Maybe inflation is not transitory after all?
We see inflation as a sustainable trend.
The S&P 500 hit its 49th record high of the year last Monday at 4,480, up 104% from the pandemic low in March 2020 and up nearly 20% so far this year. Our full-year target is 4,500, so we’re practically there in mid-August, though our full-year target price in 2022 remains at 5,000.
But we are concerned about several near-term headwinds, including the ongoing humanitarian crises in both Afghanistan and the southern U.S. border, the Covid-19 delta variant, worries about peak growth in the second quarter, the federal government’s debt ceiling, potential fiscal policy missteps in Congress, rising inflation, changes in the trajectory of Federal Reserve monetary policy and a possible leadership transition at the Fed at a critical inflection point.
As a result, we’ve been bracing for a possible 5-10% air pocket in stocks during the August-through-October period, which in a worse-case scenario could take stocks back down to the 200-day moving average of roughly 4,000. In fact, stocks have already pulled back by about 2% in recent days and benchmark 10-year Treasury yields have slipped from nearly 1.38% to 1.22%. An equity-market correction of this magnitude would be healthy and cleansing, removing some of the froth and creating an attractive re-entry point.
Ultimately, we believe we’ll successfully navigate most of these near-term risks and that stocks will eventually find their sea legs, rallying back to our year-end target of 4,500 during November and December. But with the Fed’s annual monetary policy symposium next week in Jackson Hole, Wyo., let’s review the current status of the “transitory versus sustainable” inflation tug of war, and analyze some key Washington policy decisions investors can use as signposts.
Inflation is rising We see this as a sustainable trend—despite what the government says—that is likely to continue for the next several months:
- Core Producer Price Index (PPI) Wholesale inflation hit a pre-pandemic peak at 1.6% year-over-year (y/y) in January 2020, troughed at -0.20% in May 2020 and has since surged to a 7-year high of 6.1% in July 2021.
- Core Consumer Price Index (CPI) Retail inflation peaked at 2.4% y/y in February 2020, troughed at 1.2% in June 2020 and has since soared to 4.5% in June 2021, a 30-year high. But the core CPI did ease to 4.3% in July.
- Core Personal Consumption Expenditure (PCE) Index The Fed’s preferred measure of inflation peaked at 1.9% y/y in February 2020, bottomed at 0.9% in April 2020 and has since nearly quadrupled to 3.5% in June 2021, a 30-year high. July is expected to rise a tick to 3.6%.
The spread between core CPI and core PCE is typically about 0.5%, and the current core PCE is well above the Fed’s oft-discussed long-term 2% target. Importantly, the negative inflation readings from the Fed’s so-called procedural base effects have already rolled off from April and May 2020, and inflation is still rising, although at a less-elevated pace. While supply-chain bottlenecks and strong business and consumer demand remain in place, the elevated savings rate has declined from 26.9% in March 2021 to 9.4% in June, and the federal government’s $300 weekly unemployment bonus has already expired in 26 states, with the balance ending Sept. 6.
In his Humphrey Hawkins testimony before Congress and his Federal Open Market Committee press conference in July, Chair Jerome Powell acknowledged that “inflation has increased notably and will likely remain elevated in coming months before moderating.” So, his keynote address in Jackson Hole will take on outsized importance, as investors await formal acknowledgement of sustainable inflation trends and details on the Fed’s prospective change in monetary policy.
Oh, SNAP! Food prices are higher This week, the U.S. Dept. of Agriculture (USDA) announced the largest-ever permanent increase in food stamps, known now as the Supplemental Nutrition Assistance Program (SNAP). Benefits soared by $36 per person, a 27% increase from pre-pandemic levels, to $169 per month. Starting October 1, that amounts to a new benefit of $676 per month for a family of four, 26% higher than the $537 per month that the average four-person household actually spent on food at home in 2019, according to The Wall Street Journal. Roughly one out of eight Americans (42 million) are drawing SNAP benefits. This reverses the trend from 2016-19, when food-stamp rolls and benefits declined 19% and 16%, respectively. There are neither restrictions on what food people can buy with food stamps (sweetened beverages, candy, deserts, salty snacks, etc.) nor any work requirements to receive benefits.
Why the need for an increase in benefits now? Wheat prices have risen more than 50% over the past year, and corn and soybeans have surged nearly 80%. These increases in the three most important agricultural commodities in the U.S. have filtered through our food-supply chain. Milk and meat prices, for example, rose 6.2% and 5.9% y/y in July, respectively. Government policymakers essentially are admitting that sharply higher food inflation is here to stay.
U.S. policies contribute to rising energy prices From an oversold $34 per barrel in early November 2020, crude oil (West Texas Intermediate, or WTI) surged nearly 130% to $77 in July, a 7-year high. Over this same period, the daily national average for lagging gas prices hit $3.19 per gallon, also a 7-year high and up 52% from $2.10 last November. WTI has rolled over in recent weeks, trading below $63 as of this writing.
President Biden’s energy policies have contributed to the tighter global supply/demand balance and rising prices. Due to environmental concerns, the administration canceled the Keystone XL Pipeline project, banned fracking on federal lands and suspended oil leases in Alaska’s Arctic National Wildlife Refuge, which have helped to reduce daily production in the U.S. from an industry-leading 13 million barrels per day to 11 million. Also, our accelerated longer-term shift to electric vehicles has curtailed exploration and production activity among major oil drillers.
Moreover, the Biden administration’s efforts to re-engage in nuclear disarmament talks with Iran could lift the U.S.-imposed oil production sanctions. OPEC’s third-largest producer is not currently subject to any OPEC quotas, so Iran could add one million or more barrels per day onto the market, which could take additional market share from the U.S. The administration actually has asked the OPEC cartel to increase oil production, lest higher oil and gas prices—and sustainable energy inflation—serve to inhibit the powerful V-bottom economic recovery the U.S. has enjoyed since the recession ended in April 2020.
Wages rising sharply, and companies pass those costs to customers Average hourly earnings grew at an annual pace of 6% over the past four months through July, more than double the 2.7% rate over the 14-year average of this metric. The labor market is strong, with a record 10 million open jobs in the most recent June JOLTS report, a 17-month cycle low in initial weekly jobless claims and an 11-month high in July’s nonfarm payroll tally.
President Biden’s $1.9 trillion American Rescue Plan (ARP), signed into law in March, extended a federal unemployment bonus of $300 per week until Sept. 6, on top of the average $318 per week state unemployment benefits. That combined $618 average in a 40-hour work week translates to $15.50 per hour—double the federal minimum wage.
It made financial sense for lower-wage workers concerned about contracting Covid or facing childcare issues to collect unemployment rather than returning to their now-open jobs. As a result, companies found themselves bidding against these generous tax-advantaged unemployment benefits to entice employees to come back to work, and they simply rolled those costs into higher prices. Although 26 states eliminated the $300 federal unemployment bonus in June or July and the other 24 states are allowing the program to expire next month, these wage gains are sticky.
Housing prices soar Home prices have risen 17% y/y through May 2021, tying a 17-year high, with more increases expected in coming months in the S&P’s lagging Case-Shiller index. The surge is due to strong pandemic-related demand, low mortgage rates, soaring commodity prices (especially lumber and copper), labor shortages and higher wages, and limited inventory. Consequently, many people priced out of buying a new or existing home have turned to the rental market, which has boosted the rental component of the key inflation metrics.