GO ON, FIGHT THE FED: WHY, AND HOW, INVESTORS SHOULD GIRD FOR INFLATION RISK / BARRON´S MAGAZINE

Go On, Fight the Fed: Why, and How, Investors Should Gird for Inflation Risk

By Lisa Beilfuss

Producers have been eating cost increases on many goods, but gas prices have been on the rise. Here, a gas station in Mill Valley, Calif., on a recent day. / Justin Sullivan/Getty Images

How long is temporary?

That’s the big question looming over the U.S. economy as it laps data gathered during the height of pandemic-driven lockdowns, setting up year-over-year comparisons that will look either artificially amazing or awful. 

This dynamic matters most, of course, to inflation measures that are bound to get hot.

Over the past two weeks, the Federal Reserve has worked hard to assure investors that upticks in inflation would be temporary, owing more to math than to economics.

“We might see some upward pressure on prices. 

Our best view is that the effect on inflation will be neither particularly large nor persistent,” Fed Chairman Jerome Powell told lawmakers this past week, reiterating comments he has made since the latest, $1.9 trillion stimulus package was signed earlier in March.

It’s easy to see how so-called base effects would make for some superficially high inflation numbers over the coming months, when calculating the year-over-year rates of change include depressed lockdown levels of a year ago. 

But how do you know that price increases are fleeting, especially as prices rise in everything from copper and oil to homes and haircuts?

A $4.2 trillion increase in money supply over the past year, driven by extraordinary fiscal and monetary aid, is reason enough for investors to question guidance that inflation is temporary and due to year-over-year pandemic comparisons. 

Ed Yardeni, president of Yardeni Research, says the 27% increase in M2—a measure of monetary supply that includes currency, deposits, and shares in retail money-market mutual funds—from last year could help create an inflationary boom in the second half of the year as more people get vaccinated and as supply-side inflation lingers.

Looking at a variety of recent economic indicators, it seems prudent for investors to prepare for the possibility that inflation isn’t so transitory. 

More immediately, there is evidence that even potentially temporary price increases are affecting corporate profits.

Consider the spread between wholesale and consumer prices. 

For the first time since July 2019, the producer-price index is outpacing the consumer-price index. 

That’s according to Department of Labor data for January and February. 

While two months don’t make a trend, the shift reflects increasing pricing pressures that many businesses face—while showing that, at least for now, firms are absorbing those higher costs instead of passing them on to their customers.

Recent surveys highlight the strain. 

“Higher prices have ensued,” IHS Markit said this past week in its March purchasing managers index, with prices “running far above anything previously seen in the survey’s history.” 

That follows the highest level of input prices since 1980 in the Philadelphia Fed’s latest manufacturing survey.

Companies eating higher costs fits with the Fed’s view that rising prices aren’t here to stay: If corporate executives see price increases as transitory, they won’t go through the pain of raising prices, says Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management. 

But while absorbing price increases instead of passing them on may be a positive macro sign, it’s at the expense of bottom lines.

That’s a problem for stocks, given potential profit margin compression as margins sit near peaks, Shalett says. 

A weaker U.S. dollar isn’t helping, as it’s making the cost of importing raw materials more expensive.

Beyond what is happening on assembly lines, there’s the fact that companies across all sectors face higher financing costs via rising bond yields—especially given the record amount of corporate debt.

“Powell is putting a happy face on the backup in bond yields,” attributing the moves to recovery optimism, Yardeni says. 

“The Fed has decided to let bond vigilantes be the bad guys and do the tightening,” and, he adds, “it’s quite possible bond yields continue to surge.”

The cost of credit doesn’t just affect the cost of doing business. 

There’s also the impact on chief financial officers, says Torsten Sløk, chief economist at Apollo Global Management, particularly in terms of how borrowing costs affect inflation expectations.

Keeping inflation expectations stable at about 2% is crucial to the Fed’s ability to control inflation, as expectations for rising prices can pull spending forward, creating something of a self-fulfilled prophecy.

Several recent indicators suggest that such expectations are rising well above that level. 

The Atlanta Federal Reserve Bank’s March report showed that businesses’ year-ahead inflation expectations jumped to 2.4%, the highest reading since the survey began in 2011. 

And according to the University of Michigan, inflation expectations among those 55 and older are the highest since May 2015. 

That’s particularly noteworthy, as the cohort accounts for roughly 40% of total consumer spending in the U.S., Sløk says.

Markets, meanwhile, are pricing in significant increases in inflation. 

A measure compiled by the Minneapolis Fed shows that traders place a 30% chance that the CPI surpasses 3% for the next five years. 

That’s the market increasingly betting that the Fed is behind the curve as it focuses on the roughly 10 million workers still unemployed and expresses new tolerance for higher-than-normal inflation.

To Yardeni, summer is the point at which it would become clear that building inflation isn’t so temporary. 

Year-over-year readings of 2.5% or higher after June will mean that price increases are indeed a problem, he says, an outcome he anticipates.

“They’ll have to tighten earlier than telegraphed. 

There’s no way they can’t be raising rates next year,” Yardeni says of the Fed, which has suggested that it won’t lift rates before 2024.

Every weekday evening we highlight the consequential market news of the day and explain what's likely to matter tomorrow.

So what is an investor to do as the inflation debate continues, with the Fed and market apparently at odds and inflation data set to spring higher?

Equity strategists at Barclays built an inflation proxy to quantify the exposure of sectors and stocks to inflation expectations. 

Using the proxy, they came up with long and short baskets for investors to consider as market-based inflation expectations rise. 

Their indicator, they say, is long on media, banks, and energy and short on capital goods, healthcare, and real estate stocks.

The bank’s top long ideas include oil-and-gas company Halliburton (ticker: HAL), media company Viacom (VIAC), energy producer Pioneer Natural Resources (PXD), regional bank Comerica (CMA), and electrical-equipment company Emerson Electric (EMR). 

In the basket of stocks to consider selling: real estate investment trust Crown Capital International (CCI), chemical company Ecolab (ECL), and security company Allegion (ALLE).

Elsewhere, analysts say it’s wise to underweight bonds and prepare for declines in emerging market stocks, which have done well amid near-zero interest rates. 

In addition to high-growth technology companies that are more rate-sensitive, analysts say consumer staples and utilities stocks are less attractive amid hotter-for-longer inflation, while cyclical stocks and banks should benefit.

Investors looking to keep their finger on the pulse of the inflation debate should watch wage figures closely. 

Labor, after all, is most companies’ biggest cost, and wage inflation has been missing for a long time.

It is possible the Fed is right and rising inflation will be temporary. 

But given the continuing recovery, massive amounts of stimulus, and clear supply-side pricing pressure, the risk of not preparing for the possibility that the Fed is wrong seems much costlier than the risk of readying for higher inflation and interest rates.