What I Care About This Week | 2021 Feb 22

by Franklin J. Parker, CFA

The Summary

  • Suddenly everyone cares about inflation. Bond and stock investors are adjusting portfolios in an attempt to get ahead of a possible inflation spike. This is pushing bond yields higher (and prices down) and generally pushing stocks down, though some sectors are holding up fairly well.

  • The $1.9 trillion stimulus package is entering its final stretch. The House is expected to vote on the provision at the end of this week, and negotiations in the Senate are in full swing–all 50 Democrat senators are needed to pass the measure. Markets have priced-in the direct stimulus provisions, such as the $422 billion in direct payments to individuals and $250 billion in extended unemployment benefits. Signs of wavering would likely send stock prices lower.

  • This is a busy week on the economic data front: we get talks from two Fed governors (who will no doubt address the inflation concern), Fed chairman Powell testifies on Wednesday, durable goods orders post on Thursday along with initial jobless claims, and Friday sees data on personal incomes/spending and consumer sentiment. I would expect some volatility, especially on Wednesday, as investors digest this information.

The Details

Inflation is dominating the news (seriously, inflation is pretty much the only story across my news feed). It is interesting to me how a known problem can come to dominate market consciousness all at once. There is nothing all that different about today’s economic environment versus six months ago, but all of a sudden investors across stocks, bonds, and commodities, are moving portfolios around in an attempt to get ahead of a possible spike in inflation. To be fair, US Congress is about to authorize $1.9 trillion in spending that is to be financed largely by the Federal Reserve (read as: newly created money).

That said–and I admit this is difficult for me to say–I’m not sure inflation is as big a concern as everyone is making it out to be right now. Of course, I am taking steps to inoculate portfolios from inflation risk, but there are three basic reasons why I see the sudden excessive worry as misplaced.

First, the Federal Reserve has a unique way of measuring inflation: they tend to factor out energy and food prices (because they are volatile) and they look more closely at prices on consumer goods. While we have begun to see some price inflation in consumer goods, much of that is simply due to Covid-related supply shortages (which can be fixed relatively quickly), not necessarily from a structural shift. The Fed has repeatedly made this point, so I would not expect a policy shift from them even if inflation spiked for a few months.

Second, the Fed changed their policy on inflation management. Previously, the Fed would take action if inflation posted higher than 2%. Now, however, the Fed intends to “average” inflation over “a cycle.” The vague language is almost certainly intentional. The current inflation management policy gives the Fed plenty of room to let inflation run hotter than normal before taking action. On the downside, the lack of a clear line also makes reading their next move that much harder.

The third reason brings us to the Chart of the Week…

Chart of the Week

It is my view that inflation won’t be a problem until interest rates rise meaningfully, which hasn’t happened yet. There is some nuance to this view, but in the end it has to do with opportunity cost. All of this newly-created money is getting “stuck” in financial markets, banks, and corporations because there is no difference between holding cash and investing it. Because people are hoarding that cash it isn’t causing inflation.

When interest rates rise, however, suddenly there is a cost to holding cash. People begin to invest their cash as do corporations. At that point, cash begins to move around the economy and that is when inflation shows up. As you can see in this week’s chart, even though the money supply has expanded at the fastest pace on record, the velocity of money (a measure of how often a dollar changes hands) has simultaneously plummeted in 2020.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

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