This summer's rise in inflation is expected after last year's economic shutdown.
- Inflation is expected to climb over the summer as industries struggle to catch up with the surge in demand as the economy reopens.
- While prices may rise in the near term, it is expected to be temporary as manufacturers, retailers, and service providers ramp up their businesses.
- Markets already expect rising inflation and prices reflect those expectations.
- Investors should also know that the rate of inflation is expected to be in the range that has been helpful for equities historically.
Inflation has become quite a big topic in the media and among my clients. As a country, we have not faced the realistic prospect of rising inflation for a while so nervousness is understandable. At this moment, I wouldn't be overly concerned and I will explain why. Here are a few things to know about inflation:
1.Inflation is likely to increase over the summer as the U.S. economy reopens
Why? Remember at the beginning of COVID in spring and summer 2020, there were shortages in masks, toilet paper, hand sanitizer, and workout equipment because of an unexpected shift in consumer preferences. Global supply chains were not prepared for a pandemic, forcing prices of the newly demanded goods to spike.
We are now experiencing the same spike, but in the reverse: Global supply chains are now prepared for pandemic life, but fortunately the economy is reopening faster than expected. Suppliers are again not ready for these shifting consumer preferences, and hotel rooms, airline tickets, and gasoline are now going to face the same supply/demand imbalance leading to spikes in prices.
In addition, we are comparing prices from a locked down economy of May 2020 to one that is reopening. If you think about it that way, it's really no surprise that prices for hotel rooms, airline tickets, and gasoline are a lot more now than a year ago.
2. Markets (and most experts) see the rise in inflation as temporary
Going back to my previous example after the initial shortages in pandemic related goods, shifts in manufacturing and production have occurred swiftly. If you walk into a big-box store today, you will likely find that we have enough hand sanitizer and toilet paper now to live through another pandemic. I believe that the current shortages will also be resolved: Production will ramp up, supply fears will calm down, and prices will eventually go down and return to levels close to pre-pandemic.
In fact, the fixed income markets give you a pretty good indication of what kind of inflation we might experience going forward. I apologize for getting a little technical here, but there is something called an inflation breakeven spread.
It is the inflation rate that makes the projected return of a U.S. Treasury Bond identical to the return of a TIPS (Treasury Inflation Protected Security) with the same maturity date. Securities issued by the U.S. Treasury (Treasurys) have fixed interest rates and the TIPS interest rate is inflation rate dependent. The breakeven spread is the inflation rate that makes those returns identical. As markets are viewed to be efficient, that inflation rate is the market's best guess on what the inflation rate will be going forward.
At this moment in time, markets are expecting inflation to be around 3.3% for the next 12 months and then to gradually recede to an average of about 2.6% over the next five years (barely over the Fed's targeted rate).
3. What does temporarily heightened inflation mean for your investments?
There are a couple of things to point out here. Most importantly, this kind of scenario is likely priced into the markets, and so markets may not react materially (in either a positive or negative direction) to any inflation report. This means that interest rates should not rise much further from here if inflation develops along these lines. (Interest rates could still go up or down for other reasons, but inflation should not be the catalyst.)
Secondly, this kind of progression should be positive for equities, as an inflation rate of around 2% has historically been the sweet spot for equity valuations meaning the markets traded at multiples to earnings that were the highest. As the chart indicates, multiples were lower for periods of higher and lower inflation rates. (The price-to-earnings ratio, or P/E, is called an earnings multiple because it shows how much a dollar of earnings is worth to investors.)
Average S&P 500 trailing 12-months P/E compared to year-over-year CPI
P/E is price-to-earnings ratio and CPI is Consumer Price Index. Source: Strategas. Data as of 1950 through 04/30/2021.
Will inflation be short-lived as expected or sustained?
The inflation numbers that we may see over the summer could be even higher than the 5% year-over-year headline CPI announced June Tenth by the Bureau of Labor Statistics. But that is over the short term. I do not expect it to materially influence equity prices or interest rates over the upcoming months, as this is what markets expect and it is already priced in. The key question going forward is if higher inflation is really just transitory (which I believe) or if it is more sustained. I will be on the lookout for any signs of inflation being durable but only time will tell.