It was falsely prophesied over the past decade, many times, yet the path to a real U.S. inflation scare may finally be coming into view. If economic reopening-driven price increases occur at the same time as easy spring 2020 comparisons are being lapped, inflation could soon rise meaningfully above the U.S. Federal Reserve’s 2% target.
Fed Chair Jay Powell has made clear that the Fed is willing to tolerate a modest overshoot to make up for the many periods when inflation came in below 2%. How the Fed would respond to a substantial overshoot remains to be seen, but Powell has stressed that transitory inflation would be less of a worry. The Fed may even want to look through a lens of rising prices.
Financial markets are pricing an initial rate hike by early 2023, however, so higher inflation is likely to test the Fed – and investors. Recognizing the drivers of inflation will be important.
UNITED STATES – March 8: The Federal Reserve building is pictured in Washington on Monday, March 8, … [+]
Should higher prices emerge, investors will need to differentiate between central bank and governmental policy actions that are steps toward a re-normalization from emergency/crisis measures versus policy tightening measures to combat overheating. This will be especially true if these actions are taken during or after a higher inflationary period.
In the near term, none of these signs are easily discerned. Investors should closely monitor incoming data to judge whether inflation is clearly breaking one way or the other.
Prospects for robust economic growth in 2021 and beyond are encouraging. With the national vaccination campaign ramping up, approximately 15% of the U.S. population has received at least one dose. Penetrations are higher in more vulnerable cohorts such as the elderly (nearly 50% of those 65+ have received at least one dose) and front-line workers.
With the vaccination campaign set to accelerate in March and April as more manufacturing capacity comes online and additional vaccines receive FDA emergency-use approval, investor attention is turning toward economic reopening. The timeframe is accelerating relative to expectations of a month or two ago, which is a positive for risk assets.
Full-year consensus GDP expectations were revised higher in February by 80 basis points (4.1% to 4.9%). Expectations for 2021 S&P 500 Index earnings rose nearly $2 per share, just over 1%.
And there are more signs that momentum is accelerating. The Citi Economic Surprise Index for the U.S., a measure of how economic data is doing relative to expectations, has inflected higher. Data such as retail sales and durable goods orders have been coming in well ahead of consensus.
Commodities are a standout, with copper prices at their highest level in nearly a decade. Further strength in areas such as lumber and steel align with bullish readings, and two business activity indicators – profit margins and truck shipments – also appear likely to improve if trends hold.
Breakeven rates – the level of inflation implied by the pricing of Treasury inflation-protected securities (TIPS) relative to similar maturity U.S. Treasury bonds or notes – have risen along with intermediate and long-term interest rates.
With economic activity picking up and fiscal and monetary policy still quite accommodative, investors should be increasingly concerned about the possibility of an overheating economy.
Jeffrey Schulze, CFA, is a director and investment strategist at ClearBridge Investments, a subsidiary of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice.
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