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Pressure Drop: Easing Inflation Pressures Ahead?

Pressure Drop: Easing Inflation Pressures Ahead?
Key Points
  • Often lost in the inflation debate is the economic growth backdrop, which has had a significant effect on equity market returns.

  • Some inflation pressures are already easing; with attendant impact on affected industries’ stocks’ performance.

  • Signals from the bond market, wage growth and productivity are key to the outlook for inflation looking over the medium-term.

Inflation remains in the spotlight. But often absent in the debate is the economic growth backdrop at the time of rising inflation pressures; especially as it relates to equity market performance. My friend Jim Paulsen at The Leuthold Group prompted us to look at inflation during every economic expansion since 1950. Using the consumer price index (CPI), the first chart below highlights what many investors might expect—that stocks have had significantly higher performance when inflation was falling vs. when inflation was rising.

Inflation Hurts Stocks …

062821_cpi bar chart

Source: Charles Schwab, The Leuthold Group, 1950-3/31/2021. *Based only on economic expansions (all quarters when trailing y/y real GDP growth rate was positive).  Past performance is no guarantee of future results.

Bringing in the economic growth component changes the picture entirely. As shown below, when inflation was rising, but economic growth was in its lowest quartile, stocks fell. However, when inflation was rising, but economic growth was in its highest quartile, stocks not only rose; they rose at a faster clip than when inflation was falling in that same growth zone.

… But Not if Growth is Strong

062821_gdp quartile

Source: Charles Schwab, The Leuthold Group, 1950-3/31/2021. *Based only on economic expansions (all quarters when trailing y/y real GDP growth rate was positive).  Past performance is no guarantee of future results.

The net is that the growth backdrop needs to be considered alongside the inflation backdrop. At least in the near term, the surge in economic growth expected for the second quarter serves as an offset to the upward pressure on inflation. In addition, the bloom may already be coming off inflation’s rose if search activity is considered.

The charts below show Google search trends for ‘inflation;’ as well as its counterpart extremes, ‘hyperinflation’ and ‘deflation.’ Not only have search trends for ‘inflation’ eased significantly since the spike in mid-May; search trends for ‘hyperinflation” have fallen, while search trends for ‘deflation’ have risen.

Changing ‘flation Searches

062821_google inflation

Source: Charles Schwab, Google Trends, as of 6/25/2021. Numbers represent search interest relative to the highest point on the chart for the given region and time. A value of 100 is the peak popularity for the term. A value of 50 means that the term is half as popular. A score of 0 means there was not enough data for this term.  

062821_google hyperinflation

Source: Charles Schwab, Google Trends, as of 6/25/2021. Numbers represent search interest relative to the highest point on the chart for the given region and time. A value of 100 is the peak popularity for the term. A value of 50 means that the term is half as popular. A score of 0 means there was not enough data for this term.  

062821_google deflation

Source: Charles Schwab, Google Trends, as of 6/25/2021. Numbers represent search interest relative to the highest point on the chart for the given region and time. A value of 100 is the peak popularity for the term. A value of 50 means that the term is half as popular. A score of 0 means there was not enough data for this term.  

Price pressures easing

Among myriad metrics that amplified the hyperinflation narrative are the prices components within the Institute for Supply Management (ISM) Manufacturing and regional Federal Reserve banks’ purchasing managers indices. The latter cohort is shown as an average of several banks for which we have June data; and as you can see below, that has spiked along with the broader ISM series. 

Peaking Price Pressures?

062821_fed ism

Source: Charles Schwab, Bloomberg. *Regional Fed banks include Philadelphia, Richmond, New York, Dallas, and Kansas City. Regional Fed data as of 6/28/2021. ISM data as of 5/31/2021.

The surge came alongside an extreme lengthening in delivery times and a buildup in order backlogs, underscoring that the entire supply chain had been severely disrupted. Understandably, rising price pressures were a direct result of that stress, mainly because demand had returned at a time when companies were still getting back online. In essence, the desire to reopen and spend on the part of the consumer was just as strong, if not stronger, than the speed with which the economy and companies closed down last year—causing a rupture.

Given that, it’s logical that price pressures would surge rapidly and across so many industries. Yet, as the chart shows, we may already be starting to see some easing. All but two of the regional banks (Dallas and Philadelphia) saw a downtick in prices in June. The ISM prices index rolled over slightly in May; and given its close proximity to the regional Fed data, may continue to do so in June. As the second half of the year unfolds—and assuming employment trends continue to improve and supply shortages are alleviated—a continued move down in prices may coincide with some easing of inflationary fears.

The market has already confirmed an easing in a few of these areas—namely, the auto industry, which you can see has had a significant correction from the peak earlier this year. The three other S&P 500 industries in at least correction territory are also shown, and unsurprisingly reflect the market’s message that price bottlenecks are starting or will begin to ease. 

062821_industry table

Source: Charles Schwab, Bloomberg, as of 6/25/2021. Past performance is no guarantee of future results.

Bringing down the house

Another area showing a similar pattern—albeit a bit accelerated in timing—is housing. For obvious reasons, home sales fell precipitously last year as the pandemic initially hit the economy; but they quickly bounced back as consumers embraced the work-from-home dynamic and set out to look for more space. The rebound more than offset the pandemic losses, and sales became quite stretched relative to their longer-term average. Since then, sales have fallen 14% from their peak in October.

Home Sales Rolling Over

062821_existing home sales

Source: Charles Schwab, Bloomberg, as of 5/31/2021.

One of the main reasons for the decline has been historically low inventories and rapidly accelerating prices. As shown in the chart below, the number of available homes for sale is near the lowest on record; while the median price of an existing home has risen to $350,300, the highest on record. This has become a pure supply-demand imbalance, which has pushed many buyers to the sidelines, thus bringing sales down. 

Home Prices Up, Inventories Low

062821_existing homes median inventory

Source: Charles Schwab, Bloomberg, as of 5/31/2021.

Most of the inventory issue has been exacerbated by extreme moves in the lumber market. With last year’s surge in demand for housing came a massive spike in the price of lumber—which rose fourfold from last October to an eventual peak in early May. Similar to the aforementioned issue in the manufacturing sector, sawmills became swamped with orders from homebuilders and retailers. That put upward pressure on prices and encouraged a subsequent rapid increase in production. Ultimately, prices simply became too high and rolled over. As you can see, lumber futures contracts are 53% off their peak. 

Lumber Gets Cut Down

062821_lumber futures

Source: Charles Schwab, Bloomberg, as of 6/25/2021.

Prices are still hovering at nearly double their level one year ago, but the broader trend is of more importance and emphasizes the fact that the boom-bust pattern in lumber prices (along with several other commodities) is confirming the ‘transitory’ nature of inflation pressures.

Bonds’ crystal ball

The temporary nature of these shocks has been confirmed by what we’re seeing in the bond market. To be sure, the ten-year Treasury yield has been on the rise since the middle of last year, and did in fact spike rapidly to 1.7% in late-March. That coincided with a fairly swift -10.5% correction in the NASDAQ, driven by the concern that longer-duration market segments with higher multiples (typically housed in the NASDAQ) would come under pressure in an environment of rising rates.  

Yields have since retreated and have been trending sideways for the past few months. The same has been the case for real yields which, as you can see in the chart below, remain deeply negative. Much of the selloff in the growth-oriented areas of the market earlier this year—mainly Technology and Consumer Discretionary—was driven by the rise in real rates into March. They have since come down and drifted sideways. 

Yields’ Inflation Message

062821_implied real rates

Source: Charles Schwab, Bloomberg, as of 6/25/2021. An inflation swap is a transaction where one party transfers inflation risk to a counterparty in exchange for a fixed payment.

That has given the growth trade some more breathing room, as the NASDAQ has reasserted some leadership over the S&P 500 in the past month. Importantly, though, while some cyclical and value-oriented areas have eased their ascent, they haven’t come down meaningfully; confirming the strength in both the prospects for the economy and the continued durability of value factors’ leadership. 

Show me the inflation 

Rounding out the discussion on inflation, we’ll focus on the components that are crucial in determining both the level and duration of inflationary pressure. The aforementioned metrics—survey-based price reports, lumber, and housing—don’t directly feed into, or correlate well with, long-term trends in inflation metrics. Additionally, there continue to be spikes in measures such as CPI due to base effects; but those should wane as we move further into the summer (given the level of CPI started to rise at this time last year).

In an attempt to “control” for base effects, I looked at the two-year change in the CPI (shown in the chart below), along with a two-year change in wages and salaries. The main takeaway is that while CPI increases from one year ago have undoubtedly been strong, the changer over two years disputes the notion that we’re seeing a high and sustained increase in prices. Inflation remains well below levels seen during the Global Financial Crisis, and nowhere near the stratospheric climb in the 1970s. 

Comparing Inflation to Pre-Pandemic

062821_CPI Wages 2Y

Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics, as of 5/31/2021.

Wage growth also remains subdued. You can see above that high double-digit percentage increases in workers’ pay preceded the hyperinflation of fifty years ago. Not only are we not seeing that this time, but we’re also in a different labor environment. The number and power of unions has waned, global wage inflationary pressures have eased, and technological innovations have boosted productivity. 

In sum

We likely won’t see a rapid reversal in those secular forces, which should keep the inflation genie in the bottle. That isn’t to say that prices will come crashing back down in a disinflationary spiral, but the ingredients necessary for a return to hyperinflation are simply too few and not strong enough.

What you can do next

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