Inflation Expectations Increase, Here’s Why That’s Okay

There were multiple signs last week suggesting that inflation expectations have risen. First, we saw yields rise in the bond market: The 30-year U.S. Treasury bond closed at 2.01 percent on Friday, up from 1.65 percent at the beginning of the year. The breakeven rate (spread between market rate and inflation-indexed rate) for 5-year Treasury notes also reached its highest level since 2013.

In addition, we saw hints of future inflation within several economic reports last week, building upon ISM data earlier this month. On the other hand, the January consumer price index (CPI) reading was tame. As with most fluctuations in the economy and financial markets, investors are asking: Is inflation sustainable, and is it manageable?

Based on the current data, we believe the answer to both of these questions is yes. Inflation is a forbidden word in some investment circles; it generally carries negative connotations of diminished purchasing power and Central Bankers intervening to pour water on rising prices. However, we see the current environment as the reflating of an economy that’s attempting to regain its footing after being hit with several significant setbacks during the COVID-19 pandemic.

The U.S. economic recovery has been apparent in the data since last summer, and we expect that trend to continue as the vaccine rollout expands. Approximately 40 million Americans have now received at least one of two necessary injections. The current rate of vaccine distribution suggests another 50 million doses could be administered in the next month, which should allow for more business and travel restrictions to be lifted on a rolling scale.

As for the Central Bankers, Jerome Powell reiterated at a speech for the Economic Club of New York on Wednesday that the Federal Reserve has a healthy tolerance for inflation at or above its 2 percent annual target. The Fed remains focused on accommodative monetary policy, in order to encourage a rebound in the labor market. This includes keeping interest rates low and buying $120 billion of bonds each month.

If inflation emerges, we believe there are multiple ways for investors to protect themselves and even prosper. Recent market returns have confirmed what history has previously shown us: Small-cap, Mid-Cap and International stocks, in addition to inflation-protected bonds and commodities, tend to outperform when prices are on the rise.

WALL STREET WRAP

NFIB Small Businesses Confirm Higher Prices: Tuesday’s report from the National Federation of Independent Business showed that small-business owners were busy raising prices in January. A net 17 percent of firms reported higher selling prices last month, and a net 28 percent expect further increases over the next three months.

Both of these readings hark back to levels seen in the second half of 2018. At that time, the Commerce Department’s personal consumption expenditures (PCE) measure was running slightly north of 2 percent, and the FOMC was actively raising interest rates.

A trade war with China and the COVID-19 pandemic had kept inflation down since then. What we’re seeing now in the NFIB data could be the reflating of prices back toward those 2018 levels; however, the one important difference this time around is that Jerome Powell does not presently appear to be concerned about inflation overheating.

University of Michigan Shows Lower Consumer Sentiment: This preliminary reading on Friday declined to 76.2. According to survey Director Richard Curtin, “Households with incomes in the bottom third reported significant setbacks in their current finances.” To this end, relief is likely soon coming in the form of the $1.9 trillion stimulus package put forth by President Biden, including a proposed $1,400 direct payment.

Below the headline number, inflationary expectations were also on the rise in this survey. The outlook for a 3.3 percent increase in prices over the next year was the highest reading since 2014. The figure fell to 2.7 percent annual growth in the five-year outlook, but it confirms the other signs of inflation we’ve been seeing.

Consumer Prices Rising but Below Fed’s Target: While there are signs of potential rising inflation in the future, this past Wednesday the Bureau of Labor Statistics reported a 1.4 percent increase in the U.S. CPI for January. Energy and food prices were the two main culprits last month, although it’s worth noting that the price for used cars and trucks is up 10 percent over the past year. The headline figure is firmly below the 2 percent threshold that the Federal Reserve targets but is a reading that will remain closely monitored by inflation hawks.

THE WEEK AHEAD

Trifecta of Key Reports on Wednesday: Wednesday brings three important and diverse economic reports, beginning with the Producer Price Index (PPI), which is the business side of last week’s CPI. We’ll also get a read on January retail sales and see if $600 stimulus checks made an impact on a report that’s been lackluster the past few months. Finally, the Federal Reserve data on Industrial Production will serve as an important barometer for the manufacturing sector.

PMI Offers Early Read for February: The preliminary IHS Markit Purchasing Managers’ Index (PMI) data on Friday gives us the first comprehensive outlook for U.S. economic activity in February. The manufacturing side of the report has been leading the way in recent months, but this is a key early gauge of our theme that the economic recovery will broaden to other areas throughout 2021.

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