Inflation and Its Discontents

Practically everywhere you look these days there are signs of rising prices. Housing, gasoline, food, industrial commodities—you name it. Whether that spike in inflation lasts and spreads to other areas like wages, or whether it dissipates as the economy settles into a post-pandemic normal, has become the most pressing question among investors and economists this year.

And there's no good answer. There's just no historical precedent for the events of the past year or the fiscal and monetary response. 

"Whether inflation hangs around or eases up could go a long way to determining the path of the equity market and which sectors will be winners or losers," Barron's Daren Fonda wrote today.

He notes that the general consensus is that inflation will recede as pent-up demand from consumers is exhausted and supply-chain pressures ease up. That's certainly the message the Federal Reserve is sending, with officials pulling out the word "transient" more times than Fed watchers can count each time they step up to a podium.

But not everyone agrees. “We expect both headline and core inflation readings to surpass consensus expectations in the weeks ahead,” wrote analysts at Wolfe Research on Monday. “If our thesis is correct and inflation readings come in hotter than expected, you should prepare for another ‘Risk Off’ episode.” 

The answer may lie in what the labor market does. So far inflation has been largely isolated in the price of goods and assets. Depending on how fast unemployment falls and how much wages increase, that could be the extent of it—or it could be just a precursor to a new inflationary cycle, Daren writes.

Treasury yields have climbed sharply in 2021, dragging down the prices of bonds everywhere. If inflation looks to go higher, that will continue. As for the stock market, here's Daren:

For equity investors, there are a few potential outcomes. One is that the markets retreat in the near term if inflation readings exceed forecasts or expectations pick up sharply. That would be a “risk off” trade, and it would pressure the high-growth, high-multiple corners of the equity market, along with yield-sensitive sectors like real estate.

But the reflation trade has been a winner so far this year, and it could keep going if inflation doesn’t jump sharply and bond yields don’t spike again. Value could be a winner in that scenario, led by financials, according to Wolfe. Other potential winners could be energy, materials, and industrials—all beating the S&P 500 so far this year.

But if bond yields do spike again and the Fed reacts by stepping up its asset purchases to try and support the market, that flood of liquidity would be bullish for the growth-oriented areas of the market that did so well in most of 2020. That includes the likes of technology and consumer discretionary.

Read the rest of Daren's report here. And check out this article from Barron's latest issue. Ben Levisohn has a stock pick designed to hedge against inflation.