How will the winners of the pandemic economy cope with higher inflation? What has been happening in the United States?
An inflation-themed showdown is unfolding between the US Federal Reserve and the market. In one corner, the Fed — led by chairman Jerome Powell — are adamant that inflation will be low and controllable and any spikes such as last month’s eye-popping 4.2% year-on-year CPI rise — the highest since the 2008 crisis — will be merely “transitory”.
In the other corner, investors are waking up to a market where critical commodities such as copper, iron ore and lumber are seemingly hitting all-time highs every other day, driving items such as housing prices to double-digit price increases.
Who is right? In our view, only time will tell. History has shown that when inflation arrives, it tends to arrive harder and faster than both regulators and market participants expect, making it a difficult phenomenon to predict indeed.
Thus, while April’s sky-high CPI reading has captured the attention of US equity investors, we believe that there is evidence to show that the market correction may have been overdone in the short term and that the Fed may be correct in its assessment that inflation may be a lot harder to bring back than most expect at least this year.
Inflation expectations from April’s reading are most likely overblown thanks to energy inflation
Chart 1 from the US Bureau of Labor Statistics, highlighting that CPI all-items inflation for April has come in 4.2% higher on a year-on- year basis. However, a look at the inflation reading will yield a few key clues to the puzzle:
• The 12-month CPI reading of 4.2% is considered high, being the largest increase on record since 2008.
• However, when inspecting the components of that increase, energy rose the most as compared to other items in the CPI basket. This is striking as oil is coming from a low base in April 2020. At that time, oil prices famously turned negative and were changing hands at around $0 to –$40 per barrel for a time as oil demand dried up.
Thus, investors worrying over a new supercycle of inflation often do not consider the large contribution energy has made to the CPI readings thanks to the unusual situation energy markets were in last year. In our view, April’s CPI reading should not be particularly alarming and a decline in May’s CPI reading would likely confirm this analysis.
Inflation fears have been overblown for years
Expectations of super-inflation are not new, with many recent examples. In the decade between the 2008 global financial crisis and this year, many market observers have long feared rampant inflation thanks to the Fed’s liberal Quantitative Easing (QE) programme. However, inflation has remained largely below the Fed’s 2% target despite the injection of trillions of dollars under the programme into the economy since then.
However, taking reference to Chart 2, the US economy started at a relatively benign 0.7% inflation at the beginning of the year, making April’s spike to 4.2% very noticeable indeed.
However, as CPI spiked to 4.2% in April, could it be different this time? It could be, in the medium to long-term.
Reason #1: The velocity of money
The velocity of money is a calculation of the number of times money changes hands as it makes its way through the economy. Accordingly, velocity is thus calculated by the nominal GDP (numerator), divided by the stock of available money (denominator).
In summary, a high velocity of money means that government stimulus measures tend to have more effect on the economy as “helicopter drops” of cash get spent several times, spurring consumption and GDP data higher.
Conversely, a low velocity of money indicates that government stimulus measures will go directly to things like bank accounts, therefore limiting the effect on consumption, constraining GDP.
From the above chart, we can see that the velocity of money in the US has been on a long-term downtrend, as GDP growth has failed to keep up with the increase in the money supply created by the Fed. The pandemic has precipitated that trend, bringing the velocity of money to all-time lows, keeping inflationary pressure low.
Previously, injections of money created by the Federal Reserve would not enter the economy but get funnelled into bank reserves. Banks would keep that money as excess reserves instead of spending or lending, leading to very little of the injected money being circulated.
Difference #1: However, the past year has seen the government deliver money straight into the hands of consumers in the form of stimulus checks, unemployment insurance, grants, and other large cash payouts. Far from being locked up in banks, the spending of that cash should add inflationary pressure to the economy.
Reason #2: The US savings rate
And this takes us to our second reason, a spiking US Savings Rate. As the government pumps citizens full of cash handouts, the US savings rate has been skyrocketing to record- high levels.
From chart 4, we can see that the US savings rate trended at under 10% for the last 35 years. During the pandemic, however, it exploded through previous highs, peaking at around 35% as people ran out of things to spend on.
Difference #2: How do we make sense of this? In essence, US consumers are now more than ever, sitting on a figurative mountain of cash without anything to spend on as parts of the economy remain closed — for now.
As the US continues to increase vaccinations and lift pandemic restrictions, we fully expect this tidal wave of cash to spend its way into the economy, starting with suffering sectors such as retail and hospitality.
So how will inflation affect equities? Studies on how inflation affects the stock market have often yielded conflicting results. To begin with, however, inflation erodes the future earnings of companies.
Dividend-paying companies such as the S&P500 list of Dividend Kings (companies that have increased dividends consistently for 50+ consecutive years) will see their investor appeal diminished by rising inflation.
For illustration, there are over 30 such companies on the Dividend Kings list in 2021, containing companies such as 3M and Coca-Cola.
How will growth stocks do?
During periods of high inflation, growth stocks will almost invariably be the first casualties in terms of investor sentiment. As growth stocks tend to justify their valuations on future earnings, high inflation will erode those earnings forecasts, making their current valuations increasingly unattractive. Thus, pandemic-era darlings that have achieved sky-high stock prices above their industry peers such as Tesla, Nvidia or Netflix may see value stocks continue to pull ahead, as value stocks — with stronger current cash flows, will “benefit” more from an inflationary environment.
