- With ongoing and significant monetary and fiscal support, deflation is likely off the table at this point.
- If the successes of the rollout of the vaccines and fiscal stimulus are not adequate, the employment situation could stagnate.
- High asset, commodity, and ultimately consumer goods and services prices combined with stagnant employment could lead to inflation or even stagflation.
With the rollout of the vaccines, declining coronavirus case numbers, and optimism about a full reopening of the economy, the path to sustainable economic growth is becoming clearer. Just a year ago, the level of uncertainty around the virus and shutdowns not only sent markets into a tailspin, but it made the outlook around growth, inflation, deflation, and stagflation quite cloudy.
At this point, it looks like we will at least avoid deflation. A commitment by the Federal Reserve to accommodative monetary policy and the prospect of more, and ongoing, fiscal stimulus, indicate that asset prices will receive significant support for the foreseeable future.
Unfortunately, rising asset and commodity prices increase our vulnerability to the prospect of stagflation, although that threat seems fairly muted at this time. While asset and commodity prices receive support and climb, a faltering employment picture could derail overall economic growth, leading to the stagflation morass of higher prices, slow, stagnant growth, and less than full employment.
The employment picture is dependent on the ability of businesses to keep employees on the payroll even as they remain shuttered or operating at less than full capacity. It is a race against the clock for when the vaccines can be rolled out fully and lockdown measures can be lifted. If these two critical actions can be taken soon, in conjunction with adequate fiscal stimulus, then our economy should not only avoid stagflation, but possibly enter a period of higher than historical trend growth.
Questions that have received less attention in recent months due to the pandemic and political environment concern the relations between the U.S. and China. Will the phase one trade deal remain intact under the Biden administration? Will subsequent phases be negotiated and implemented as was originally the plan prior to the pandemic? These are questions that do not have clear answers at this point, but will likely play out in coming months.
The outcome of future trade talks could certainly have a material impact on prices for consumer goods. This would be separate from a potential resurgence in consumer demand combined with higher commodity demand and prices following a successful reopening.
The case for Inflation
If actions by the Federal reserve and Congress are successful in supporting the economy, in acting as a bridge to when the pandemic ends, then it is reasonable to expect higher inflation. The Fed’s balance sheet has ballooned from $4T to more than $7.5T in a matter of months as shown below, and that trend is likely to continue with future stimulus efforts.
Accommodative fiscal policy in the form of direct transfer payments (stimulus checks) and increased unemployment benefits have placed money directly in the hands of consumers who would otherwise be underwater financially. While that is positive in the short to intermediate term, it could lead to unintended consequences.
The economy was performing well prior to the onset of the pandemic and the implementation of shutdowns and social distancing measures to slow the spread of the virus. If we are successful at bridging this economic gap, creating and distributing effective treatments and vaccines, reopening businesses, and getting people back to work, then inflation is the risk. The Federal Reserve has been explicit in stating that it will be more accommodative, essentially stating that it has no intention of raising rates for the next two years, allowing inflation to rise above the target 2% for a period in order to restore full employment.
While this is a departure from past policy to act preemptively to contain inflation, it is unlikely to result in either hyperinflation, and any higher than typical inflation is likely to be short-lived. Once full employment is restored, or it is clear that we are on the path there because of the success of the vaccines and businesses reopening, then it is reasonable to believe that the Federal Reserve will adopt a policy similar to that of the last 20 years.
The massive amount of debt and printing of cash have caused the dollar to decline in value relative to other currencies. A weaker dollar is bullish for a number of assets. Precious metals are priced in dollars and are traded globally. As the dollar declines in value, all else equal, gold increases in price in dollar terms. This is one reason why gold has been an effective hedge against inflation as well against geopolitical uncertainty.
Gold has served as an alternative currency used as a store of wealth and to facilitate transactions throughout history. However, gold (IAU), (GLD) has underperformed in recent weeks as Bitcoin (BTC-USD) and other digital assets have likely received more of these flows for this purpose.
As stated above, while we are likely to see higher inflation than what we have experienced in recent years, it is unlikely to be runaway hyper-inflation. The efforts by the Federal Reserve and federal government are focused on backstopping and backfilling the economic crater left by the virus-driven lockdowns. And while these efforts may overshoot the real need, it is better to err on the side of too much than too little as this could result in a little higher inflation rather than any amount of deflation, which can be devastating for the economy as seen during the 1930s.
Furthermore, I expect any higher than expected rise in inflation to be relatively short-lived and controllable as the Federal Reserve maintains its dual mandate of full employment and price stability. In other words, although the Fed is willing to allow inflation to meander higher than in recent years, it will continue to be vigilant with price stability while watching for full employment to avoid an overheating of the economy.
For those concerned with inflation, I suggest looking at the Vanguard Short-Term Inflation Protected Securities ETF (VTIP). The fund has a short duration of about 2.5 years and is pure play on inflation expectations rising. That said, I advise caution as 5-year and 10-year inflation breakeven rates have not only recovered since last March, but are approaching multi-decade highs. This is more pronounced on the 5-year breakeven than the 10-year.
The rise in inflation will lead to higher real asset prices, including those within commodities and real estate. With lumber prices skyrocketing since the pandemic began, names like Weyerhaeuser (WY) and homebuilders including Toll Brothers (TOL) have been and will likely continue to be beneficiaries. While the dividend was cut at Weyerhaeuser, it has recently been reinstated, and with the current tailwinds within the industry, the company is well-positioned to bring it back in line with where it was pre-pandemic.
As mentioned above, the probability of a deflationary environment is minimal given the commitment of the Federal Reserve to support the financial system and asset prices. This is a major improvement from the uncertainty experienced one year ago when the 5-year and 10-year TIPS breakeven rates plummeted to the lowest levels since the Financial Crisis, but quickly rebounded (see graphs from FRED above.)
Deflation at this point would only be possible if the monetary and fiscal stimulus programs in place are inadequate in bridging the gap until the economy recovers from the damage done by the pandemic. The destruction of demand in that scenario would cause prices to decline, triggering even more business closures, layoffs, and economic malaise.
Investing in that scenario is not exciting, as cash and bonds are some of your best bets. If we were to enter a period of deflation, taking on more duration within high quality bonds would be advantageous. To hedge your bets, ETFs like the iShares 20+ Year treasury Bond ETF (TLT) would work, but would still likely provide insufficient total returns for retirees and others dependent on savings to make ends meet.
I had discussed the possibility of stagflation in an article from over two years ago. In that article, the driving force behind the possibility of higher prices and slower economic growth was the trade dispute with China and the use of tariffs. Needless to say, much has changed in the last two years, although trade relations between the world’s two largest economies remain fragile. While trade relations with China remain uncertain, the risk of stagflation stems from stalled employment and economic growth combined with inflated asset prices supported by monetary policy.
In other words, disproportionate efforts by the Federal Reserve and Congress would ultimately create a stagflationary environment: The Federal Reserve helps assets prices that make goods more expensive, while the Federal government provides inadequate support that results in continued high unemployment and possibly more job losses.
Again, while gold performed well during the stagflation of the 1970s, I advise caution here. Instead of gold, it might make more sense to look at other commodities and related businesses. Lumber and real estate were mentioned above, but other options might include a broader commodity basket like the Invesco DB Commodity Index Tracking Fund (DBC), which tracks metals (precious and industrial), in addition to agricultural products.
For exposure to energy, I suggest avoiding common vehicles including the United States 12-Month Oil ETF (USL), the United States Brent Oil ETF (BNO), and the United States Oil Fund (USO) given the structure and expenses associated with these funds. In other words, you may not be gaining the appropriate exposure, or the exposure you expect.
Instead, I would suggest positions in income-producing assets that benefit from higher demand and rising commodity prices, namely MLPs. The Alerian MLP Index (AMLP) provides exposure to the best of breed in the space, while other options include the JPMorgan MLP ETN (AMJ) and the Tortoise MLP & Pipeline fund (TORIX). TORIX is also available in other share classes.
While these strategies benefit from rising commodity prices, they also offer growing current income that is attractive in an inflationary environment. Infrastructure, grounded in real assets, may also offer another means of inflation protection in an environment in which unemployment stagnates. As fiscal and monetary policy continue to be supportive of asset and commodity prices, and as demand recovers, those exposed to both volume (i.e. demand) and price are likely beneficiaries.
The ideas I described above can be interpreted as being tactical given the suggestions to add to specific styles, sectors, and individual stocks and funds. Using the above strategies should be looked at within the broader context of the global financial markets and sized appropriately. These suggestions are intended to be incremental moves that tilt the complexion of portfolio assets in a way that may improve investment outcomes.
Any overweight or underweight position to an asset class, sector, equity style, or individual stock needs to be considered carefully to understand its impact on long-term total returns. I look forward to your feedback and answering your questions in the comment section below.
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Analyst’s Disclosure: I am/we are long IAU VTIP TLT AMLP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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