Inflation Head Fake?

The financial markets freaked out last week as yields rose on fears, yet again (sigh), of growing inflationary pressure. The benchmark 10-yr Treasury yield briefly crossed 1.6% Thursday, the highest level in a year, sparking a sell-off in Growth and Momentum stocks. But so what? The 10-yr was back at only pre-Covid levels, and everyone knew those stocks were grossly overvalued...Yes, the 12-month CPI came in at 1.4% in Jan vs the average of 1.2% for 2020. And true, there is another $1.9T of stimulus on the way even as the economy is poised to take-off (Goldman Sachs is forecasting ~7% GDP growth for 2021). From that angle, you might expect some handwringing in the media about inflation... though sell-side research loves to cheerlead remind clients rising yields is good for stocks as it reflects strong fundamentals (there's never a bad reason not to own stocks).

But, what seemed to really have panicked the markets was the disorderly nature of the bond sell-off. The magnitude of the move last week was more than 2 standard deviations, which is typically associated falling equity prices. So last week both bonds and stocks lost value together. The nightmare scenario from a portfolio construction perspective! Anyways...continuing with what happened...Goldman Sachs' Portfolio Strategy team notes that long-duration growth stocks fared especially poorly, including a 15% sell-off in a basket of non-profitable tech stocks that had risen by 230% since the start of 2020. In contrast, cyclicals with falling sales in 2020 have returned +25% YTD. There was also the chart below, which got a lot of attention showing the 10-yr was now yielding as much as stocks and signaling potentially more outflows out of stocks as investors re-think their income source:   

But we've been here before...as the above chart shows, including famously in 2013 with the "Taper Tantrum." Each time growth has been slower than expected and inflation way lower than anticipated. I'm with PIMCO's Dan Ivascyn, who continues to see "powerful disinflationary trends. [And] after an initial recovery there is likely a world of excess capacity." In Ivascyn's opinion, inflation will remain contained due to secular trends in demographics, technology and weakness of organized labor. The upshot is a material risk of an "inflation head fake." 

Secular Stagnation

This all goes back to the secular stagnation argument that Summers raised a few years ago. Despite high levels of debt and historically low interest rates, growth and inflation has remained, surprisingly, tepid for more than a decade. Essentially, Summers argues that the post-GFC challenges require a different response than what is prescribed by the traditional monetary policy playbook. He identifies the following key issues:

Lack of new investment: Demographics is, in many ways, destiny. The working age population of the industrial world and even China is declining. At the same time, the increased labor force participation from women entering the workforce has plateaued. These trends, by themselves, reduce the demand for new capital goods. But they are further reinforced by advances in technology; whereby a $500 iPhone today has more processing power than supercomputers priced at millions of dollars from a generation ago. Consequently, the amount of savings necessary to purchase a given amount of capital goods has dropped sharply:    

The savings glut: At the same time just as investment demand has been falling aggregate savings have been increasing, for several reasons. First, economic policies of the last thirty years have favored capital over labor with the benefits of economic growth accruing heavily to the wealthier segments of society who have a greater propensity to save. Moreover, corporations have increasingly used their profits to buy back their own stock (once again benefiting the wealthy who are more likely to own shares) rather than use it for R&D and other capital expenditure. Second, uncertainty around future growth and the lower likelihood of government support has also contributed to the need for more savings. And third, stronger financial regulations and stricter lending standards have further increased the need for savings (e.g., no more 0% down payments on mortgages).

Summers believes that the failure of private investment to absorb private savings leads ultimately to insufficient demand and supports the secular stagnation thesis, because: (i) A high supply of savings and low levels of demand help explain the downward trend of interest rates over the last two decades, despite rising budget deficits, (ii) difficulty in absorbing savings generally lead to slower growth and deflationary pressures (as evidenced by the post-GFC environment) and (iii) periods of slow growth and deflation logically lead to asset price inflation as abundant savings are pushed into existing assets (stocks, homes), raising price-to-earnings ratios while decreasing the term premium on long-term debt. All certainly persuasive agruments as we've noted before.

And I suspect to a good extent a lot of investors also feel that way. After all the 5-yr TIPS rose more than 10-yr TIPS last week; suggesting any spike in growth and inflation will not be permanent. And while Powell and Yellen are willing to let inflation run high for the sake of higher growth, just getting the economy back near to potential seems a steep climb, let alone past potential.

I suspect everyone realized that markets had gotten way ahead of themselves in the past couple of months and needed an excuse to pull back. CPI numbers coupled with the passage of another $2T of stimulus was a good enough reason as any. Also, the bond market just seems to have needed some assurances from the Fed (as is the case from time to time). Powell and Yellen have already made it clear that they do not see inflationary pressures ahead and that the real rate of unemployment is closer to 10% (near GFC levels), so there is a lot of slack in the economy. And I'm sure the Fed and Treasury will provide as much soothing as necessary to keep the party going. So, pretty soon, everyone will back to buying Growth and Momentum and Bitcoin will be well on its way to $100,000!

Back to Dan Ivascyn, who thinks that the back-up in rates has been healthy and that a rise in yields above 1.5% would represent a "good buying opportunity" for investors...Buy! Buy! Buy!