Inflation: What’s the Buzz?

Jul 6, 2021 | Newsletters

Inflation: What’s the Buzz?

Dear Clients and Friends,

The great reopening continues as warmer weather and loosening Covid restrictions allow for greater freedom of movement and improving economic conditions in the U.S. In Washington, DC an invasion of cicadas has proven to be a temporary nuisance in the reopening process. Meanwhile, investors are grappling with the arrival of a different kind of unwanted guest as the economy roars back: Inflation.

Like the cicadas, inflation generally comes and goes in cycles, although investors are concerned that the current brood of higher consumer prices may eventually lead to lower stock prices. Our sense is that inflation will, at some point, moderate. In this quarter’s letter, we will review the buzz on both sides of the inflation debate and its impact on markets.


Pent-up demand

In 2020, many Americans cut back on discretionary activities such as eating out, travel, and new clothing purchases. This year, stimulus policies, vaccines and plummeting Covid numbers have reignited consumption and helped drive both corporate profits and stock prices higher. The broader stock market has nearly doubled from the depths of the lockdowns in late March 2020, as the economy and corporate profits recovered and then some. The second quarter of 2021 was another chapter in the recovery story as stocks rose 9%.

Investors like higher stock prices but they cringe at the prospects of higher prices in other parts of the economy that can trigger a downturn. The boom-bust nature of the Covid pandemic strained labor markets and global supply chains, which led to shortages and higher prices in areas such as semiconductors, lumber, and hourly labor. Some investors fear that inflation may careen out of control, leading to higher interest rates and lower profitability, eventually weighing on both stock and bond markets.

A more moderate view of inflation might look more like the current Cicada invasion: pretty intense, but then—Poof! They’re gone. Supply chain problems seem like attractive areas for American ingenuity, and, if successful, improving logistics could reduce current inflationary pressures. Rising semiconductor supplies are already allowing car companies to boost production, for example.

It is possible that higher hourly pay may trigger a more significant impact on inflation. However, as more people get back to work, we believe wage growth will revert back to historical trends. In the meantime, the Fed may hit pause on tightening the economy until millions more Americans find work. Historically low interest rates will continue to help companies borrow money to grow and potentially hire workers, at the expense of low yields for bond investors.

While the Fed remains cautious, we expect Chairman Powell to recommend taking the Fed’s foot off the gas later this year by slowing the monetary printing press. As the U.S. gets back to full employment, we expect the Fed to start hitting the breaks in 2023 by raising interest rates.


Earnings take flight

When the U.S. economy nearly shut down in early 2020, many companies cut costs aggressively, used Zoom for customer meetings rather than air travel, and shifted to highly profitable e-commerce platforms. With a tight labor market, workers are becoming more productive by doing more with less, helping drive profits beyond investor expectations.
While bearish investors are concerned that inflation could trigger Fed tightening, rising corporate profits could help stocks climb this wall of worry. On one hand, companies are managing through rising wages and higher supply chain costs; on the other hand, a surge in overall demand and improving productivity are blowing away a modest drag from inflation.
Although current valuations appear to be on the high side, our sense is that investors may be under-appreciating the potential upside in corporate profits and the next set of earnings results could continue a pattern of favorable surprises for markets, off-setting inflation concerns. Investors currently expect corporate profits to grow roughly 35% this year, but when the dust settles, we could be looking at 40% to 45% growth. If stocks generally follow earnings, improving corporate results should lead to improving investor sentiment.


How are we positioning?

Low interest rates and swarms of American consumers are boosting the economy, driving profits and lifting stock prices, which should be good news for investors, right? Unfortunately, good news in the rear view tends to create challenging scenarios ahead. As equities exceed long-term allocations, investors now face an iron triangle of too much stock exposure, rising cash levels from maturing bonds, and relatively unattractive bond yields.

In general, we prefer a gradual approach to solving this three-sided problem. We see a rising earnings trend as a reason to keep a full allocation to stocks, but we also are inclined to gradually rebalance portfolios into high quality corporate bonds as conditions permit. If equity markets correct at some point this year, we would consider shifting new purchases towards stocks trading at more attractive prices, rather than bonds.

As we look towards the second half, we will be focusing on the dynamics of rising profits and rising inflation. For now, we believe profits will deliver a win for equity markets, but we remain open to new information that may change our views. Expect inflation to go the way of the cicadas—more of a temporary nuisance for markets than a long-term issue. Overall, we continue to see long-term opportunities for companies to generate growth and provide attractive total returns that meet our core investment principles, remaining ever mindful of your goals and objectives.
We wish you and your families all the best for this Fourth of July as we celebrate our country’s Independence, the return of social gatherings, fireworks, and hugs.

Michael Bailey, CFA
Director of Research

Stein A. Olavsrud, CFP®
Executive Vice President,
Chief Compliance Officer

All opinions expressed in this newsletter are not intended to be a guarantee or forecast of future events, do not constitute a solicitation to buy or sell securities nor are they a complete description of our investment policy, the markets, an investing strategy or any securities referred to in the newsletter. Opinions expressed herein are not intended to be used as investment advice and are subject to change without notice based on market and other conditions. Different types of investments involve varying degrees of risk, and there is no assurance that any specific investment will either be suitable or profitable for a client’s or prospective client’s investment portfolio, and no one should assume that any information presented here serves as the receipt of, or a substitute for, personalized individual advice from FBB Capital Partners, its research team or its portfolio managers. The value of investments and the income from them may fluctuate and can fall as well as rise.
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