Let’s get this out of the way first and foremost, I am not an economist. I am not building and maintaining econometric models. I believe in markets and I believe that they are discounting mechanisms. For the most part they are efficient but not perfectly efficient. Given this, I like to use market based metrics and trends to get a sense of what investors are thinking about the economy. Let’s call it the wisdom of crowds and leave it there.
Lately, there has been the thought that given the unprecedented amount of fiscal and monetary stimulus that has been deployed, there will be a bout of inflation. A period of generally rising prices. Yes, the Federal Reserve has been providing some form of stimulus for the better part of the past 12 years. We have all seen the chart of the Fed’s balance sheet but I will give it to you here one more time because it really is awe inspiring. Here it is going back to 2005. By the way, that’s a log scaled chart.
Amazingly, except for the early days of the aftermath of the global financial crisis, I have not heard much as it relates to inflation. For the most part, the big spike in inflation that many thought would be the consequence of QE failed to materialize. I have my theory on this that largely centers on the fact that much of QE failed to reach the “real economy.” You see, while the Fed has been aggressively printing money and the money supply has been increasing, the velocity of money is in secular decline.
However, with the onset of COVID-19, the fiscal side of the house has also joined the party. According to the IMF the amount of fiscal stimulus that the US has provided to citizens is well over $2.5 trillion. Many Americans have seen an increase in unemployment benefits and at the same time have received some form of DIRECT payment from the government. This has led to an increase in inflation expectations being priced into the market, bringing us back to the point of letting the market send the message. The chart below shows five-year, five-year forward inflation expectation. Two things are clear on this chart. First, expectations remain below the Fed’s stated policy goal of around 2%. This likely gives the Fed cover to keep rates lower for longer just has Chairman Powell suggested during his last post-FOMC press conference. Second, inflation expectations are rising in the near term. The bottom of the chart is the 52-week rate of change of those expectations. Still below zero, but certainly moving higher.
I took a look at how a basket of different ETFs representing various parts of the equity, fixed income and commodity markets have performed since 2004 when the 52-week rate of change crosses above the zero line, becoming positive on a year / year basis. Here is the basket that I have put together:
From there we can take a look at how each of these funds performed in the 126 days (six months of trading) after a cross of the zero line. I sorted the list by the median return over this timeframe. As you might expect, it was the hard assets, gold (GLD) and real estate (VNQ) which had the best returns. It was somewhat surprising to see the gold miners (GDX) near the bottom of the list and this may be a good excuse to explore that topic further in a future post.
Of course the market could be wrong when it comes to inflation expectations, remember it is mostly, but not perfectly, efficient. However, it makes sense to start thinking about what changes can be made to portfolios should the market have it right and we do begin to see inflation crop up in the economy.