One of the biggest debates this year has been that of inflation vs. deflation. Despite the double-digit price rises year-over-year in several commodities -- from lumber, copper, iron ore, steel and some food staples, the market is still of the view that this may be "transitory."
After all, can you blame the participants if their leader, Fed Chair Jerome Powell, keeps humming on about the same thing. The truth of the matter is they do not really know. They are just hoping they have stimulated enough that the economy gets a full-blown recovery together with inflation. The only question is we are definitely getting the latter, the former being sustainable is debatable.
We know that U.S. bonds' 10-year yields are coming from all-time lows of 0.5% toward 1.6% today at the time of writing. Even if we go back toward 2%, it will not be a big move, just more of a normalization of the levels that seem synonymous with this level of growth. But it is the pace at which the yields move that is more relevant than the level that it gets to. It is the direction change as this has implications of asset allocation and subsector preferences. An excess of $4 trillion in monetary accommodation mixed with $2 trillion of fiscal stimulus, the broad money supply growth surely makes a case for higher inflationary readings ahead. The Fed are adamant in letting this run hot, sustainably above 2% before they even think about thinking about raising rates. Just because inflation did not appear in the last decade, most seem accustomed to the fact that it may not happen now. That is naive thinking as never before did we combine so much fiscal stimulus with monetary policy.
The soaring prices in construction materials, copper and other raw materials is the demand surge from China via their infrastructure spending and growth to boost gross domestic product from the depths of the COVID crisis. This is putting an inordinate amount of pressure on the supply side as demand is soaking up all the excess material. Combined with the net zero emissions, electric vehicles, sustainable movement, this adds a further leg higher to an already tight market. Iron ore was up 10% today at one point. World food prices increased for an 11th consecutive month in April, hitting their highest level since May 2014, with sugar leading a rise in all the main indexes, the United Nations food agency said on Thursday. The Food and Agriculture Organization's food price index, which measures monthly changes for a basket of cereals, oil seeds, dairy products, meat and sugar, averaged 120.9 points last month vs. a revised 118.9 in March.
Whether the Fed thinks this is transitory, the moves higher across the board are real and growing. Prices paid component and various company conference calls have all talked about pass through cost inflation to consumer. Without adequate payroll growth, it does not present a healthy environment picture at all. Unfortunately, the Fed cannot stop bankrolling the markets till it reaches its employment goals, making the inflation dynamic even worse.
During the fourth quarter of 2020 to the first one of this year's rally, it was both reflation and reopening themes that rallied. Since the second quarter started, only the reflation names are moving. Reopening is getting left behind as there are serious concerns on the pace at which economies ease restrictions, despite the vaccination rates. But not all reflation stocks are going up. Oil, for instance, has done nothing since end of March. It was one of the sectors that chased higher as every time the yields moved higher, but this time it has stayed flat or down. That is because the market knows more physical oil is around the corner whereas the same cannot be said for copper or iron ore, in the near term.
At first, the market rejoices with everything rallying up, as higher yields mean the economy is improving. But then, as real inflation ticks higher and much faster than actual GDP growth momentum, then it starts to become a real scare, an inflation scare.
This environment is typically not good for equities nor bonds. The weakness that started in technology stocks that saw vicious rotation out of them into "value" sectors is getting worse. The sector fundamentals have not changed, but the macro tailwind has now become a headwind, the same reason why lower rates took technology sector higher, is taking it lower today outside of its earnings growth stories. Sooner or later, this pressure can and will feed into the overall market, especially now when everyone is long and complacent. Fed Powell, back to you, so what will it be?
