Jeffrey Gundlach of DoubleLine Funds this week added some colour to his monthly slide deck presentation of market and investment talking points. The bond manager and a former punk rock drummer paid homage to The Clash’s second album Give ‘Em Enough Rope.
The cover features the body of a dead cowboy left stranded in the desert being attacked by vultures. Gundlach suggested there might be a similar fate awaiting bond investors if a current spike in prices in the economy persists, quipping the cover “might be a teaser for coming inflation pressure”.
No topic dominates investor concerns and conversations more than that of inflation at the moment. It frames both the near term view over the second half of the year and beyond and for good reason. By any measure, prices of both bonds and equities are sitting at rich levels and their high valuations have created a financial system that would not enjoy even a modest inflation shock sustained beyond this year.
If you own bonds, a higher pace of sustained inflation over time erodes the value of their interest payments and represents a loss in real terms. Although equities appeal to some as an inflation hedge, this relies on owning those companies able to grow their revenues, earnings and dividends at a faster pace.
Investors are debating whether the surge in prices at both a producer and consumer level will prove transitory, as the US Federal Reserve believes, or become entrenched.
Much of the angst over medium term inflation pressure becoming hotter is fuelled by the backdrop of aggressive fiscal and monetary policy. This potentially combustible mix has a policy additive from a Fed prepared to tolerate a higher pace of inflation beyond its target of 2 per cent for an unspecified period.
Summing up the present mood of uncertainty among investors, Gundlach said: “How does anyone know it will be transitory?” and referred to a chart of US consumer prices that after “going sideways in the last ten years,” is now showing “a breakout”.
This notable uptrend gained further momentum last month, with US core prices, excluding food and energy, rising by 3.8 per cent over the past 12 months to May, the fastest pace since 1992, and after a 3 per cent annualised jump in April. Sharply higher prices for used cars, followed by airfares, highlighted how consumer demand is overwhelming supply in various sectors as the economy reopens.
The message from markets, at least for now, affirms the Fed’s stance that consumer price pressure is likely to be transitory. Equities, led by the S&P 500, edged up 0.2 per cent to close at a new record high and the 10-year Treasury interest rate eased to its lowest level in three months, below 1.5 per cent.
One explanation for why a transitory inflation outlook holds sway in markets is that any shift towards a sustainably higher trend will only become apparent over the next six to 12 months. In the interim, investors and central banks will carefully monitor a range of indicators.
Eventually demand and supply imbalances become smoother. But this time around, the process may take longer to play out, pushing the definition of what is considered transitory price pressure as consumers flush with lockdown savings make up for spending time lost in the pandemic.
Playing a key role is wage growth. At a time of elevated unemployment, reports of labour shortages have been resounding. In May, nearly half of US small business owners reported unfilled job openings, and they “are offering higher wages to try to remedy the labour shortage problem”, according to the National Federation of Independent Business.
Again there is an argument that higher wage growth will prove short lived, with expectations that more people will seek work after September once government assistance ends. But a cause for concern is that rising consumer prices may encourage workers to seek higher wages and in turn companies will pay up and then raise prices. A wage and price spiral typified economies during the 1970s.
“The normal stickiness of wage trends has been overwhelmed by today’s exceptional economic conditions, and firms may believe they have more pricing power than we originally assumed as well,” said Lou Crandall, economist at Wrightson Icap.
While the US is running ahead in reopening its economy, there are grounds for seeing a similar dynamic in other countries as they follow suit. This would likely exacerbate global supply chain pressures and should underpin commodity prices, led by oil.
In turn that will keep bond market expectations of inflation elevated and leave investors in a corridor of uncertainty. Investors will have to bet on how much inflationary pressure central banks are willing to tolerate before they act.
“It will be important for investors to monitor not only the strength of the rebound but, perhaps more importantly, its duration,” said Dario Perkins, global macro strategist at TS Lombard in a research note.
This will not be easy. There will be many more “teasers” of inflationary pressure in coming months.