"Keep Calm and Carry On" #9

Hopefully, we have built up some “keeping calm” skills in the last year. We are going to need them. We thought lockdowns were tough, but reentry is going to present its own set of challenges. So too with the markets. Last year we spent much of the year wondering how the stock market could perform so well when things in daily life seemed bleak. While there were several reasons for that, the main one was that the market was anticipating economic recovery. Well, here we are. Business activity is improving. Jobs are returning. People are spending. Fiscal stimulus and easy money are helping. Markets continue strong performance though with a new set of market leaders. Can we keep this up and what might interrupt the process? An example of just how much attention has shifted from fear of a weak economic activity to fear too much pent-up demand is the recent resurgence of inflation fears.


Some historical context may help. After the Great Financial Crisis (GFC) there was a lot of concern that the government responses, both monetary and fiscal, would cause inflation to spike. This was certainly reasonable because a lot of investors remembered the inflation of the 70’s and 80’s. They also remembered the pain of reversing that trend. Fast forward to the GFC and inflation caused by “loose” money and government spending seemed like a real risk. But the risk for much of the succeeding years was deflation not inflation.


Now we have a new crisis, and the policy responses are a commitment to even lower interest rates combined with even bigger government spending. Inflation is again a concern. The factors that support higher inflation are obvious. The Fed has said they will keep short term rates near zero for the foreseeable future while the Congress has passed a series of bills to support workers and consumers and stimulate economic activity. This is different in both magnitude and form from the actions taken in response to the GFC. The stimulus in the GFC era focused largely on stabilizing the financial system. This stimulus is going directly into consumers’ bank accounts. Combine cash with the urge to spend of consumers long held back, and you have a recipe for demand driven inflation, at least in the short term.


There are also factors that may support inflation longer term. One of the primary factors that has held down inflation is globalization. Low cost was the mantra. Global supply chains enabled the most efficient producers to provide product. But we have seen the downside when supply chains were interrupted with little flexibility or resilience built in. Supply chains will be rethought, and cost will not be the only criteria.


Then there are the factors working against persistent inflation. Some of those are short term; some are more fundamental. In the short run, un-and under-employment is still substantial. The jobs news is better, but we have a long way to go. Some low wage jobs will never come back as consumer habits change. Some workers who were forced to stay home in the pandemic will not return and some careers interrupted will never regain their former trajectory. This is bad for individuals and constrains wage costs.


On a more positive note, the pandemic has unleashed a lot of innovation. The rapid development of new vaccine methodologies, the virtualization of the office, and expanded e-commerce are but the tips of the icebergs. Productivity is improving and that is a powerful antidote to inflation.


In the short run it is almost inevitable that we will see inflation. In the longer term the case is much less clear. The concern is higher interest rates come hand-in-hand with higher inflation and that hurts economic activity. Current interest rates, even after recent moves, are historically low. They will likely go up even if inflation stays well-grounded. That is not necessarily bad news when it is driven by strong economic growth.


The market continues to climb the wall of worry but, with a twist, the worry is too much strength instead of too much weakness. Inflationary fears are just one of the worries we will need to navigate. Worry can be functional. If we run out of worries, we know we are at a market peak.


Quote of the Day:


“Worry is a down payment on a problem you may never have.” Joyce Mayer