The Impact of Rising Inflation on Investment Markets
As we approach the end of year, we have seen economic growth slow down and inflation speed up. Both of these moves are driven by a combination of pandemic-related supply chain issues and a surge in demand for energy (primarily oil and natural gas).
This has created an unusual environment where both interest rates and equity markets are rising simultaneously. Below we discuss some of the drivers of this environment, but more important: how your portfolios are positioned to take advantage of it.
U.S. Economy: A Reopening Challenge
The economy slowed markedly in the third quarter of this year as inflation continued to rise. According to the Atlanta Federal Reserve Bank’s GDPNow model, GDP growth was expected to land at more than 6% for the quarter. But by the quarter’s end, growth had declined to roughly 2%. Literally, every economic statistical input declined over the past quarter.
Historically, the Atlanta Fed’s GDPNow model has been a good barometer for economic growth.
While economic growth is slowing, inflation remains high as indicated by the PCE (Personal Consumption Expenditures) Chain Price Index, which is the preferred inflation indicator for the Federal Reserve.
For most households, their monthly budgets are driven by food, transportation (gas), shelter and clothing costs, all of which are becoming increasingly expensive.
Auto sales are also a good indicator for what is occurring in the U.S. economy. Auto sales have fallen to a 12.2 million run rate for total light vehicles sales, down from a 18 million-plus run rate at the beginning of the year. This places auto sales essentially at recessionary levels. At the same time, auto prices are higher due to lack of inventory caused by supply chain issues. We are seeing supply chain issues across the economy from autos to retail to home building as supply chain constraints slow economic growth and lack of inventory is driving prices higher.
While supply chain issues continue, demand for energy is increasing. As the economy reopens and Americans begin to move back to normalcy, the demand for energy is increasing and the supply remains tight. The supply chain challenges in combination with higher demand for energy are driving inflation higher. Over time these issues should stabilize, albeit at higher levels.
The longer-term drivers for inflation are mixed but tilt toward more persistent inflation going forward.
As this chart illustrates, inflationary forces and deflationary forces are staging a tug of war contest with inflation slightly ahead. To put it into context, let’s review the factors at play.
Prior to the pandemic, globalization was waning and the world was rethinking the “just-in-time” supply chain model. Today, the fault lines and fragility of the global supply chains have been brought to light. Globalization is shifting to on-shoring and “just-in-time” is shifting to “just-in-case.” This process will take a long time to play out, but ultimately it will drive prices and inflation higher.
In the United States, demographics are mixed as retiring Baby Boomers hand off their productivity mantle to Generation X and Millennials.
As you know, high levels of debt tend to slow growth, while credit creation tends to be expansionary. Currently, the debt levels are far greater than credit creation — on balance our current debt to credit structure will be a headwind to economic growth and is deflationary.
The pandemic accelerated the adoption of technology. Technological innovation improves productivity and is a catalyst for economic growth and lower prices. Technological innovation creates good deflation.
The big question now is what happens with government policy. Typically, expanding government spending is inflationary. With the infrastructure plan making its way through Congress, we would not be surprised to see increased government spending lead to higher inflation over the next several years.
Going forward the long-term trends of technological innovation, on-shoring our supply chain and the emergence of the Millennial generation represent great opportunities for investors.
However, for fixed-income investors, persistent inflation pressures will create a challenge and require a thoughtful approach.
Investing In Fixed Income During an Inflationary Period
We have seen a lot of volatility in the bond market this year. This year there have only been three segments of the U.S. bond market with positive returns: Senior Loans, High Yield Bonds and Treasury Inflation Protected Securities. We have maintained overweights in these segments of the bond market all year. This has allowed us to generate positive returns in a challenging climate.
The U.S. Bond Market has been driven by the ever changing shifts in the U.S. economy from an expected economic reopening to a soft close with the rise in the Delta variant back to economic reopening. Throughout this economic back and forth, the rise in energy prices and supply chain disruptions continue to drive inflation higher. Meanwhile, the general trend to U.S. fixed income has been one of falling bond prices and rising yields.
There are a couple of issues that will likely affect the bond markets in the near term. The first is the Federal Reserve tapering its bond purchases. Currently, the Federal Reserve is purchasing $120 billion dollars worth of Treasury Bonds and Mortgage-Backed Bonds each month. They do this by printing money and buying our bonds. According to the Federal Reserve’s statements, it intends to reduce bond purchases starting this year and should end them sometime next year. However, if inflation spikes, it may be forced to accelerate this process which could cause interest rates to rise sharply, putting more downward pressure on prices of existing bonds.
Another issue facing the bond markets is that yield spreads between different classes of bonds have gotten extraordinarily tight. For example, at their lows this year, the difference between U.S. Treasury Yields (the safest bond in the world) and U.S. Corporate Bonds and High Yield Bonds (also known as Junk Bonds) was 0.8% and 3% respectively. These were the lowest yield differences in history. It is likely that as we move forward that the yield spreads between different classes of bonds will widen to more normal ranges–thus putting even more pressure on segments of the bond market.
For these reasons, we remain cautious toward the fixed income markets.
We are and have been overweight in the best performing segments of the bond market with our highest overweights in Treasury Inflation Protected Securities (TIPS), High Yield Bonds and Senior Loans. TIPS benefit from generally rising inflation as well as being a safe haven asset. High-yield bonds have benefited from credit rating improvement especially in the energy sector. Senior Loans and Floating Rate Bonds also benefit from this environment as their returns follow inflation. Senior Loans tend to be backed by hard assets such as real estate. For those in the highest tax brackets, tax-free municipal bonds remain relatively attractive.
We are likely to remain in an environment of rising inflation and rising yields for some time. This will continue to put pressure on the U.S. fixed income market.
Re-Opening and Inflation Drive U.S. Stock Market
The U.S. stock market has seen a lot of rotation lately as leadership has shifted from technology companies to companies participating in the economic reopening and now to industries benefiting from higher inflation. This rotation, combined with typical seasonal weakness in September and October, has made for a choppy market environment. Historically, softness in September and October sets the stock market up for a rally that continues into spring.
While we have seen economic growth slow, the demand for goods remains high. Therefore, many companies have been able to maintain their margins through price increases. This has helped boost equity prices as profits rose. Going forward, as the pandemic subsides, we are likely to see a shift away from goods demand toward demand for services. This shift will likely be the major driver of equity market returns in 2022.
One near term concern is the potential for a spike in inflation that could drive interest rates higher than the market expects. As you know, the market does not like surprises, so an interest rate spike could create short term volatility in the markets. We are not anticipating a spike in inflation, but it is one of the risks we are watching closely. Assuming the economy continues to re-open and consumers shift from demanding goods to demanding services, we believe the U.S. stock market should continue to move higher into year-end and into 2022.
In the near term we expect inflation trades such as financials and energy to lead the markets. On a longer-term basis, the expansion and adoption of technology will change the way we live, work and play, transforming industries from health care to industrials to transportation. The rise of the Millennial generation will boost economic growth for the next decade as they create families, build businesses and drive consumption trends. A major part of this will be the rebuilding and rethinking of our infrastructure from celestial-based communication systems to roads and bridges. These major themes will be market drivers both now and for the next decade.
Good Opportunities, but Step Lightly
In summary, the economy both in the U.S. and across the globe is slowing, hampered by supply chain challenges and rising inflation. The U.S. Bond Market remains a challenge as the most likely direction for interest rates is up putting downward pressure on existing bond prices.
Over the last few months, the leaders in the U.S. Stock market have rotated from technology and growth names to industries that benefit from the economy reopening and that benefit from higher inflation.
We believe these areas will lead the stock market through year end and into early 2022. We note that one of the risks we are watching closely is the impact of inflation on interest rates. A spike in either inflation or interest rates could put a short term chill to any stock market rally. Assuming the move higher in interest rates remains orderly, stocks should do well. We are in a step-lightly environment with a few more risks to keep an eye on but our base case is for a strong market to year end and a good start to 2022.
The Riggs’ Report is written and published by Riggs Asset Management Company, Inc. The information contained in this Report is for informational purposes only and should not be construed as investment advice.
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