Consumer spending is expected to accelerate into the summer as economies re-open. Lumber prices have already tripled (or more) in the past year to the surprise of many doing home improvements. Oil, copper, steel, and other commodities have also risen substantially from their pandemic lows. According to Warren Buffett at last week’s Berkshire Hathaway AGM:
“We are seeing very substantial inflation… we are raising prices and people are raising prices to us, and it’s being accepted… it’s a red hot economy and we weren’t expecting it.”
Bond investors are betting that monetary and fiscal stimulus will push inflation higher, with the 5-year U.S. breakeven inflation rates (a measure of expected inflation) trading at 2.7%. Equity investors have been re-positioning for economic growth by rotating into cyclical sectors such as energy, materials, financials and consumer discretionary.
Source: Federal Reserve Bank of St. Louis, 5-Year Breakeven Inflation Rate [T5YIE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T5YIE
There is also increasing evidence of labour shortages putting upward pressure on wages. A recent National Federation of Independent Business survey revealed that 42% of businesses had job openings they couldn’t fill, an all-time high going back to 1974. The Biden Administration’s American Jobs Plan is also targeting a major investment in infrastructure emphasizing higher quality and better paying jobs. U.S. labour has lost out to capital since Reagan, and there is increasing public buy-in to correct this disparity. In addition to increasing price inflation, it’s possible that wage growth will accelerate.
Canada’s central bank has already responded to incoming data suggesting the economic recovery is stronger than expected. The Bank of Canada has scaled back its bond buying program, reducing stimulus and liquidity to the market. The Bank is also expected to raise its policy interest rate in 2022, earlier than previously expected.
Down south, U.S. Federal Reserve Chairman Jerome Powell appears to be unconcerned about the possibility of persistent inflation. Powell says that any inflation spike will be temporary because of base effects (new price index readings being compared to their depressed levels twelve months prior) and bottlenecks in supply chains. After that he predicts inflation will fall back to recent norms. But what if the Fed is wrong?
If price and wage increases emerge quicker than expected, the Fed could be forced to tighten policy sooner than telegraphed. In our view, markets aren’t necessarily prepared for that possibility. For instance, U.S. Treasury Secretary (and former Fed Chair) Janet Yellen warned on Tuesday that the economy is at risk of overheating. The tech-heavy Nasdaq (a good benchmark for high growth, long-duration assets) immediately sold off by 2.5%. We expect the market to be increasingly sensitive to emerging data and commentary on inflation.
For the past decade, the best performing investments have been long-duration assets with high expectations for future growth. That was sensible in an era of mediocre economic growth and low inflation. However, the high valuations of these assets may also be the most vulnerable should inflation and interest rates continue to rise.
In our view, investors should be diversified while emphasizing shorter duration assets with solid cash generation and reasonable valuations. Recent market momentum is clearly in this direction. Our portfolios have been riding this momentum and many of our cyclical holdings are coming into fair value range after years of being undervalued.
Just as the high growth trade of the past decade was overextended, at some point so too will the re-opening trade. As this momentum continues, we may re-allocate some of these gains into more defensive investments as their relative attractiveness improves.