Inflation isn’t going away, at least not soon. Recent data show consumer prices rose 0.9% in October which means 6.2% over the last year.
As a result, real inflation-adjusted average hourly wages continued their trend downward since peaking in April 2020. They’re now down 1.2% over the past year. Comparatively, real average hourly wages are up only 1.5% since February 2020 (pre-pandemic), versus a gain of 2.3% in the 20 months before COVID-19 arrived.
One of the justifications for the Federal Reserve’s loose monetary policy was to offset damage from the pandemic lockdowns. But it's increasingly apparent that strategy may have backfired as inflation is accelerating more rapidly than the Fed hoped.
Looking forward, the central bank says inflation is going to drop next year. That’s technically true – prices will rise, just not as fast. So, while it won’t be as bad, there will still be above trend inflation.
From an economic standpoint, the problem is the Fed’s most recent forecast (by its favored inflation measure) suggests inflation will be only 2.2% next year. We think the Fed is making the same mistake as last year when it projected inflation would be up 1.8% in 2021. Obviously, that was way off.
Based on our analysis, we believe Consumer Price Index (CPI) inflation will run around 4% next year. The CPI could continue to climb at that clip for years until the M2 money supply dwindles. That could happen by money flowing through the economy or the Fed forcibly draining it from the monetary system through trimmed asset purchases.
But, if the Fed keeps thinking inflation is “transitory,” it won’t drain money from the system. That’s why we said in the past it should have started tapering sooner.
To summarize, the Fed’s loose monetary policies have taken root in the U.S. economy. This is difficult and time-consuming to unwind, so we don't expect to be back at the Fed’s 2.0% inflation target anytime soon.
Thus, we need to plan accordingly as investors.
The Investor Mindset
We just discussed a lot of nervous topics. But it’s important to now take a deep breath and look at facts to adjust our inflation fears from an investment perspective.
First, let’s attack the fear case for inflation by looking at the five-year breakeven inflation rate. This is an objective marketplace indicator of where investors think inflation will be in five years. Currently it's hovering just under 3%, which is the highest reading in 20 years:
Earlier this year, Wall Street consensus didn't expect the first interest rate hike until the second half of 2023. Well, what a difference six months makes. Wall Street now forecasts a 95% chance of the first hike being done by December 2022 and a more than 77% chance we'll see two hikes by then:
Putting this into perspective, historically one of the biggest threats to bull markets has been an overly hawkish Fed. A central bank with this mindset raises rates too far, too fast, sending the economy into a recessionary tailspin.
That sounds scary, right? Well, let’s flip the script a bit by focusing on the data and the positives.
Undoubtedly, rising inflation is bad news for bonds because bond prices move inversely with interest rates. So, as interest rates rise, the value of bonds declines.
Conversely, from a historical perspective, stocks have weathered moderate inflation perfectly fine. Since 1927, in years where inflation ran above average, the S&P 500 has registered average annual returns of 4.9% above the rate of inflation:
The reason is inflation tends to rise when the economy is growing…like now. In these scenarios, demand is robust and pricing power is abundant. That’s all good news for corporate revenues and profits. Additionally, dividend growth also helps stocks weather higher prices because investors favor increasing equity payouts over fixed bond coupons.
Of course, there are reasonable concerns from an economic standpoint, which the media won’t let us forget. But let’s examine what the “big money” institutional investors are doing. The data indicate such investors aren’t buying the inflationary bear narrative.
Why is that?
“Big money” knows when inflation and interest rates are normalizing off rock-bottom levels, it represents validation of economic recovery rather than a threat to growth. These institutional investors know stocks follow earnings, and with third quarter earnings season almost over, the outlook for corporate profits remains record-breaking.
On earnings calls we're hearing companies continuously talk about strong demand, which is allowing them to pass on supply-driven cost increases and higher wages. While that creates a higher cost for us as consumers, as investors we can take advantage of that via fundamentally strong earnings.
For instance, looking at the 2021 consensus earnings per share (EPS) forecast, you can see the estimates remain near record levels at $210:
More importantly, the forward-looking 2022 EPS estimates are holding strong at $226. This implies an 8% growth in earnings over the coming year. From a macro level, these are solid numbers and provide a strong backdrop for assets like stocks. Such data support the historical precedent that many companies do well when inflation heats up, as long as things don't wildly overshoot.
That said, we recognize the potential economic issues for workers and will keep a close eye on the risks of inflation and rates overshooting. But from an investment lens, there are opportunities out there. The bottom is not falling out. At CFS, we’ll continue to monitor the data and look for those opportunities.
Securities sold through CoreCap Investments, LLC. Advisory services offered by CoreCap Advisors, LLC. Cornerstone Financial Services, CoreCap Investments, and CoreCap Advisors are separate and unafﬁliated entities.