Transitory. Anyone following the markets recently has heard the word bandied about ad nauseam, and the question of whether inflation would serve to be temporary (transitory) or more permanent has often driven the daily movements of the market.
As the debate over “transitory or not” has heated up, every economic reading is being scrutinized as to whether it was indicative of more persistent inflation. If inflationary, then the 10-year Treasury would sell off, value stocks would lead growth, and vice versa.
Despite monthly CPI readings that show large jumps, the markets so far seem to believe inflation is transitory, as long-term bond yields came off the late March highs, and the yield curve has flattened.
This caused investors to pile back into growth stocks and sell interest-rate sensitive stocks (for example, banks and other financials) during the second quarter, as a consensus developed that we were poised to be in a persistently low interest rate environment. As discussed in previous blogs, lower long-term yields tend to favor higher-growth companies as future earnings are discounted at lower rates.
So, is the market right? Will inflation prove to be transitory despite the rapid economic expansion and unprecedented stimulus, and thus are we destined for a semi-permanent low-interest rate future? Before a conclusion is reached, we believe several important questions need to be answered. Here are three key considerations:
What will be the long-term impact of materials, goods and labor shortages?
By this point, we have all likely experienced some impact from recent shortages of products, materials or labor. If you were looking to build a deck, or a similar project, you surely noticed the impact as lumber prices soared to over $1,600 per thousand board feet from under $400 a year prior. In the market for a car? You’ve likely had trouble finding one, and / or noticed the sky-high prices of what is actually available.
A confluence of pandemic-related events has led to shortages of lumber, autos (due largely to a lack of semiconductor supply), and many other products. When the pandemic hit, manufacturers shut down plants, sawmills, etc., laying off workers in the process. In a normal recovery, these plants and mills slowly come back online as the economy gradually improves. However, during this unprecedented v-shaped recovery, supply has been unable to recover as quickly as demand – creating these product shortages.
Additionally, this has been compounded by a labor shortage despite continued high levels of unemployment. Whether because out-of-work individuals are reluctant to go back to work due to ongoing COVID-19 concerns, the lack of child care, or the ongoing stimulus payments they are receiving, many companies are finding it hard to re-staff their factories, shops, restaurants, etc. For example, many restaurants have been forced to open on a limited schedule due to staffing shortages.
While many of these shortages will work their way through the system, proving to be temporary (e.g., lumber prices are back to just under $600 as mills have come back online or ramped up production), it remains to be seen how much will last longer term. Prices are increasing on products as companies attempt to keep up with input cost pressures, and businesses are being forced to raise wages to entice new employees.
Will these price increases reverse as supply chains stabilize and will wage pressures abate as enhanced unemployment benefits roll off in the fall, causing some unemployed Americans to start looking for jobs again?
Not be overlooked, given rents make up about one third of CPI – will an eventual end to the moratorium on evictions enable landlords to adjust leases, and cause a significant rise in rents? That moratorium was extended through early October for people in areas with high levels of Covid-19 transmission, so this key question remains unanswered.
Will we get more stimulus in the form of an infrastructure bill?
The Senate has passed a bipartisan, $1 trillion infrastructure package, and the House will vote on it in September. The House has also passed a $3.5 trillion budget framework that unlocks the reconciliation process, and opens up the potential for Senate Democrats to pass a broad package supporting health care, education and climate initiatives. The final approval of either package would represent another substantial stimulus effort.
Already, we have flooded the economy with unprecedented stimulus. To date, an estimated $5 trillion has been injected into the economy by the U.S. government, equal to 24% of GDP. This compares to $1.6 trillion during the Great Financial Crisis, or 11% of GDP, of which a large portion was aimed at stabilizing the financial system versus directly stimulating the economy. This is in contrast to the pandemic-induced stimulus program, of which much went directly into consumer pockets (via checks, school lunch aid, unemployment insurance, etc.) and to small businesses (PPP Program, Economic Injury Disaster Loans, etc.). This stimulus has unquestionably aided the current “v-shaped” recovery.
Any new package could add an additional boost to an already rapidly expanding economy and raise the specter of increased inflation.
How big is a potential COVID resurgence?
Even if the aforementioned scenarios all point in the direction of rising interest rates, the wildcard will be the degree to which we see a resurgence of COVID-19. Concerns over the “Delta” COVID-19 variant have already weighed down the market at times and contributed to the rally in Treasuries, further depressing interest rates.
There have also been reports of a “Lambda” variant, that has hit some South American countries and even Canada. Should one or more of these variants cause the vaccines to prove ineffective, we could see a slowdown, or even a double-dip recession.
More than likely however, this would lead to another flood of government stimulus, and just delay the expansion as vaccine boosters effective against the new strains are developed. The added stimulus and continued ballooning of the U.S. balance sheet would further stack the deck in favor of an inflationary period and increased rates down the road, albeit delayed by the virus.
Editor’s note: The blog below is an excerpt (lightly edited) from our Q2 client letter that was published in July 2021. We believe the information remains relevant at the time of publishing.