Inflation concerns have entered the mainstream; a bit of a shame, since I quite enjoyed being out of consensus. Now there is growing agreement that inflation will most likely move to healthier levels as the economy reopens; more interestingly, the risk of a sharper surge in inflation has become the topic of a heated public debate.
Recovery already set to accelerate
To judge the potential impact of the fiscal stimulus, we need to factor in the economy’s momentum — not just how far we are from full potential, but in what direction we are moving and how fast. And most indicators still suggest the economy is recovering at a robust pace, much faster than after the global financial crisis (GFC).
US employment has already staged a healthy recovery from last spring’s shocking job destruction; and wages and salaries have enjoyed a true V-shaped rebound.
US consumers continue to enjoy good financial health, thanks to government support, with household net worth near record highs and the debt to disposable income ratio back around the 2000 level.
This all helps explain why retail sales have already jumped over 10% beyond pre-Covid-19 levels (with a marked shift from services to goods, for the time being).
In a nutshell, households have a lot of pentup desire to spend and the income and savings to satisfy it once the economy reopens. And, the health care data suggest that the reopening might soon accelerate: new cases and deaths have dropped sharply and hospitalisations have more than halved since the start of the year.
About 60 million people have been inoculated already (over 13% of the population) in the US, and the pace of vaccinations is accelerating, now at about 1.5 million per day (seven-day moving average).
Soft pricing power of high expectations
The Fed has made it abundantly clear that if and when inflation accelerates, it will at first sit back and watch. It has committed to let inflation run above 2% for some time, to make up for previous undershoots.
With accelerating economic growth, a massive fiscal stimulus, and the fastest growth in broad money on record—M2 is up 26% since February 2020, the biggest monetary expansion since 1943—inflation could easily overshoot under the approving eye of the Fed. Assuming that inflation expectations will nonetheless remain firmly anchored could be unduly optimistic. As an aside, one-year ahead consumer inflation expectations in the University of Michigan’s consumer sentiment survey released in mid-February have already jumped to 3.3%, partly because of higher gasoline prices.
This time is different
When the Fed launched its quantitative easing programmes in response to the GFC, some economists also warned that loose monetary policy would result in inflation. It famously did not. So why should it be any different this time around?
There are two critical differences: First, this time monetary policy plays second fiddle to a massive fiscal expansion. Second, the economy is already primed for a rebound as vaccinations make it likely that a broad-based reopening will materialise later in the year.
After the GFC, firms were reluctant to invest and hire, the job recovery was painfully slow and households were saddled with debt and unwilling to spend. The money the Fed created simply sat around in banks’ reserves, offsetting the desperate deleveraging of the financial system.
This time, jobs have already started to come back, and households are in a strong financial position and eager to go back to normal spending habits. And on top of this, an unprecedented fiscal expansion will take care of putting the money to work, directly fueling a surge in spending.
After the GFC, with consumer spending missing in action, the Fed’s monetary expansion translated into asset price inflation. This time, with fiscal policy boosting aggregate demand, it is much more likely to result in good old-fashioned consumer price inflation.
Fixed income investment implications: Reduce duration, pick yield judiciously
At the end of last year, 10-year US Treasury yields were hovering at about 0.91%, and the expectation implied by market pricing was for them to reach merely 1.12% by yearend. Yields have quickly blown past that target and have already reached 1.55%, with most of the increase in the past month. Markets have been forced to revise their pricing for year-end, and now expect 10-year yields to reach 1.75%.
We should be prepared to see year-end rates exceed even these revised projections if the vaccines deliver on their promises and the government launches the fiscal stimulus discussed above. Thus, despite the recent rise in long-term yields and the subsequent steepening of the yield curve, it is hard for me to be positive about the duration outlook.
At the same time, spread sector valuations are becoming increasingly stretched on balance making me more cautious — even allowing for the support of an improving growth outlook.
We continue to favour very select securities, industries and market segments within the high-yield and floating rate loans and the emerging markets debt space. The operative word is select: both high-yield and emerging markets debt are likely to experience more pressure, especially if the rise in US bond yields should extend more significantly to the short-end of the curve. In a first clear sign of stress, the exchange rates of the more vulnerable emerging markets have already weakened.
Both the Fed and the European Central Bank have reiterated their reassurance that monetary policy will remain supportive, but markets may be challenging central bank credibility. Given the underlying strength of the economy, I think widening spreads will offer opportunities in short duration fixed income assets in the coming weeks. Finally, I would expect the US dollar to come under frequent bouts of pressure as this scenario plays out.
