With the passage of the latest $1.9 trillion COVID relief package in March, changes are in full swing. Vaccination efforts have continued to expand largely across the U.S. and other countries around the world, though blood-clotting concerns from the Johnson & Johnson and AstraZeneca vaccines have affected distribution efforts in a number of countries. In particular, the health crisis in India has reached heartbreaking levels of morbidity and mortality.
All eyes are now on Washington, DC as an approximate $4 trillion infrastructure plan was announced. While President Biden has set the debate in motion, Democrats in Congress must now attempt to craft a package that can pass both the House and Senate. There are two separate plans: American Jobs Plan (AJP) and American Families Plan (AFP), each of which aligns expenditure components with proposed offsets from tax increases.
The first plan (AJP), which provides roughly $2.3 trillion in outlays, bundles physical infrastructure—roads, bridges, water projects, ect.—with increases to corporate tax rates. The second plan (AFP) of almost $1.8 trillion, or the “human” infrastructure component, narrows in on a broad assortment of social programs and spending—aimed at affordable child care/expanding tax credits and subsidies—and is bundled with increases in personal tax rates, directed at upper income earners.
There is a lot going on underneath the surface of these plans, and the potential political and policy permutations of a deal is innumerable at this stage. However, while the total figure will most likely come in lower than originally projected, the ultimate goal and focus from the Democrats is to go ‘big’. For instance, after the Global Financial Crisis it took an excruciating 81 months to get back to prior peak employment levels set in 2007. Policy makers are trying to avoid the past mistake of not pounding the table hard enough this time around.
*As Proposed; Source: Axios, Cowen & Co, Washington Post, Melhman Castagnetti.
Eyeing at the above table, it is not hard to spot the size and magnitude of the fiscal packages already passed and the ones that are being proposed. The question now is whether all of this fiscal stimulus will cause runaway inflation.
Taking a peak at April’s data might provide a clue. The last Consumer Price Index (CPI) reading was a shock. Headline CPI came in at +0.8% month-over-month (largest jump since June 2009) and on a year-over-year basis was +4.2% (largest jump since September 2008). Stripping out food and energy, Core CPI jumped +0.9% month-over-month and +3.0% year-over-year. Rocketing the inflation numbers higher were a few key components with outsized (and unlikely repeatable) gains, associated with the economy’s reopening.
According to Andrew Husby and Yelena Shulyatyeva at Bloomberg, close to 60% of the month-over-month increase came from five categories—used cars, rental cars, lodging, airfares, and food away from home. As businesses work their way through supply shortages, and the base for comparison remains low, CPI will most likely continue to run hot and heavy into the summer months. The Fed has said that it views price pressures as transitory and is focused on alleviating the labor market slack.
On the off chance the Fed is wrong and prices continue to rise unabated, how might security prices react? Looking at history, there seems to be a clear connection between inflation, the economy, and the stock market. Bucketing CPI into different ranges, one can see that higher inflation has led to diminishing growth rates for productivity, real GDP, S&P 500 performance, and the S&P 500 price-to-earnings (P/E) ratio.
Source: Charles Schwab, Ned Davis Research, Inc. Past performance is no guarantee of future results.
If inflation is high/rising, investors will require a higher rate of return on assets to compensate for rising rates, less visibility into future revenue growth/margins/cash flows, and higher risks of default. Because of these risks, high/rising inflation has led to lower valuations in the market, but the “sweet spot” for CPI has been in the 0-2% range. In the 0-2% CPI range, the S&P 500 has historically had the highest forward P/E; on the other hand, as inflation rises into elevated territory, downward pressure has been exerted on P/Es.1
Inflation is finally showing up in subsets of the data. There is no question about that. To date, it is unclear whether this pop in inflation reflects a return from an economic shutdown, which may subside once things settle down, or a sign of a permanent increase from the low levels seen this past decade. If this inflation does happen to be permanent, and we see inflation levels on par with the 1970s and 1980s (>5%), stocks and bonds have a good chance of being repriced lower. While a 1970s and 1980s scenario is not completely out of the realm of possibility, we do not see this as the likely outcome. This is due to an ageing demographic cohort, structural shifts in the labor market, globalization, large debt overhang, and more of an independent Federal Reserve.
In any case, we are closely watching this scenario as it unfolds and any implications it might have on asset allocation now and in the future.
1 World of Inflation: Transitory of More Nefarious by Liz Ann Sonders