 2022. Whatever the timing, the Fed is likely to give ample warning. Given the 2013 “taper tantrum,” the Fed is acutely aware it needs to carefully manage the task of pulling back accommodation without alarming the market. Rate increases would follow tapering, and both the Fed and the market are currently looking for those to begin in 2023.

Low interest rates continue to support elevated P/E ratios. The forward P/E ratio for the S&P 500 is approximately 21x. Earnings are expected to grow approximately 35% in 2021 and low-double digits in 2022. The positive news is earnings estimates for 2021 have increased since the start of the year, the opposite of the more typical trajectory of reduced estimates as the year progresses, and serves as yet another sign of the rebounding economy. The timing with which the Fed chooses to act remains a risk but owning pieces of reasonably valued, growing companies remains a good way to participate in this rebound.


Reprinted from the July 2021 issue of the Investor Advisory Service. For more information, to download a sample issue, or to subscribe to the best investing newsletter in the U.S., visit Investor Advisory Service.