Earlier in the year, especially in the beginning of the pandemic, there were some rumblings from both the press and academia about what inflation may do given the sudden shift in consumption. Although some prices did rise like for food, overall inflation remained tame. Most economies, putting to work the QE that they previously deployed during the finance crisis, managed to keep dangerous deflation at bay while cutting rates to near zero or even below zero. The natural result of this was a rally in those safe government bond prices. There is so much focus on dropping yields and interest rates, I notice many more novice investors lose sight of the fact that lower rates produce higher bond prices. The iShares 20+ Year Treasury Bond ETF has rallied over 27% since the start of the year and returns essentially came all at once when rates were cut dramatically in March.
I had shared some research in earlier posts about how the shift in consumption may shift the CPI, the makeup of which is adjusted annually by the BLS, a statistical agency. It’s important to keep in mind that the CPI is an average for all Americans and doesn’t necessarily describe your personal situation when it comes to rising prices, it is only meant to be a broad measure.
Consumption tends to shift and show cyclical behavior during the year so adjusting it for the middle of year doesn’t tend to make sense for the larger picture. But these aren’t normal times. One of the questions brought up in the early days of the pandemic noted the shift in consumption and asked whether consumption had shifted permanently. The jury is still out on this. It seems that consumption patterns for many will change given the massive social and work changes that will still be with us post pandemic, the guessing game is how that consumption will play out based on these changes and if it will impact inflation. You can see the December 2019 inflation contribution pie chart based on the data from the BLS below.
Housing, transportation and food & beverage make up the biggest share of inflation at around 72%. Transportation costs have seen a big drop off as more people worked from home. Food costs may also have increased. Yet house prices may be the big differentiator. With relatively stable jobs and savings increasing, an unexpected housing boom is occurring in many suburban areas while urban areas, especially in larger coastal cities, are seeing a historic collapse. This means the pandemic meant some people may have seen transportation drop costs due to staying in but housing and food may have increased. Poorer households may have experienced lower rents but higher food prices. This is the temporary shift in consumption that was referred to earlier and shows that the experience of inflation tends to be personal for everyone.
Enter the Vaccine
Since the start of lockdowns, consumption has been in a holding pattern. The public has been waiting for better news on Covid and has been hoarding cash as there is much less to do and less ways to part with their money even if they wanted to. The result has been a huge jump in household saving. This is almost like kinetic energy, a pent up demand ready to be released on the world when things start to go back to normal. It’s one reason that those beaten down “old economy” stocks like energy, travel and leisure jumped last week on news that Pfizer had a vaccine which proved to be 90% effective in independent trials.
This trade was based on the idea that investors now see a light at the end of the Covid tunnel. For those “zombie companies” especially in travel & leisure (those whose income is less than their interest expenses) those that are able to survive until a vaccine is widely distributed may be able to increase their market share as weaker competitors have dropped out of the field. This would bump up their expected future share prices and investors snapped them up anticipating this.
What has been less talked about though, is how this has given a deadline for those all those household savings to be put to work work and potentially witness a huge reflation in certain industries. Housing and transportation are two that come to mind besides leisure. This will surely produce an upswing in earnings and hence share prices of many depressed stocks but it could also see inflation go far beyond the target rate of 2% which the Fed keeps as its long term goal.
Given that the vaccines will take time to distribute both in the US and abroad, we may be looking at a 6 month period for these things to be realized based on the most recent estimates. This would put us in may or June to start to see the signs of some type of return to normalization and the release of all those pent up funds.
The Fed has already announced that it is willing to endure temporary inflation above 2% for periods of time in order to get the average annual rate back towards their 2% target. However, the magnitude of this potential reflation is anyone’s guess.
If things go right, the status quo will remain. Bonds will yield little, remain expensive and debt will be cheap. Shares may continue to rise in the medium term and bubbles outside of the tech may start to develop.
If things go wrong however, and higher inflation takes hold for a period longer than just a few months, it could exacerbate the growing disparities between the rich and poor and strain the already tense political situation. Think of a homeowner in the suburbs with a cushy tech job that can work from home full time. They will see an drop in transport costs due to not commuting, their home value will increase and food is already not a significant part of their budget. If you are poor however, you don’t get the benefit of higher home prices, only the costs of rent increasing which may happen when the landlord’s taxes increase. The higher food costs will be a larger part of your budget, and with public transportation seeing huge budget deficits, your cost of transportation may actually increase, especially if you are working a job which requires your physical presence on a daily basis.
On the income side, if we are seeing a massive shift away from certain industries (restaurants and gyms for example) towards more deliveries and internet classes, this will take time for people to adjust to and gain new skills, meaning their could be slack in the labor market for some time. If that occurs, don’t expect lower paid wages to keep up with this new inflation, squeezing many people.
What Can You Do?
If you read this site at all, hopefully you have a somewhat diversified portfolio or at least the ability to construct one. The message here is that despite what you read in the headlines, despite all the voices that say inflation won’t come back, keeping a hedge just in case is always a smart idea. If you saw gains from the price rises in medium and long term bonds, the next few months may be a time to realize some of the gains by selling them down. At the same time taking a small position in stocks that have been beaten down and can benefit from an inflation play such as residential real estate and utilities may offer some upside if there is a sustained inflation surprise.
The investors that may pay are those that hold onto those long term bonds and those that have a heavy tilt towards bonds in general. If inflation maintains itself at higher levels for longer than expected, all bets are off. We could see a route in the bond market like we haven’t seen in decades. If we just see a more temporary but significant bump in inflation in 2021, bonds may simply reprice lower and fall back towards investors longer term expectations of inflation levels.
Both the wealthy and the government wouldn’t mind a temporary jump in inflation. Any inflation discounts ever so slightly, the government’s nominal debt burden and the wealthy benefit from those higher prices for real assets like real estate and commodities. Longer term high levels of inflation though, would hurt both. This would push up nominal interest rates for everyone including the wealthy and cut off access to the cheaper credit we take for granted now. Markets may fall on the surprise of higher sustained rates and the effect on the poor could produce political instability, undermining the benefit to the government of its large debt pile being inflated away.
So the message remains, stay diversified and be on the lookout for surprises. I could read this a year from now and be wrong but if I’m not, you could take some small actions now to protect yourself.
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