Earnings Momentum Trumps Overblown Worries About Inflation And Valuations

Of course, China has become a formidable rival for economic, technological, and military hegemony. But China is highly indebted and leveraged like everyone else and desperately needs global capital inflows. And as long as the yuan is pegged to the dollar, with only the US able to print such vast sums of money at will without stoking massive inflation, China won’t be able to catch up to our per capita GDP.

The dollar being the world’s reserve currency is what allows us to maintain global hegemony – but it also emboldens our leaders to engage in unfettered money-printing to fund various bailouts and boondoggles. So, if today’s de facto implementation of Modern Monetary Theory (MMT) induces no inflation, there is theoretically no limit to what our government might try to do, including forgiving college loans, bailing out municipal pension liabilities and state budget shortfalls, or even providing reparations for any person or group who feels wronged by historical slights, cruelty, misfortune, misguided leadership, or their own poor choices.

It is an uncomfortable situation to behold for any financially responsible person, and as a result, investors seem to be hedging their bets with increased allocations to gold. Gold had been sort of treading water far longer than most commentators had predicted. But then last month brought about a solid technical breakout above all key moving averages. As renewed physical demand in China and India combines with continued investor demand, some think that record highs may be on the way, with predictions of perhaps $2,500 by the end of 2022.

Inflation may not be what it seems

“Don’t fight the fed” remains the key adage to live by, and the bond market certainly is not as investors (alongside the Fed itself) continue to buy what the US Treasury issues. Moreover, investors appear to believe the Fed has their backs in pursuing higher yields. Investment grade and high yield corporate bond spreads remain quite low (91 and 334 basis points over Treasuries, respectively, as of 5/31), which are at or near pre-pandemic lows. Importantly, the BBB US corporate bond spread (historically an indicator of market risk perception) is quite tight at only 113 bps.

The +4.2% headline CPI reading on 5/12 (and +3.0% core) spooked markets and spiked volatility – and made many cable news commentators hyperventilate – but it was misleading. As DataTrek pointed out, used car and gasoline prices together produced well over half (235 bps) of the headline number. Used car and truck prices rose due to chip shortages that limited supplies of new cars, and gasoline spiked YOY only because of low comps from zero demand during the depths of the lockdowns (i.e., low base period), which forced shut-in oil production that is slow to restart. In fact, if you ignore the brief pandemic dip one year ago and instead overlay a smoothed hypothetical CPI trendline during that timeframe, the headline number would have been more like 2.9% YOY inflation instead of 4.2%.

As fears about rampant price inflation following that big CPI print have moderated and the 10-year Treasury yield hovers around the 1.6% level, it appears that the spike in many input prices was mainly driven by constraints on production capacity due to disrupted supply chains and the flipside of cost-efficient Just In Time manufacturing (and lean inventories) and couldn’t come back onstream fast enough to meet a sudden spike in demand. No doubt, we are seeing asset inflation given the currency printing presses at full speed, and investable assets can’t grow as fast as the printing press can run. But when it comes to rising consumer demand, supply can indeed catch up as supply chains and manufacturing are resurrected and labor shortages are resolved. Moreover, there are many disinflationary structural factors at work like aging demographics, slowing global population growth, re-globalization of trade and supply chains, and of course the rapid pace of development of new innovative/disruptive technologies that improve productivity in ways that are hard to fully foresee.

Thus, I continue to doubt we are on the verge of an inflationary surge (leading to “stagflation”) – that is, assuming some level of congressional gridlock serves to restore a little post-pandemic fiscal restraint and prevent the federal government from taking control of all aspects of our lives, rewriting the Constitution, and curtailing states’ rights. It appears the Fed is maintaining its “transitory” view of inflation and is more willing to err toward accommodation rather than be too quick to tighten. Historically, the Phillips Curve suggested that inflation and unemployment have an inverse relationship. But that relationship has been all but deemed permanently broken by the trend of persistently low inflation over the last 30 years even as unemployment hit record lows, thus convincing the Fed that both low inflation and low unemployment are attainable.

Supporting this “transitory” inflation theme, TIPS implied inflation rates remain subdued. Although CPI printed 4.2%, TIPS are showing 5-year breakeven inflation at only 2.6% while 5-year, 5-year forward inflation is forecasting 2.3%. According to Deutschland bank, we have seen the heaviest flows into the TIPS market since 2010.

Moreover, according to Carl Weinberg of High-Frequency Economics, we are a long way from getting “the labor markets in developed economies to the point where the employment objectives of all the central banks are going to be met by enough of a margin that they will consider withdrawing monetary support.” He thinks that by year-end base effects will have passed and one-time factors like the rise in oil prices and the global chip shortage (both due to supply shocks) will “resolve themselves through normal market mechanisms.”

As I discussed last time, the velocity of M2 money stock remains near a record low (currently around 1.12), indicating little multiplier effect on the money being injected into the economy and thus little inflationary impact. In addition, there are still many disinflationary factors in play like aging demographics, slowing global population growth, re-globalization of trade and supply chains, and technological disruption/innovation in science, technology, and medicine that create prosperity while offsetting inflationary drivers by improving productivity and efficiency.

Similarly, Cathie Wood of ARK Invest got a lot of press recently with her interesting opinions on the path of inflation. She thinks the greater risk is deflation – from innovation/disruption like I described above as well as the “creative destruction” of companies that chose to buy back shares rather than innovate and modernize. She thinks commodity prices have spiked due to rapid rebuilding of inventories, so unwinding those inventories will actually cause prices to fall.

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Disclosure: At the time of this writing, among the securities mentioned, the author held protective puts in SPY.

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