Inflation up, COVID-19 cases down, fiscal stimulus in limbo  

Brian Nick

The last week’s market highlights:

Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s 2020 Midyear Outlook:
  • U.S. economy: Looking for a full recovery by late 2021, albeit with high unemployment.
  • Global economy: More monetary and fiscal stimulus is needed to keep businesses afloat.   
  • Policy watch: No Fed interest rate hikes until well after the economy has healed.
  • Fixed income: Lean into higher-risk assets to generate income.
  • Equities: Focusing on quality across the board (and dividend payers, too).
  • Asset allocation: Consider benefits of active management amid idiosyncratic opportunities.

Quote of the week:

“The sweet smell of summer nights is serenity for the soul.” ̶  Sean Mahar

July’s higher inflation is likely temporary

The Consumer Price Index (CPI) for July topped forecasts, with the core inflation rate, which excludes food and energy costs, rising 0.6% compared to June — its biggest one-month jump since 1991.5 On a year-over-year basis, though, core CPI edged up just 1.6% in July, the fourth consecutive month in which it remained below 2%.6 The latest reading reflects subdued price pressures for April through June that were among the lowest in a decade.
Although a moderate rise in annual inflation (around 2%) is considered a sign of a healthy economy and generally welcomed by investors, significantly higher increases are not. Bond holders in particular are especially sensitive to inflation, since it erodes the purchasing power of their fixed payments.
Inflation hawks have been on the lookout for a significant pickup in consumer prices in the wake of the Federal Reserve’s massive monetary stimulus response to COVID-19. Through its open-ended quantitative easing (QE) program, the Fed has flooded the market with liquidity by purchasing U.S. Treasuries and other assets to the tune of $120 billion per month. Stimulative activity of this scope would normally be expected to drive inflation higher.
But we don’t foresee that happening in the near to medium term. Here’s why:
  • Huge parts of the economy still have considerable spare capacity. Prices of hotel bookings and airline tickets, for example, have plunged since last year and will probably remain depressed, at least until a coronavirus vaccine is developed.

  • Rising wages — a key part of the 2018-19 inflation narrative as headline unemployment tumbled to multi-decade lows — are less likely to be a factor while the unemployment rate stays above 10%.

  • During this national health crisis and period of economic uncertainty, companies may hesitate to raise prices, continuing a multi-year trend that was in place even when the economy and labor market were strong. Last year, for example, many firms were forced to pay higher taxes on imported goods due to President Trump’s tariffs. Instead of passing on all or most of the full cost of these levies to consumers, companies generally settled for skimpier profits. In today’s environment, customer loyalty is still being valued more than pricing power.
Even if higher inflation does appear, the Fed has the proper tools to deal with it. One of those tools will be to … simply ignore it. Sometime in the next few months, we expect the Fed to announce a new approach to monetary policy. Rather than continue to target a steady 2% increase in the Personal Consumption Expenditures (PCE) price index — the Fed’s preferred inflation barometer — Chair Jerome Powell and his colleagues could take a far more flexible, longer-term perspective. Through clear forward guidance, they may signal a willingness to tolerate PCE readings of 2.5% or even 3% for a period of time when the economy is operating at full capacity to offset unavoidably low inflation during downturns like the current one. Such an approach makes sense to us, especially considering the Fed has rarely met its inflation goal anyway: Not since 2018 has the PCE hit 2% on a rolling one-year basis.7

A bad time to dawdle on further COVID-19 relief

Following the previous week’s release of July’s better-than-expected payrolls report, last week brought more encouraging news on the labor market front.  Notably, first-time unemployment claims fell below 1 million for the first time since March, and continuing claims have now dropped in 10 out of the last 12 weeks.8 These improvements are both an encouraging sign for the recovery and a worrying one to the extent they diminish the sense of urgency on the part of lawmakers seeking to break a stalemate on another round of aggressive fiscal stimulus.
We believe such stimulus is critical to keep the economy going. But rather than try to hash out differences between the $3 trillion HEROES Act passed by the Democratic-led House and the $1 trillion HEALS Act put forth by the Republican-controlled Senate, negotiators refused to budge before heading into their August recess.
President Trump tried to circumvent the deadlock via four executive orders. Two of them – extending certain student loan benefits enacted under the CARES Act and asking federal agencies to explore ways to ease evictions – are narrow and unlikely to help the U.S. economy much in aggregate, even if they work as intended.
The third order, providing extending enhanced unemployment benefits via a labyrinthine system of state-run disaster aid pools, may never get off the ground given its complexity. Also problematic: there’s not enough money in the program to fund more than a few weeks of enhanced benefits at what would likely be no more than 50% of the now-expired $600/week supplement under the CARES Act.
Then there’s the fourth order — a payroll tax “cut.” For workers making less than $104,000 per year, Trump’s plan defers the payment of the 6.2% Social Security tax withheld from their salary. (Employers contribute another 6.2%). While this arrangement would lift take-home pay upon enactment, it would provide little economic stimulus overall, as employees must repay the taxes at a later date.
The president has said he wants to make the 6.2% cut permanent if he wins reelection. But we think any proposal depriving Social Security of funding (and therefore cutting future benefits) will die on arrival in a lame-duck Congress or a new one in January. Remember that less money is already flowing in to the system, due in part to the huge demographic shift caused by retiring baby boomers, along with currently elevated rates of joblessness.
There’s a reason Social Security has long been known as the “third rail” of U.S. politics, a reference to the highly electrified third rail that powers trains. Politicians who step on that rail by proposing to decrease benefit payouts in any form shouldn’t be “shocked” by voter responses at the ballot box.
So where does the economy stand at the mid-point of the third quarter? In our view, the feared August “economic cliff” is being carved into stone. Following the July 31 expiration of the $600/week unemployment benefit, no additional government checks are being sent to those who need assistance the most. As a result, personal income and the savings rate may fall sharply. Consumer confidence could decline as people become less secure in their own situations and less confident about the overall economy. Reduced incomes and shakier confidence, in turn, would likely dampen consumer spending, which makes up 70% of GDP.
Even if the number of new COVID-19 cases and continuing unemployment claims continue to drop, we believe the failure of Congress to act will inflict significant damage on the economy, leading to lower expectations for growth in the second half of the year.
  1. Treasury.gov
  2. Marketwatch
  3. Bloomberg
  4. Marketwatch
  5. Haver
  6. Haver
  7. Bloomberg
  8. Bloomberg, Haver
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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