June 2021 | Swan Insights
The threat of inflation has been hanging over the economy as the post-pandemic recovery gained steam. Trillion-dollar quantitative easing programs and stimulus packages pumped into the economy tend to do that. Inflation never took hold during recent periods of loose money, despite some doomsday proclamations. Is this time different or are the hawks just crying wolf?
To get a proper read we need to see the present, the future, and try to understand how policymakers will respond to it all. For the present, price pressure has extended beyond supply-side factors and the commodities boom, and it is bleeding into consumer prices. The April core PCE report was the largest spike in a decade, and core personal consumption expenditure was 3.1% in the latest report. This measure excludes volatile food and energy prices and is wide enough not to be driven completely by a chip shortage. There is real demand pressure in the economy, and the Congressional Budget Office says that the output gap is closing, and we will exceed it by the end of the year. That is, there isn’t any more slack in the economy, and aggregate demand is high.
Both markets and surveys indicate higher future inflation. The TIPS market projects 2.5% inflation and the Michigan survey has inflation expectations increasing. The policymakers are not just projecting higher future inflation, they are welcoming it. Both Treasury Secretary Janet Yellen and Fed Chairman Jerome Powell have indicated that higher inflation is a good thing. This is a big paradigm shift and runs contrary to the last several decades of monetary policy. The Fed also sees itself bound by forward guidance to maintain credibility: locking down interest rates into the near future, even if they slow bond purchases.
For investors higher current and future inflation could be disastrous for portfolios. There will be no relief in the bond markets as prices fall and even moderate inflation eats away at all the yield. The stock market might not be safe either as so many companies in the S&P are dependent on future cash flows, but inflation will decrease the value of those future cash flows.
The next core PCE report is around the corner, and the Fed will most likely respond with more complacency. Investors need a barbell strategy, one that hedges the risk of inflation but maintains portfolio exposure to growth opportunities. Most portfolios utilize bond exposure as a hedge against equity volatility. However, the risk of persistent inflation, or worse, stagflation, will most likely neuter that potential hedge. A strategic, options-based hedged equity approach may be the barbell that addresses what appears to be the biggest risk in the market right now.
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