As we step into the second quarter, a full year after the coronavirus pandemic hit and the world came to a standstill, there is just one word on every fund manager's mind: inflation.
Last year all asset prices got hit drastically, especially commodity prices, so prices today, on a year-over-year comparison, are showing some aggressive double-digit increases, and this is to be expected, but nonetheless worrying, as no one knows the extent to which it is going up in reality. Is this really the much-desired inflation, or just a mathematical marked to market increase year-over-year?
The answer to this question will dictate how one allocates her resources going forward, not only in bonds or equities, but also to which sectors.
The Fed claims this increase in inflation will be "transitory" due to "base effects," which just means the first quarter of 2020 saw unsustainably lower prices, which should smooth out over the next few months.
This week, we saw the CPI print for March. Expectations into this print were quite bullish as it was expected to show about 2.5% you increase, which came in at 2.6% year over year. Core CPI came in at 1.6% year over year, vs. 1.5% expected. The market aired a sigh of relief as these numbers hit the tape, they were much lower or contained than expected.
This caused bonds to rally, as yields fell allowing the equity market to break higher on removed inflation fear concerns. Inflation is certainly there, the only point of contention is whether it is temporary as in previous cycles, or different this time around.
But these year-over-year increases are just starting, as April and May will see even more aggressive year over year comparisons. The Fed's constant claim that it will be transitory is just justification on their part to keep pumping the market with more QE and buying assets to support it. They cannot afford to stop now, if they do, the market will collapse. Their biggest dilemma will be if inflation prints above 2% on the core CPI and stays above for some time, without GDP growth recovering. That will be check mate for them, as they will have no other tools left, but to raise rates or tighten the markets effectively.
Last year saw record global central bank easing. The U.S. Fed alone expanded its balance sheet by $4 trillion and change just over the past year. The markets have recovered and then some, yet they seem to still be buying $120 billion in monthly Treasury assets. Even the U.S. Treasury General Account, TGA, which had about $1.4 billion in excess cash just sitting there, is now being drained down by June.
On top of that, the U.S. just announced a new $2 trillion fiscal stimulus, as checks have been sent out to its citizens. There is just too much liquidity around to get bearish equity markets or stocks in general. Liquidity has been one of the most powerful measures of asset markets. Looking at any generic measures of debt to GDP or Enterprise Value to earnings before interest, taxes, depreciation, and amortization or price to sales ratios would leave you underweight the market for the past two years and have you underperform drastically. The game has changed and so have the players.
One of the biggest risks, and perhaps the most important, is when the Fed decides to ease its foot off the pedal and stop quantitative easing, or at least stop buying bonds every month. We saw how markets reacted back in 2018 when the Fed hinted it would start to taper. They are too well aware and will avoid that. Their goal post to stop is either full employment recovery or inflation above 2% target. We fear the latter might come before the former. If that happens, that will be a serious risk to this rally, but we are some time away from that for now. The rate of U.S. vaccinations is accelerating and by the end of the summer it is expected to fully reopen. That could be another indicator for the Fed to ease off the money train, as the pandemic will be mostly over, unless we see new strains emerge and more lockdowns.
Just because the last few QE programs never generated inflation does not mean it can't or won't this time. The last decade was a dis-inflationary one, now we are in a paradigm shift in supply chains and de-globalisation. With more liquidity being pumped, and fiscal stimulus programs on top of monetary policy, it is sure to generate inflation. One just needs to look at lumber prices, food, groceries, and basic consumer goods. The Fed uses an artificially distorted basket to gauge its level of inflation. If wage growth does not match this, it will be a brutal time for the U.S. consumer. Let's see how the next few months evolve on the inflation front, but for now, sit back and enjoy the ride on the liquidity train, it has not reached its stop yet.