Over the last year, the biggest debate has been the growth over value switch trade. During Q4, growth got severely hit as value took over after years of underperformance as economic recovery hopes were starting to get priced in. U.S. bonds got sold as yields spiked, so did Energy, Financials, and Industrial stocks. Q1 also saw the biggest underperformance of bonds. As Q2 started, given the Fed's constant reassurance that they would do whatever it takes to support this recovery with more money printing and balance sheet expansion, the bond market got a bit of support as 10 year yields were capped around 1.6%. This support helped the growth stocks reverse half of the underperformance during Q1 and the debate continues -- which sector will perform well over the course of the year. Perhaps it is not that simple after all, as there is another theme developing that warrants a much more serious debate. Inflation!
Chairman Fed Powell did a wonderful job in denying that any form of inflation exists in the system. Even Janet Yellen is going out of her way to claim that Biden's new stimulus package will do nothing for inflation. Clearly they seem to all be in denial, or fear rather, because every single company is talking about inflation during their second quarter conference calls. It is one of the most mentioned words around at the moment. Companies from Kimberly-Clark (KMB) to Proctor & Gamble (PG) are all talking about how rampant prices are and that they would be passed along to the consumer. Costco (COST) recently kept their paper towels the same price, but reduced the number of sheets per package by 20. This may seem small in the grand scheme of things, but this is something we refer to as "shrinkflation". Inflation may not be apparent yet, but with fewer and fewer products for the same price, it is in essence an increase in inflation as the consumer has to buy more eventually to keep up with the same usage patterns. After shrinkflation, companies tend to just increase prices. The Fed's Powell claims this effect during Q2 is transitory given base year over year effects, but it is something much more sinister than that.
What can the Fed do really? If inflation is picking up as seen by a host of commodity prices from construction to grains to food items, bond yields are at risk of rallying further. If they do, how much longer the Fed can support them remains to be seen. Either way, even if they cap gross bond yields, real bond yields can keep falling. The Fed is gambling on the fact that the economy picks up so sharply that it will be ready to remove all the excess monetary accommodation from the past year. But if we have growth leveling off it seems with higher prices, stagflation, this is going to be the worst of all scenarios for the Fed. They will have their hands tied and unable to raise rates or support equities or bonds.
One thing is clear, transitory or not, we will start to see much higher CPI and PPI prints. The Fed can dismiss them as much as they like, but the market soon will start to get spooked. The only place to hide will be and has been commodities, as they are truly inflation protection assets. The ones with the best demand/supply balances will fare the best as inventories get less and less. This asset class may fair better than equities outright, growth or value, it is important to be diversified and step outside of the traditional 60/40 way of thinking. The rate scare is coming.