The government’s fiscal and monetary policy response to COVID-19 this year has fueled the discussion on one of the most misunderstood components of the economy to levels that may seem unrealistic, at least in our view. We are talking about inflation. The discussion has been further amplified following the initial results of the U.S. presidential election when considering the spending proposals that have been announced by the Democratic leadership. Although it is true that excessive debt and excessive consumption can produce the perfect environment for harmful inflationary pressures on the economy, the topic of inflation remains highly misinterpreted by investors. The current economic backdrop remains fragile and is just now beginning to recover in a way that may boost aggregate growth to pre-COVID levels. As that occurs, it becomes important to gauge inflationary pressures and whether they remain justified (or even needed). Let us explore that discussion with an inherent assumption that further fiscal stimulus will occur under either Democratic or Republican leadership in the White House.
For starters, we must recognize that annual inflation around 2-3% is necessary, it is healthy, and it is an essential part of a growing and prosperous economy. Period. Lack of inflationary pressure results in central bank deficiencies, stalled consumption, weak economic innovation, anemic research and development efforts, and even poorly performing equity markets. Those are all things that can spell disaster and they are all things that the Japanese government has dealt with for decades. For a better perspective, consider this. For the 20-year period that ended 11/30/2020, Japan’s main equity Index (Nikkei 225) has underperformed the Standard & Poor’s (S&P) 500 by a staggering 161% total return. This is not to say that lackof inflation is solely to blame for the weak relative performance, but it is certainly a key cause.
Many market participants categorize sovereign debt as one of the main culprits to runaway inflationary pressures. Such debt, which comes in the form of accommodative fiscal policy (like the initial COVID-19 stimulus package), is simply one part of the formula tied to inflationary fears. But there is more that is needed to cause problems in a way that some investors are fearful of. The most critical piece, in our opinion, is that the economy must have an ability to absorb excess capacity. Under an accommodative fiscal and monetary policy, which assumes low interest rates and excessive government spending, the goal is to boost economic production and create jobs. The presumptuous fact in that statement, however, is that there will be ample consumer capacity to absorb such production. The only way that can effectively occur is if the actions taken to remedy the labor market are appropriately working. It also means that said jobs are providing sufficient net-of-tax income to boost aggregate discretionary spending. As we look at the current labor market, relative to actions taken in Congress, and relative to consumption data, there is little indication that consumers’ have absorbed the current excess capacity of economic output. We believe such a fact downplays the fear of inflationary pressures over next two years because that is how long it may take to bring back economic growth to pre-COVID levels. The eventual recovery may start as late as April 2021 due to the potential for economic lockdowns in the early part of the year. Virus cases have soared back in the U.S., which means the potential for government driven lockdowns (especially under Democratic leadership) remains probable. This is also why we believe treasury yields may hover around 1-1.25% next year with minimal potential to exceed that, even in the event of strong gains in the equity market. To assume notably higher yields would simply be another way of saying that economic activity has surpassed the COVID recession and is now capable of sustained growth. Although we will get there soon, the first half of next year is not likely to indicate such growth. The equity market may certainly price it into the upside, but the bond market may not. This has historically produced a relationship of weak (or negative) fixed income returns without regard to equity market performance.
Edison Byzyka, CFA – Chief Investment Officer – Credent Wealth Management
Investment advice offered through CX Institutional, a registered investment advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted.
All return data sourced from Bloomberg.
All other data soured from Bloomberg, through the release of monthly figures from the Department of Labor, Bureau of Economic/Labor Statistics, U.S. Census Bureau, or from the Federal Reserve and any of its affiliated regional locations.
Small Business Optimism sourced through NFIB. Small business hiring plans sourced through NFIB. Consumer sentiment sourced through the University of Michigan.
Earnings data sourced through Bloomberg Intelligence and through Bloomberg’ earnings analysis composites. Interest rate cut/rise probabilities are sourced from Bloomberg’s tracking of futures contracts tied to the Federal Funds interest rate.
Manufacturing data – Markit PMI – Bloomberg
Economic Policy Uncertainty data sourced from Bloomberg via The Baker, Bloom, and Davis Index.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changed in the aggregate market value of 500 stocks representing all major industries.
International markets are represented by the MSCI EAFE.