Hello again? Weighing potential market threats from inflation

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Will inflation return to its pre-pandemic rate or reverse its decades-long decline? And what does this mean for your portfolio?

Gary Schlossberg, Wells Fargo Investment Institute Global Strategist
Gary Schlossberg
Global Strategist
Wells Fargo Investment Institute

Full circle?

It’s nearly full circle for those of us who have been following the economy longer than we care to admit. The dominant theme early in my career was the damaging effect of high and rising inflation on stocks, bonds, and other financial assets, all withering under increases in the Consumer Price Index (CPI) peaking in double digits during the early 1980s.

Short-term investments were about the only game in town back then, beyond gold and other tangible, or physical assets. That put the spotlight on money market funds, capable of taking full advantage of then Fed Chairman Volcker’s efforts to break the back of inflation by raising short-term rates to unprecedented levels.

Volcker’s successful effort was the catalyst for a decades-long decline of inflation, or disinflation, propelled increasingly by fundamental changes to the economy. These changes ranged from diminished union power, deregulation, an aging population, and the migration to low-cost suppliers abroad under the banner of globalization. The resulting fall in interest rates accompanying those declines laid the groundwork for the golden era of bonds and stocks, by sending bond prices higher and allowing equities to accommodate higher valuations.

Disinflation’s climax came during the economy’s pandemic-induced free fall, serious enough to trigger declines in the CPI during the spring of 2020. Inflation is playing catch-up following its deep dive during the economy’s free fall last year. Increases already are emerging. Services inflation is rebounding from a 10-year low, propelled by increased airfares, hotel rates, entertainment costs and other frontline industries hit hardest by the pandemic. Goods, or merchandise, inflation is weighing in with outsized increases in used car prices and other sizable increases contributing to the largest one-month increase over 55 years. Increases in goods and services prices could be sustained by labor-market dislocations and by supply-chain disruptions created by a V-shaped recovery of global economic growth and world trade.

Will inflation return to its pre-pandemic rate or reverse its decades-long decline?

What’s next for inflation?

These likely are temporary supports for re-inflation, begging the question of inflation’s outlook beyond increases extending into early 2022. Will inflation continue to rise beyond its pre-pandemic peak, reversing its decades-long decline? Our view is that inflation will face hurdles to sustaining a rate that’s expected to climb to a 13-year high in 2021. Here’s why:

  • By the early part of 2022, economic growth may well throttle back to a more sustainable rate easing demand pressures on capacity as the impact of the economic stimulus subsides.
  • The economy has shown an ability to grow more rapidly than its measured potential for sustained periods during 1996 – 2000 and again in 2018 – 2019 without a material acceleration of inflation, partly because of the fundamental restraints mentioned earlier.
  • Those fundamental restraints on inflation, though eroding, still appear strong enough to keep a lid on inflation, much as they have since the 1980s.

Potential pitfalls and opportunities for investors?

For investors, a moderate rise of inflation does have its potential benefits. The outlook for corporate profits likely will improve if more rapid price increases are being propelled by economic growth strong enough to lift sales volumes and business pricing power. That same lift to corporate profits can help support credit quality among corporate bond issuers.

Still, be mindful that even a modest rise in inflation and interest rates can have an impact on certain types of securities that happen to be unusually sensitive to interest-rate changes. These securities may include longer-dated bonds and income-generating areas of the stock market such as dividend paying stocks and REITS that may not look as attractive if bond yields are in a sustained rise.

Investors looking at their portfolios going forward may want to consider higher quality corporate and preferred securities and those backed by assets, all of which have been less likely to feel the impact of any increase in interest rates. In the stock market, we believe investors should consider the sectors that should benefit from a strengthening economy, such as industrial stocks and materials producers.

I recommend checking our Wells Fargo Investment Institute content on a regular basis for our up-to-the minute market commentary.

Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.