Inflation—the Primary Theme of the Current Cycle
- An inflation rate in the US that rises gradually from the pre-Covid average of 1.5% to 2.5%-3% in the medium-term will not cause tangible stress to the economy or the markets.
- May or June of 2021 should mark the peak of the present inflation cycle.
- Market forces will gradually overcome supply chain disruptions, production bottlenecks and shortages.
- The regime change from deflationary conditions of the past to significantly stronger economic growth with modestly higher inflation is welcomed by the markets.
The following two events have confirmed that we are witnessing the most important shift in global macro policy since the beginning of the Ronal Reagan/Paul Volcker era some 40 years ago. (1) Released on June 10, the US core CPI number for May was the highest in nearly three decades. The headline and core CPI inflation rose from 4.2% YoY and 3.0% YoY respectively in April to 5.0% YoY and 3.8% YoY in May, the highest levels since August 2008 for the headline rate and June 1992 for the core. (2) The June 16th Fed meeting proved to be as hawkish as could be realistically expected at this stage within realistic expectations. The most hawkish development was the Fed signaling a much quicker (2023) timeframe for raising interest rates, such that the market is now is pricing in two rate hikes (25bps), compared to zero hikes after the last meeting. The Fed made it clear that it is shifting away from managing downside risk to the economy towards upside risk to inflation expectations. Also, it has accepted the risk that inflation may not be transitory.
- Is the inflation increasing? US inflation will definitely be higher in 2021 versus 2020. And it is almost certainly going to be higher in the current business cycle than it was during 2009-2019. But the fact that inflation will be higher is already priced in by the market in the 1H2021.
- What matters now for investors, is not whether inflation is rising, but how fast and how far it will rise. In my view, an inflation rate in the US that rises gradually from the pre-Covid average of 1.5% to 2.5%-3% in the medium-term will not bring tangible stress to the economy or markets. The well-communicated-in-advance rate hikes for 2023 may represent a welcome regime change from the deflationary conditions of the past to a significantly stronger economic growth cycle that is combined with modestly higher inflation.
- Highly respected economists Alatole Kaletsky from GaveKal Research and Chris Wood from Jefferies are pointing that the base effect built into 12-month comparisons suggests that May or June will mark the peak of the present inflation cycle. Monthly inflation numbers should decline dramatically from the 5%+ annualized rates reached in the US in 1H2021.
- Supply chain disruptions, production bottlenecks, and various other constraints hindering a return to pre-pandemic production levels should be gradually balanced by the normal operation of market forces in 2H2021 and 1H2022.
- The market is obviously comfortable with the Fed’s message, as the big plunge in long-end US yields to the lowest levels since February resulted in a flattening of the yield curve while, at the same time, NASDAQ recorded a new all-time high on June 17. Thus, the market definitely seems to expect that inflation will come down in the coming months.
Today, it does not make any sense to predict inflation by annualizing 3m, 6m or 12m trends. Any conclusions made from today’s unprecedented financial conditions will be misleading. “We live in the world, where no one ever lived before”—this assumption being at the base of our investment strategy since the end of 2017. There are a few scenarios under which inflation and the economy may go forward. What we see with investor behavior in both equity and bond markets in May-June is that they are comfortable with the inflation trend and Fed’s communication. However, investors should expect more volatility around big data releases and FOMC meetings. One thing is clear—volatility will remain high and investors should buy volatility protection.
We assign a high probability to this scenario that a successful regime change in US economic policy should result in rapid economic growth, combined with a modest increase of inflation to 2.5%-3.0% in the medium-term, over the next one to two years.
So, a majority of economists and media commentators warn of serious inflation risks, but is the inflation truly a threat to the economy or markets? We think not!—for the next one to two years.
In short, investors should seriously consider the possibility that the market is right and financial commentators are wrong.
Technology of the Future Fund
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