Evidence of rising inflation and its repercussions for financial markets 

• Equities and bonds went sideways in May as positive factors were neutralized by excessive sentiment and risk of rising inflation;
• There is still more room for upside in equities, but divergencies between equity sub‑segments are likely to persist.

In early May we outlined that though there are plenty of factors to boost equity prices to even higher levels, excessive optimism indicates that markets may be ripe for reversal. During the month indeed we saw both price reversal and consequent recovery, with majority of equity indices closing flat for May. But key reason for sell‑off was not related only to sentiment, investors became increasingly worried about rising inflation as well. On the bright side, positive developments, such as steady reduction in COVID‑19 cases, new fiscal announcements, rising earnings and improving macroeconomic data still prevailed, and by the end of the month majority of equity indices were able to return close to their all‑time high levels.

Performance of equities and bonds in May

Source: Bloomberg Finance L.P.

Topic of inflation remains hot since the beginning of the year and in May its importance has only intensified. Latest data on core consumer price index (core CPI)  from USA shows that monthly change in prices of 0.9% in April was the highest since September 1981 (almost 40 years). Meanwhile, annual change in core prices in USA has reached 3%, highest value since 1995. Given that since last October each new monthly release shows only signs of price change acceleration, not surprising that more and more investors start to believe that inflation may soon become uncontrollable, and especially so, if US government and Central bank would continue to pursue very loose fiscal and monetary policies.
 
Core CPI in USA (monthly and annual)

Source: Bloomberg Finance L.P.

On the other hand, FED so far believes that high inflation is only transitory, and it will not be sustained for long after full economic reopening. It is true, that due to COVID‑19 restrictions suppliers right now are not able to fully cover all consumer needs, with excess demand putting pressure on prices. However, when all business operations would be restored and companies would also be able to expand their production facilities, price stability is likely to be regained as well. There would be no overheating any more. Such scenario is quite reasonable and definitely could happen. Problem is that it is not a guaranteed outcome, and if the FED ultimately is wrong and inflation would continue to spiral out of control, investors may become severely punished from incorrect positioning in certain assets. Nobody wants to take such risk and therefore in 2021 we are seeing rather significant outperformance of financial assets that benefit from inflation and underperformance of securities that are unable to protect from rising prices. 

But why, contrary to FED’s opinion, high inflation might turn out to be permanent? Different factors may be in play. For example, to increase supply producers would still need to hire additional skilled labor, and recent NFIB data shows that employers have severe difficulties in finding such employees. Record high 44% of small businesses said that they have open vacancies, unable to fill, as there are no suitable applicants for the job. And this is despite number of unemployed in USA still being by 4 million higher than in early 2020 before COVID‑19. Potential solution to this problem is obviously to increase proposed wages, and make job offers more attractive. But the likely outcome of this development is also to pass wage increase to consumers, so that companies are not losing their profits. In essence, that is how cost inflation persists.   

NFIB small business job openings hard to fill

Source: Bloomberg Finance L.P.

Another option to create persistent inflation is through rising demand. During pandemic, savings rate of population has jumped considerably compared to last 50 years. Through fiscal measures, majority of population also did not experience decline in their personal income throughout last year. In addition, to support economy FED has increased money supply at the highest rate since World War 2. Now, after reopening, there is risk that all this saved and newly created money would start to pour into economy, significantly increasing consumption from current levels. As too much money would be having too few goods to chase, with suppliers unable to produce adequate amount of inventory in a timely manner, inflation might be able to persist once again.

Savings rate and personal income dynamics in USA

Source: Bloomberg Finance L.P.

Unfortunately, nobody knows for sure which exact scenario would play out, but given actual data, odds are shifting more and more towards persistently higher inflation. As a result, expectations that central banks would have to introduce tighter monetary measures earlier than planned also increase. Possibility of higher interest rates puts downward pressure on longer term bond prices and causes investors to reallocate to specific “inflation protection” segments in equities.

This development is vividly seen since mid‑February, as best 2020 sectors such as IT and consumer discretionary are struggling to show positive performance, while sectors such as materials, financials, energy and industrials that tend to profit from inflation continue to show strong uptrend. 

Performance by selected sectors

Source: Bloomberg Finance L.P.

Same phenomenon is observed also when market is analyzed through “growth” vs “value” perspective. In normal conditions equities of companies with strong earnings growth and equities of cheaper cyclical, often more mature corporations tend to move in unison, though rate of change may be different. However, since mid‑February we see massive divergence between two equity investment style universes. Prices of growth stocks are still struggling to exceed levels shown 3.5 months ago, while value stocks during the same time increased by more than 10%.

Performance by equity investment categories

Source: Bloomberg Finance L.P.

Unless, some unexpected negative surprises would reemerge in June, there is high likelihood that the markets would continue trending higher this month. There is still enough of positive news impacting financial markets, such as gradual removal of lockdown restrictions happening in multiple countries, rise in global economic activity, improving corporate earnings forecasts and potential plans to have elevated fiscal budgets even after COVID‑19 is gone. Potential turbulence may be caused, if inflation release for May would turn out to be even higher than for April, and FED in mid‑June during their meeting would have to somehow address rising investor concerns.