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This week, the Federal Reserve meets to decide on interest rates. Most expect no change in rates, but inflation worries are leading to calls for the Fed to ease off the monetary throttle. The debate centers on whether recent inflation signs are permanent or transitory. The causes of today’s inflation may be linked to bottlenecks, federal spending, or a sharp rise in the money supply. Whatever the reason, the debate is likely to shape policy and market returns.

Evidence of Inflation’s Return

Inflation is the change in purchasing power of money, reflected in prices. The consumer price index (CPI) basket of goods is representative of changes in prices. Excluding food and energy, the CPI is up 5.4% through June, the fastest rise in over a decade. Producers are also seeing price increases, which raise the cost of doing business. Core producer prices, also excluding energy costs, are up 3.6%, also the fastest rise in a decade.

Commodity prices are also up. From depressed levels a year ago, the CRB commodity index is up 52%. The same index is up 18% from pre-pandemic levels. Crude oil prices are up to $72 per barrel, versus the mid-$30 range last fall and $60 pre-pandemic. And while gold is up about 15% since before the pandemic, cryptocurrencies have been on a tear.

For now, most believe the price rises are tied to reopening the economy and bottlenecks in global supply chains caused by COVID. This explains why today’s 5.4% rise in core consumer prices is not expected to continue. A look at the Treasury Inflation-Protected Bond market shows us bond investors are only pricing in 2.35% inflation over ten years.

Causes Beyond COVID-19

The two most direct links that may account for a structural shift in inflation comes from government action. In response to the pandemic, the Federal Government increased deficits to 15% of the economy’s size, and the Federal Reserve raised the money supply by 30% (Chart A below). Moreover, it now seems that policymakers are reluctant to pare back spending or monetary accommodation, despite vaccinations, labor shortages, and rising prices. This is a powerful one-two punch that, we think, lies at the heart of the inflation story.

Chart A
Stimulus In Full Swing

Reason to Worry

We think the Federal Reserve should worry about inflation as history proves it is hard to stop inflation once it becomes entrenched. History also shows the Fed is more capable of hitting the monetary accelerator than the brake. We view policy as overly accommodative in the face of mounting evidence of returning growth and inflation.

With the combination of near-zero rates, $120 billion of ongoing asset purchases, and forward guidance for continued low rates, the Federal Reserve promotes an environment of risk-taking. This is accomplished by encouraging borrowing and denying investors of safer investment options for savings. Risk appetite is especially evident in stock prices. The U.S. stock market just rose above $50 trillion for the first time ever. The value of stocks is up $15 trillion in a year, the most significant gain ever. At 2.3 times underlying gross domestic product, the valuation of equities relative to the economy is also at a record.

At some point, the Fed could be seen as “behind the curve” in responding to changes in inflation, markets, and the economy. This would complicate the Fed’s efforts to communicate policy changes. Thus, the central bank will likely focus its message on how they intend to reduce accommodation.

Portfolio Implications

Should inflation prove to be more than temporary, unexpected inflation in the years ahead is likely. It is also expected that interest rates would rise in response and as investors demand compensation for uncertainty. We find that in periods of unexpected inflation, where actual inflation exceeds trend inflation, real stock and bond returns tend to suffer (charts B&C below).

Chart B&C
How Inflation Impacts Real Returns

But investors should be aware that some companies can also benefit from mild inflation. Those firms with pricing and balance sheet flexibility in pricing are best positioned, in our view. If a company has sufficient profitability and can raise prices faster than costs, profits can grow. Other companies who struggle to turn a profit before inflation and then encounter rising costs that can not be passed on to customers could be in trouble.

Moreover, companies who borrowed heavily on the expectation debt would be rolled over cheaply may be in for a rude awakening. If higher inflation leads to higher interest costs, then overly indebted companies will face greater default risk.

Conclusion

We believe we are nearing an inflection point on policy that will require great skill from the Fed and Congress to navigate. The economy is moving beyond pandemic level activity. Accordingly, we expect the degree of monetary and fiscal support to be dialed back. As this process unfolds, there is a risk that markets react negatively.

Portfolio strategy may require a more tactical approach and a focus on flexibility and quality.

Kevin R. Caron, CFA
Senior Portfolio Manager
973-549-4051

Chad Morganlander
Senior Portfolio Manager
973-549-4052

Matthew Battipaglia
Portfolio Manager
973-549-4047

Steve Lerit, CFA
Client Portfolio Manager
973-549-4028

Paul Clark, CFA
Senior Portfolio Manager
Municipal Fixed Income
415-364-2635

Rick Marrone
Senior Portfolio Manager
Municipal Fixed Income
415-364-2917

Daniel Urbanowicz
Senior Portfolio Manager
Municipal Fixed Income
973-549-4335

Suzanne Ashley
Internal Relationship Manager
973-549-4168

Eric Needham
External Sales and Marketing
312-771-6010

Jeffrey Battipaglia
External Wholesaler
973-549-4031

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