By: Linda S. Parenti, CFA - Chief Investment Strategist
Following a poor showing from equities in September, October has been a nice change of pace. As of yesterday’s close, the S&P 500 is up 3.1% month-to-date and 19.5% year-to-date on a total return basis. Volatility has been reduced somewhat now that the deadlines for both government funding and the debt ceiling have been pushed to December 3, 2021. Although expect debate on both these issues to resurface in the weeks ahead.
For now, one of the primary concerns on investors’ minds is rising inflation. Inflation has not been much of an issue for many years and mainstream media has been devoting a lot of attention to the elevated prices of consumer items such as gasoline, used cars, rent, and travel. Since inflationary readings are expected to remain elevated in the months ahead, I wanted to provide some clarity on what this might mean for stock markets and what may be helpful to keep in mind as long-term investors.
Inflation is currently running higher than the Federal Reserve’s target. One of the reasons market participants worry about this is that if higher inflation seems lasting, the Fed may be forced to act quickly to slow the economy. If they tighten monetary policy by increasing interest rates more rapidly than planned, it increases the risk of triggering a recession. However, inflation typically rises during a recovery as demand picks up, while supply takes longer to get back up to speed. This imbalance has been worsened by a post-pandemic recovery where demand for goods and services has rebounded sharply, but the return of normal supply chains has been complicated by the appearance of the Delta variant. Eventually, supply catches up to demand and/or demand declines due price resistance, but either way inflation recedes. Understanding this, our Fed and other central banks have stated they will allow for inflation to run above their targets for a longer period. The Fed has been resilient in communicating their belief that the rise in inflation should be temporary and they have a long runway for normalizing monetary policy.
So, let’s address some of the present causes of inflation. Supply chain bottlenecks in shipping are certainly an issue. Although it could take months yet to return to normal, there are signs we are past the seasonal peak in both the number of ships waiting to unload and the cost to ship per container unit at our busiest ports. In addition, there’s been a strong surge in the number of container ships under construction. A larger supply of ships and normal port operations should allow for reduced delays and lower shipping costs down the road.
The increased cost of energy is a major source of inflation with both oil and natural gas prices up dramatically year-to-date. However, unlike the 1970’s when the U.S. could not supply their own energy needs, we now have an advantage thanks to the technological developments of recent years. Oil rig counts are rising off historical lows quickly, which will ultimately lead to more supply.
Semiconductor “chip” shortages have been interfering with the supply of countless goods and global demand remains high. But the high prices and low supply has led to increased sales of semiconductor equipment, a sign that capacity is expanding. As more semiconductor equipment comes online, the increased supply should in time help reduce shortages and ease prices.
Wage growth is another component of higher inflation. There are currently more jobs than job seekers and employers having trouble filling positions are being forced to pay higher wages. Higher wages may not be as transitory as other factors, but the impact on inflation could be somewhat reduced by changes in the workplace. For example, companies have gained economic advantages by offering employees the ability to work from home. Another offset is the improved productivity from investments made by companies during the pandemic in automation and technology.
The supply and demand imbalances causing higher inflation may last longer than we expected, but there are reasons to agree with the Fed’s outlook that many of the factors causing higher inflation should be temporary. In the meantime, it may help ease investor fears to remember that inflation is not necessarily a negative for equities. Pent up demand remains strong. Households have excess savings and ample employment is available. Companies with innovative products or in-demand services will be able to pass along higher prices to willing consumers, supporting both earnings and stock prices. Historically, this may be why equities tend to weather inflationary periods better than other asset classes.
Linda S. Parenti, CFA
Chief Investment Strategist
RISKS AND IMPORTANT CONSIDERATIONS
Views and opinions expressed here are for informational and educational purposes only and may change at any time based on market or other conditions or may not come to pass. This material is not a solicitation to buy or sell securities and should not be considered specific legal, investment, or tax advice. The information provided does not consider the objectives, financial situation, or needs of any specific individual. All investments carry a degree of risk and there is no certainty that an investment will provide positive performance over any stated period. Equity investments are subject to company specific and market risks. Equities may decline in response to adverse company news, industry developments, or economic data. Fixed income securities are subject to market, credit, and interest rate risks. As interest rates rise, bond prices may fall. Past performance is no guarantee of future results.