We seem to be experiencing a confluence of events that is exacerbating inflation worries and the Fed appears to be sitting back with no concerns. Pent-up Demand, Labor Shortages, Supply Constraints, and Disruptions all seem to be leading us down a road of higher inflation. Here's what we're seeing so far...
Economic Picture Muddled by Inflation. As we have often stated before, sometimes you have to step back and look at the forest instead of the trees. There are plenty of data points that are of concern, but the bigger picture still looks positive. When we see that the National Financial Conditions Index, tracked by the Fed, with more than 105 data points is still indicating "loose" financial conditions, it puts the inflation fears in perspective. Of the 105 data points that make up the index, only 1 is tighter than average. The remaining 104 data points is looser than average.
Today's CPI (Consumer Price Index) release did show that Inflation had increased more than expected. However, the number being quoted most in the media is the Year-over-Year number, which rose to 4.2%. A few weeks back, we warned investors not to put too much confidence in the YOY data, as it was being compared to data during the nadir of the pandemic. That being said, the Month-over-Month CPI number did also increase more than forecast. Several unusual happenings are adding to inflationary pressures, but we expected inflation to rise by at least 3.5% in 2021 (see our Market Outlook for 2021).
Pent-up Demand and Supply Issues were always going to make the recovery from the pandemic uneven. However, there are new external issues adding to inflationary pressures, such as - labor shortages, supply constraints, and disruptions. On the Labor Front, seven states decided to end pandemic-related unemployment benefits in an effort to get some of those people back into the workforce. The U.S. Chamber of Commerce called for an end to pandemic-related unemployment aid after Friday's jobs report disappointed. Even St. Louis Fed President James Bullard said state-by-state differentials between wages and aid could mean that in some places, pandemic benefits could be holding back some workers from re-entering the workforce. On Fuel Prices, gasoline is on the rise as more-and-more people get back to driving and traveling. However, a recent hack on the network of the Colonial Pipeline has created gas shortages in certain areas. The Colonial Pipeline ships about 2.5 million barrels of oil daily from Houston to the East Coast. It looks like the pipeline operation will be restored today and tomorrow, but it is likely to take a couple of weeks to return to normal operations. On Supply Constraints, we're dealing with soaring prices due to supply chain issues. There are not enough truckers to get products from point A to point B (see also, Labor Shortage) and the demand for goods is out-pacing manufacturing and production. To top that off, we've seen disruptions in supply, such as the ship lodged in the Suez Canal in April. That caused a back up of shipping routes across the world and shipping containers to be piled too high, only to fall off into the ocean during voyage. The latest disruption involves my hometown of Memphis, where the bridge on I-40 between Tennessee & Arkansas has been closed due to a crack on the bottom side of the bridge truss. This has caused trucks to be rerouted, but more importantly, 229 barges are in que and unable to pass under the bridge on the Mississippi River.
Wild Market Swings. It's important to note that we get corrections in the market during the year at least 87% of the time. These corrections average 8% on the downside. However, most of these corrections take place in calendar years that turn out to be positive. In fact, of the intra-year corrections for the S&P 500 Index shown below, 23 out of 31 (74%) corrections of 8% or more occurred in positive calendar years.
Many comparisons are being drawn between this year's economic scenarios and those of the late 1970's. We have higher inflation, higher interest rates, gas/supply chain shortages, and labor issues. While the comparison is not exactly one-for-one, the optics are relevant. However, even if the comparisons were spot-on, most people forget that the markets still finished higher during those troublesome years in the late '70s. If you had invested $10,000 in the market on December 31st, 1976 and held through the ups and downs until December 31st of 1980 would have $12,594 (+25.94%) at the end of that period.
In other words, we get wild swings in the market from time-to-time, but that doesn't mean we need to necessarily shift our focus from the long game. Clients should stick with their financial plan and investment strategy based on their risk tolerance and time horizon.
What Does our Wealth Protection Signal Have To Say? Given the recent increase in volatility, the overall level of the Wealth Protection Signal can give us a clue as to what is going on in the markets. The Volatility component of the Signal (VIX), before today's trading, had increased 65% over the last 3 days. However, the Fear component of the Signal (TED Spread) actually declined 6% over the same time period. There does not appear to be any panic in the market.
What investors need to remember is that the shock of coming off record low interest rates in August and benign Inflation for the last 12 years is real, but should not cause turmoil in equity markets. Rather, what appears to be happening is a shift from over-expensive "growth" names to more attractive "value" names. There will be a period of adjustment, but we expect markets to grind higher by year-end. The recent spike in the VIX could prove to be temporary, as has been the case twice the year already. On January 29th, the VIX hit a high of 37.51, only to head lower below both the 200-day and 50-day moving averages. Again on March 4th, the index hit a lower-high of 31.90, only to head lower below both moving averages. Yesterday, the index reached a level of 28.93, which is another lower high. Time will tell if the index follows suit to decline below both the 200-day & 50-day metrics.