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Why Is Inflation Rising?

Why Is Inflation Rising
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Market volatility has been picking up this past month, causing dismay for many investors as they worry about the economic recovery. Are these fears well-suited or are they caused by other concerns?

Many managers and economists agree that the economic recovery continues to occur. In fact, I believe that the economic recovery is quite robust and will likely continue throughout the year. However, the market will have to pass many roadblocks along the way. But as they say, the stock market always finds a way to climb the wall of worry.

The biggest worry today is rising interest rates, driven by rising inflation fears.

Inflation Fears

Inflation fears are wreaking havoc on bond prices. As you all know, bond prices fall as yields increase and vice versa. As I write this, the 10-yr Treasury bond currently yields 1.68%, up from its low of 0.50% a year ago. 

Take a look at the two charts below. The first is a linear chart of the 10-yr, which shows the nominal change in yield. You can see the recent rise in rates, even when it goes back 50+ years (including the gnarly rates of the early 1980s).

The second chart shows the same data over the same period, only scaled to log form. The severe drop and rise this past year highlights just how close the 10-year got to reaching zero. The log chart reflects the percentage gain difference, while the linear chart does not, reflecting the massive percentage gain this year. As I mentioned last year, the risk/reward ratio of most bonds are not attractive, though with the recent bond selloff, they at least look nominally more attractive today than only a few short months ago.

10 Year March 2021 Linear
10 Year March 2021 Log

As yields rise, it makes bonds more attractive relative to stocks, and that is starting to put pressure on stock prices. 

Is Inflation Cyclical?

According to ECRI (Economic Cycle Research Institute), rising inflation is not transitory, as the Fed and other bond managers believe. ECRI instead believes that inflation is cyclical, which consists of alternating periods of rising and falling inflation. There is a degree of correspondence with economic slowdowns, but they sometimes begin before, rather than after, the start of a slowdown.  

According to their latest research, ECRI believes that inflation is returning, and there is no sign (yet) that its growth is subsiding. This could be due to base effects (inflation was meager last year due to the COVID economic shutdowns), a rise in oil prices (which subsequently flow through to other products and services), and a reopening economy. There is no single catalyst as it is likely the culmination of many variables. But what most people agree on is that these factors are all inflationary. Transitory or cyclical, inflation is due to continue its rise in the near-term. 

A $1.9T Price Bump

There is also the $1.9T economic stimulus bill and the sharp increase in the money supply over the past year.

M2 March 2021

Many investors and economists would point to this rapid rise as the primary cause for higher inflation. However, I would push back on this as the catalyst for higher inflation (right now, at least) as you need the velocity of money to also increase for inflation to rise. 

The velocity of money is the number of times money moves from one entity to another, the rate at which an economy collectively spends its money. 

M2 Vs M2v March 2021

As you can see, yes, M2 supply has increased quite a bit. Though, the velocity of M2 (M2V) has dropped quite significantly. The real question is whether or not M2V will pick back up anytime soon. If it does (E.g., economic growth skyrockets), then chances are that we will see a real uptick in inflation.

Another Price Bump – Supply Chain Disruptions

Across the entire globe, supply chain woes tied initially to the pandemic are mounting for manufacturers and thus consumers. From cars to clothing to semiconductors, inventory backlogs are rising. To further compound this, extreme weather in Texas shuttered petrochemical plants, California ports have been clogged, and now there is a Suez Canal blockage. With demand beginning to spike again across the U.S. and many parts of the world, prices are expected to rise, at least in the short-term.

If you recall in your Econ 101 class, price and quantity are inversely related to supply and demand.

Why Are Price and Quantity Inversely Related According to the Law of Demand?

If supply chains remain constrained, two things can happen: 1. the price of goods will rise and/or 2. people will buy fewer goods. Of course, it depends on which goods we are talking about. Also, keep in mind that each good has its own elasticity; the degree to which demand reacts when there are incremental price changes.

Manufacturers are reporting lengthening delivery times due to a lack of raw materials. At the same time, new orders rose at the fastest pace in seven years.

Screen Shot 2021 03 24 At 7.08.10 Pm
Source: WSJ

Many are concerned that the supply disruptions will derail the economic recovery. However, I believe that this not enough to derail the recovery. However, it will likely limit the rate at which the recovery will progress. These manufacturers have every incentive to work through this backlog and these disruptions will be short-lived.

Stock Market & Looking Forward

As we ‘celebrate’ the one-year anniversary of the March 2020 market lows, I believe there are still significant tailwinds for a continued stock market rally. However, returns are likely not to be as attractive as they have been this previous year. Still, with an economy opening up, cash in consumers’ pockets, and a lot of pent-up demand, there are significant equity tailwinds.

Regarding your bond portfolio, I always look at it as a balancing act. You want a portfolio that provides protection from an economic shock (negative correlation to stocks), liquidity, satisfactory credit, and suitable duration. The last piece is key when concerned with rising rates. But the trick is to not sacrifice too much of the other three components when trying to shorten your duration. A steady hand will win this game in the longterm.

For now, I suspect that Treasury yields will continue to feel upward pressure for the remainder of this year. If you haven’t made the proper adjustments, there is no time like the present.

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