by Peter Jones, CFA
Senior Vice President

Inflation, fast becoming the most dominant market and economic theme of 2021, has media and market commentators fixated on the topic, this blog included. In fact, this will be our fourth entry covering inflation in the past five weeks. While we apologize for “beating a dead horse,” we would be remiss if we did not provide our readers with further clarification on the subject.

The major development this week was the May Consumer Price Index (CPI) report released on Thursday. Once again, inflation came in higher than expected, increasing 5.0 percent compared to the year ago period. Excluding highly volatile food and energy prices, the “core” CPI came in at 3.8 percent. This is the highest print in many years and has market participants fearing an inflation spiral that would bring the nascent recovery to an early demise. However, while we predicted higher inflation and believe it will remain elevated throughout the year, we do not buy into the concept that inflation will be a major problem for the markets and economy. This belief is due to several factors.

We can take some cues from the bond market: if inflation was going to persist and increase further, interest rates would be rising in lockstep. In theory, interest rates would be rising as bond investors require a higher return to cover the loss of purchasing power caused by rising inflation. Also, bond markets would be anticipating central bank actions to “tighten,” or raise rates, to stave off inflation. However, interest rates have fallen over the last several weeks and declined on the upside inflation report yesterday. Put another way, the bond market is sending the signal that inflation is either a) temporary and/or b) will not be problematic for the economic expansion.

In addition, the elevated inflation report is in large part due to what we would call “base effects.” Economic data is typically reported in comparative terms to the “year ago” period. Last May, the economy was in the depths of the pandemic-induced recession which depressed consumer prices and thus produced very low inflation readings. As can be seen in the chart below, the year ago period had a low base, which creates a reading for this year that is more frightening than reality. We wouldn’t go as far as to say this is an optical illusion or dismiss the notion that inflation is rising; however, we do think the most recent inflation data overstates the underlying level of inflation that is likely to persist through this year.

Next, inflation, so long as it does not spiral out of control, is not actually a bad thing for equity markets. After all, stocks are nominal assets that represent claims on corporate cash flows. The cash flows created by companies absorb the effect of inflation. In other words, if inflation is rising, so too will corporate cash flows. Again, as seen in the chart below, corporate earnings are exploding this year. As this relates to investors, we use the axiom, “As go earnings, so goes the market.”

Lastly, we spoke to clients last quarter about how we were positioned for rising rates, as higher rates had become a notable worry. This quarter, we highlight that we have positioned portfolios for higher inflation. Historically, positioning portfolios for higher rates is very similar to positioning portfolios for rising inflation.

As indicated in the chart below, we have made several changes across client portfolios to succeed in an environment of rising inflation.

Increased exposure to stocks and alternative assets. These asset classes are typically not inhibited by inflationary environments.
Reduced exposure to bonds. As mentioned above, inflation reduces the purchasing power of static interest payments.
Increased exposure to Financial, Energy and Industrial stocks. These sectors tend to perform strongly in periods of higher inflation.
Reduced exposure to Consumer Staple, Technology and Utility stocks. These stocks tend to lag behind the market when inflation rises.
Increased exposure to corporate bonds which typically perform better than treasury bonds when inflation rises.

To summarize, inflation continues to dominate the market and economic narrative. While we acknowledge the risks of rising inflation, we believe that underlying inflation is overstated. Regardless, the market should be able to absorb a higher inflation regime without falling off the tracks. We have expressed these views in client portfolios through changes in capital allocation, both across and between asset classes.

Week in Review and our Takeaways for the Week

Inflation once again surprised to the upside and continues to stoke fear across market participants
We have positioned portfolios to perform well in a rising inflation environment

Disclosures