Markets should worry less about inflation and more about government investment that produces higher rates of sustainable growth.
Vaccines rolling out, stimulus checks in the mail, and real summer holidays coming into view make the U.S. forecaster’s job simple these days. Households awash with cash and longing to spend it will drive a boom in consumer exuberance that will spill across the economy and out into the rest of the world.
Not since last year when the world economy was systematically shutting down have the next few months been so easy to predict. Winter worries about long-term labor force scars or stressed corporate balance sheets look overblown in the face of $5 trillion in government spending and unprecedented monetary support.
But, like so many dogs that finally catch the cars they chase, investors now puzzle over what to do next. Is the outlook really this warm and rosy after such a shock? Will it continue to get hotter through the fall as rising bond yields suggest? Or will the deflationary forces that produced decades of falling rates return as soon as the government support dissipates?
Yes, yes and yes.
The global picture is increasingly differentiated following a year of synchronized collapse and rebound. China, first-in and first-out of the pandemic, is already limiting its support for credit growth as activity approaches normal and authorities worry over rising real estate prices. In Europe and Japan, where fresh COVID-19 cases have delayed reopenings, the catch-up will come.
“Like so many dogs that finally catch the cars they chase, investors now puzzle over what to do next.”
But U.S. government stimulus has already boosted household incomes 12%, mainly skewed to lower-end households that are more likely to spend it. We reckon the most recent $1.9 trillion package will take annualized personal spending 9% higher than pre-crisis levels, based on recent trends. (And don’t worry about rich households, which reaped a disproportionate boom in financial assets.)
America’s economic crystal ball has rarely been clearer. We know the U.S. Federal Reserve will keep its foot on the gas until there is real proof of consistent overheating. When Fed Chair Jerome Powell stresses the pockets of lingering unemployment among Black or Hispanic Americans, it means he wants the headline rate to fall much further before withdrawing support. We’re also pretty sure the Biden administration will deliver a significant new trillion-dollar infrastructure, climate and inequality program, even if it means rejiggering the Senate’s filibuster rules.
This leaves an investor staring hard at each new data point to assess if rising prices are getting out of hand or if rising demand will fizzle out.
The inflation question is slightly easier to answer. All this activity will cause prices to rise even more than they already have, and bond markets will be even more volatile, because there are so many confusing kinds of inflation to spook markets.
We are already seeing “statistical inflation,” which can look shocking until you realize they are year-on-year comparisons to price levels when the world fell apart. There is also what economists call “cost-push” inflation triggered by limited supplies of oil or shipping capacity. And, of course, there is raging “demand-pull” inflation that will come from this overwhelming surge in pent-up consumer demand. But all these should be temporary as supply returns, prices stabilize, and markets clear.
Investors also talk “asset price inflation,” where the liquidity that has been pumped into the system winds up in eye-watering prices for beach property, fine watches, and Bitcoin. This creates worries for potential financial stability, if lenders accept collateral that takes a sudden fall, but it’s less likely to trigger a sustainable cycle of rising prices. Structural forces from globalization, technology, and demographics that have kept wage growth and inflation expectations in check across the developed world for three decades remain firmly in place.
This leaves the longer-term growth question as the most difficult to answer. Much will depend on the speed and scope of the U.S. infrastructure plan heading to Congress. Can better bridges and schools boost U.S. growth sustainably above 2%? Will investments in green technology and climate mitigation jump-start new industries? Will Europe’s Recovery and Resilience Facility deliver similar support?
It’s possible, but it will be a neat trick for the money to get out the door and deliver results as fast as the crisis support is withdrawn. This is the moment when markets may stop pricing in what 17th century Germany philosopher Gottfried Leibniz called “the best of all possible worlds” and focus once again on those lingering scars, as hidden unemployment starts to become a drag on growth or corporate balance sheets buckle under higher rates.
But those are next year’s problems. Barring a calamitous deterioration of U.S.-Chinese relations (or, say, a giant container ship permanently blocking the Suez Canal), it’s hard to imagine the overall trajectory for risk assets as anything other than higher in the months ahead, even with high valuations and tight spreads. The path will be bumpy while markets sort out what the post-recovery world looks like, but the more resilient high-yield issuers and Emerging Markets will weather the ride.
Leibniz didn’t argue it was a perfect world, but rather that the mix of good and bad couldn’t get any better. There are already plenty of dangers coming into view as the pandemic recedes, but for now it’s hard to imagine a more favorable blend of risk and reward.