Put the Market Volatility in Perspective
This article has been updated on August 30, 2021 following the release of the federal Office of Management and Budget report.
On the surface, conditions look ripe for runaway inflation. The prices of commodities are soaring. Government spending is off the charts. Consumers have money in their pockets. As states fully open back up from pandemic restrictions, people are demanding goods and services like never before.
Supply, on the other hand, is still trying to wake up from its COVID coma. Building materials like lumber are falling short of ever-increasing demand. Mix in the fact that a certain percentage of the workforce is feeling more incentivized not to work, and you have a recipe for inflation at levels this country hasn’t seen since the 1970s.
With all those factors at play, is the economy on the road to another period of soaring inflation?
The Federal Office of Management and Budget says it’s expecting consumer prices to rise 4.8% in the fourth quarter of 2021, which is double what the Biden administration forecast earlier this year, according to the Wall Street Journal. Even with this new information, inflation on consumer goods is expected to “quickly” return back to normal, projecting only a ride of 2.5% in the fourth quarter of 2022, according to The Journal article.
For most Americans, the mere thought of inflation causes a visceral reaction, conjuring up visions of long gas lines, falling dollar values, spiking oil prices and your dad’s 18% mortgage rate. So the idea that we might be heading towards an inflationary cycle gets people understandably concerned.
WHAT’S REALLY TRIGGERING THE INFLATION ALARM
According to Brad, two things cause inflation fears to rise quickly. One is the clear price increases the average consumer can see, such as skyrocketing lumber prices. The second factor is stimulus money.
“Anytime we print money, inflation fears grow,” says Brad. “So now you have consumers, the media and Wall Street buzzing about high prices and all this money being printed… it’s the perfect cocktail for irrational inflation angst.”
Economists know that inflation is not necessarily the bugaboo that history has made it out to be.
“A little inflation is a good thing,” says Brad. “The Fed wants inflation between 2-3%. That allows them to tackle our debt problem. With 2-3% inflation growth, you start to slowly inflate that debt away. As long as wages rise with inflation, it is not the horrific thing that everyone makes it out to be.”
As the government entity is responsible for keeping the U.S. economy growing, the U.S. Federal Reserve, also known as the “Fed,” has a dual mandate: control the rate of interest and control the rate of employment.
By raising and lowering interest rates, the Fed pushes and pulls on inflation in an effort to control the factors that spur or curb economic growth.
Recently, the Fed announced that it will keep interest rates unchanged until the end of 2023—a clear sign that the Fed sees the current inflationary events as transitory, a temporary spike as the supply side catches up and levels out prices.
“When you shut down and reopen an economy, there are a lot of cause and effects that you can’t plan for,” says Brad. “Lumber is everyone’s hot button, but what we really have is a short-term output gap caused by an unprecedented economic event. It might take 12-18 months to normalize, but all signs point to the fact that it will.”
INFLATION FEARS FUELING MARKET VOLATILITY
The latest period of stock market volatility started right after the 2020 presidential election in November. The Coronavirus vaccine was approved. There was a new light at the end of the pandemic tunnel. Interest rates inched up, but the inflation expectation index went to a 10-year high. The stock market reacted, as investors moved out of technology and into value stocks.
Why do investors flee technology when inflation fears rise? According to Brad, it comes down to cash.
“Technology doesn’t like inflation because tech companies have a lot of cash, and cash holds its value when there’s no inflation,” explains Brad. “In an inflationary period, cash is a devaluing asset.”
While inflation expectations will always drive stock buying behavior, Brad says the current volatility is a bit of a knee-jerk. “The way inflation is affecting the market right now is emotionally based. It’s not grounded in fundamentals.”
INVESTING IN AN INFLATION-ADDLED MARKET
Whether the volatility is warranted or not, how do investors protect their portfolios in a market reacting to inflation fears? Brad counsels his clients to make subtle changes in their fixed income, moving into short term, high yield plays.
“Market volatility in short bursts, driven by the right strategy will get you to your goals,” said Brad. “The number one thing that should make investors feel better is, we went through a pandemic and yet the S&P 500 ended the year up 18.4 percent.”
As the noted economist Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.” Recent history is proving once again that the fear of inflation is a monetary phenomenon as well.
Tectonic Advisors, LLC is an affiliate of Cain Watters and Associates