The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2021 Midyear Outlook :
- U.S. economy: The growth rate has peaked but will remain high throughout 2021.
- Global economy: The economic recovery will spread to Europe and eventually Asia as more countries achieve herd immunity from COVID-19.
- Policy watch: Policy is becoming marginally less accommodative as the recovery takes hold.
- Fixed income: Even with rates subdued, credit-sensitive parts of the market should lead.
- Equities: The best opportunities may now lie outside the U.S.
- Asset allocation: Continue to allocate toward assets poised to benefit from economic reopening and recovery from the pandemic.
Quote of the week:
"The rate of inflation can’t be judged accurately by a few items the government arbitrarily chooses to measure.” – James Cook
Inflation: used cars, airfares and hotel rooms … but not much else
Economists continue to underestimate the rate of inflation in the U.S. The latest example? The U.S. Consumer Price Index (CPI) jumped 0.9% in June, marking the largest monthly increase since 2008.4 The core index, which excludes food and energy prices, also rose 0.9%, tying April’s result for the biggest gain since 1982.5 These figures just about doubled the median forecast, dashing hopes that June would show a deceleration. Instead, the trailing 1-year rates perked up further: headline and core CPI increased 5.4% and 4.5%, respectively.6
Investors should take comfort knowing that inflation is being driven by a narrow set of goods (where there are still shortages) and services (where prices are still well below pre-pandemic levels and have some catching up to do). Used cars were once again among the biggest contributors to CPI, fueling a third of the jump in June’s headline index and nearly half of the increase in the core index.7 Prices of preowned vehicles are up over 45% in the past 12 months as new auto production is held back by the global shortage in semiconductors (essential components in today’s cars) and rental car companies bid up prices to restock their fleets.8 On the services side, airfares rose 2.7% in June yet remain 11% below their September 2019 peaks.9
In what areas of the economy hasn’t inflation reared its ugly head? Prices of home furnishings barely budged. Shelter costs, the single largest component of CPI, showed no signs of acceleration outside of hotel rates. Neither did medical services or education prices. In short, the price of the median good or service isn’t rising very much, even if the overall average price is.
Although consumers likely noticed June’s 1.5% upswing in energy prices, reflected in higher prices at the pump, the energy category tends to be volatile.10 That’s why central banks discount it. The Fed isn’t going to raise interest rates on the grounds that gasoline prices have risen too high or too fast.
That said, if the inflation genie does get out of the bottle, the U.S. economy could potentially run into two primary headwinds:
1. Tighter financial conditions caused by Fed rate hikes and/or rising market-based interest rates as investors demand higher yields on U.S. Treasuries to compensate for the eroding effects of inflation on investment returns. Thus far, recent inflation surprises have helped pull forward expectations for rate hikes, as represented by the Fed’s “dot plots.” But we doubt the Fed will raise rates next year, as the fed funds futures market currently implies. (Fed funds futures are used by traders to place bets on the path of interest rates.) And as of yet, conditions in corporate credit and equities remain quite loose. So for now, inflation hasn’t had an adverse effect in those areas.
2. Falling consumer confidence as purchasing power and standards of living fall. But this hasn’t happened. The Conference Board’s Consumer Confidence Survey has climbed steadily since January to a 16-month peak.11 Consumers are aware that headline inflation has increased sharply, but they may only feel sticker shock when filling up their gas tank or if they purchase a used car. (Of course, most people don’t buy used a used car every month.)
Moreover, a number of positive factors may well outweigh inflation concerns. Adding to the glide in consumers’ stride:
- Incomes have risen and are about to get yet another boost from the expanded Child Tax Credit, which went into effect last week. Tens of millions of families will receive extra funds each month through the end of 2021, along with a tax break next year.
- Consumer savings rates and household net worth remain remarkably high just one year removed from a recession.
- Job openings are plentiful and wages are rising.
Overall, we don’t expect the current type of inflation — limited in scope and driven by temporary supply shortages in the face of unleashed pent-up demand — to derail the economic recovery anytime soon.
As far as the Fed, Chair Jerome Powell delivered his semiannual testimony before Congress last week and focused on the economy’s road ahead to achieve full employment and keep the recovery going. He was somewhat less willing to call high inflation “transitory,” acknowledging that it had risen faster than he’d expected and hoped. Powell’s job as a communicator now is not to comment on inflation but rather to persuade markets that the Fed won’t start tapering or hike rates earlier than necessary.
Economic policy: tilting more toward higher wages, away from higher profits
Lost in the shuffle of a fast-moving few weeks were the dozens of new executive orders (EOs) signed by President Biden over that time aimed at “promoting competition in the U.S. economy.” In truth, the themes they cover vary so widely that it’s difficult to categorize them under a single umbrella. But we’d summarize them as efforts to:
- Lower out-of-pocket costs (prices and fees) for consumers across a variety of industries such as health care, by allowing hearing aids to be sold over the counter, and airline travel, by facilitating the process for people to get refunds on tickets and
- Tilt the balance of power away from employers and toward employees in areas like licensing, compensation and mobility.
EOs usually don’t have the same impact as enacted laws and are prone to reversals by future presidents. And while most of the ones Biden signed during the prior week are merely designed to “instruct” or “encourage” more than a dozen federal agencies to “look into” an issue that could encourage competition, they could lead to concrete policy changes in the executive branch that will affect the way companies interact with their workers and customers.
Economic policy is becoming more populist, even at central banks, which have become increasingly tolerant of hotter inflation in exchange for faster wage growth. Of course, while some employers will bristle at higher labor costs, faster economic growth is not a zero-sum game — as we’ve seen just this year. Profits can grow alongside wages if demand and productivity also rise. These EOs have the same directional goal but cast the issues in the labor market, in particular, as more oppositional between management and labor (or customer). Preventing airlines from charging extra hidden fees, for example, is a policy with clear winners and losers — less about growing the economic pie than about changing the rules of the system.
We don’t yet know how big an impact these EOs will have. But to the extent they work, we should see somewhat higher nominal GDP growth, more robust average wage gains and somewhat lower corporate profits as more economic benefits accrue to labor vs. capital. This has implications for financial market returns over the long term as well. Equity market performance is ultimately tied to earnings, while portfolios built to generate income could be frustrated by lower-for-longer interest-rate policy and higher average inflation.