Investors can be a fickle bunch when it comes to topic obsessions; but a persistent one this year is inflation. Bear with me on this topic—today’s report is a bit lengthier than usual, but it covers much of what has been top-of-mind for our investors and dives into implications for the stock market and valuations.
Inflation fears were unleashed alongside epic levels of both monetary and fiscal stimulus; which fueled a 27% year-over-year jump in M2 money supply at its recent peak (see chart below). When the 10-year Treasury yield first spiked to above 1.7% in March of this year, the volume of concerns grew louder. Those fears have become almost gospel recently given the spikes witnessed in the most widely-watched inflation metrics.
M2 Growth Surge/Velocity Plunge
Source: Charles Schwab, Bloomberg, Federal Reserve Bank of St. Louis, as of 3/31/2021. The velocity of money is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity is increasing, then more transactions are occurring between individuals in an economy.
With regard to money supply, although stimulus has fueled the surge in M2 growth, money velocity remains on the floor. Velocity denotes the rate of turnover in the money supply and is a gauge of economic health. When it’s low, it suggests a preference for saving over spending. In fact, surveys done in the aftermath of the three significant fiscal stimulus measures (2020’s CARES Act, last December’s supplemental fiscal relief package and 2021’s American Recovery Act) show a declining share of the three rounds of “stimmy” checks was used for consumption; while a rising share was used for savings and/or deleveraging. If velocity does not pick up, it would lend credence to the view that current elevated inflation readings are “transitory.”
QE: GFC vs. GVC
Money supply also accelerated during the Global Financial Crisis (GFC) in 2008-2009, with inflation remaining tame amid plunging velocity. There was an important difference between the GFC era and the GVC (Global Virus Crisis) era though. As BCA Research points out, the Federal Reserve (Fed) used quantitative easing (QE) to rescue creditors (the financial sector) rather than debtors (the real economy). By providing support to the banking system, the Fed was counterbalancing a deflationary financial industry shutdown rather than injecting an inflationary real economic stimulus.
In the case of the GVC, BCA notes the deflationary shock came through the real economy, not the financial economy; meaning that fiscal stimulus was needed. As such, QE was partly used to finance Main Street stimulus programs via the Fed’s purchases of long-dated Treasury and mortgage-backed securities; pushing interest rates back to zero and helping facilitate government stimulus spending. Over the past year, QE money reached the real economy and ended up in the private sector’s bank accounts—thus contributing to rapid M2 growth—whereas in 2008 QE was mainly locked in bank reserves. For now, a large percentage of the recent stimulus is being used to counterbalance the deflationary pandemic shock; but it could begin to drive inflation higher.
Transitory?
The word “transitory” is increasingly part of the inflation narrative—certainly when it comes to the view of Fed officials—notably its chair, Jerome Powell. The Oxford Dictionary defines “transitory” as not permanent. By that definition, even the systemic wage-price spiral version of inflation in the 1970s was “transitory.” In essence, whether the current bout of inflation is transitory or not is a function of the time frame one uses to define transitory.
We do not believe the conditions currently exist for a return to 1970s-style inflation; and my colleague Kathy Jones, Schwab’s Chief Fixed Income Strategist, recently penned a report on just that subject. Notwithstanding a somewhat benign risk of the type of systemic wage-price spiral inflation Americans suffered through in the 1970s, near-term inflation pressures are undoubtedly acute. We also believe that the impact of government debt on inflation is often misunderstood, and we recently penned a report on that topic.
First, the data
The Consumer Price Index (CPI) for April was released last week and it was a doozy:
- Headline CPI +0.8% month/month (largest jump since June 2009)
- Headline CPI +4.2% year/year (largest jump since September 2008)
- Core (ex-food/energy) CPI +0.9% month/month (largest jump since September 1981)
- Core CPI +3.0% year/year (largest jump since January 1996)
A look back to 1958 at both headline and core CPI is in the chart below. In terms of the April data, the miss (relative to expectations) for headline CPI was 5.0 standard deviations above the norm, while the miss for core CPI was 6.0 standard deviations above the norm.
CPI’s Takeoff 
Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics, as of 4/30/2021.
Adding fuel to the inflation engine were a few key categories with outsized (and unlikely repeatable) gains, associated with the economy’s reopening and surging demand for services (especially travel-related) and certain goods (used cars given semiconductor chip shortage-related new car supply constraints). In contrast, some pandemic “winner” categories either had more subdued gains (home furnishings and recreation) or a deceleration in gains (food at home). You can see both sets of categories in the charts below.
Surging CPI Categories 
Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics, as of 4/30/2021.
Benign CPI Categories 
Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics, as of 4/30/2021.
Another segment of CPI is Owners’ Equivalent Rent (OER). When evaluating housing and shelter, OER of a primary residence is one of the three components of the shelter category within the CPI. The calculation takes into account rental values, owners’ equivalent rent and lodging away from home. As you can see in the chart below, the year/year change in OER of residences is in stark contrast to not only other CPI categories; but also belies the strength in home prices over the past year. This divergence has been exacerbated by the eviction moratorium the Center for Disease Control (CDC) began advising in August of 2020 and extended several times. Given it was recently vacated by a judge as being an overreach, the moratorium is set to end shortly. In sum, “asking rents” have been on a tear alongside home prices; while “collected rents” remain historically-low due to the moratorium. This is key to watch in the next couple of months.
OER Set to Reverse? 
Other short-term influences
The vagaries of the OER component of the CPI is but one short-term influence on inflation readings. There are others as well; most of which are tailwinds. Some measures of wages show upward pressure—especially among small businesses. The share of small businesses—via the National Federation of Independent Business (NFIB)—with positions they’re not able to fill has spiked to a record high, as you can see in the chart below.
Workers Needed 
Source: Charles Schwab, Bloomberg, NFIB (National Federation of Independent Business), as of 4/30/2021. Data quarterly prior to 1986.
The enhanced unemployment insurance associated with the pandemic, set to expire in early September, is seen as a contributor to this growing problem. Economists estimate that somewhere between one-quarter and one-half of enhanced unemployment insurance recipients are taking in more money via those programs than if they went back to work. This is why a growing number of states have announced a halt to those enhanced benefits (18 states as of this writing).
At the same time small businesses are seeing higher prices today and in the near-future; although not to the same degree as in the 1970s, as you can see in the second chart below.
Price Pressures Spiking 
Source: Charles Schwab, Bloomberg, NFIB (National Federation of Independent Business), as of 4/30/2021. Data quarterly prior to 1986.
Other short-term forces pushing inflation higher include the much-discussed “base effects” given that inflation decelerated rapidly last spring during the worst phase of COVID lockdowns; so naturally, the year/year changes are in a robust phase at least through the next month or two. The pandemic has also brought about supply-side constraints; both on the goods and services side of the economy. That said, as my friend and esteemed economist David Rosenberg has been pointing out, there is a big difference between price-level adjustments to protect profit margins and a true inflationary process.
Indeed, global inflation pressures could begin to wane. China, the world’s second-largest economy and a fierce driver of commodity prices—is in the process of deleveraging; while at the same time, its property market is cooling off. This “negative credit cycle” suggests that China’s demand for raw materials will ease, lessening the upside pressure on many commodity prices. Economics 101 also taught us that “the cure for high prices is high prices” in terms of the supply-demand curve for commodities.
Finally, another shorter-term inflation tailwind could soon lose some force. Much of the surge over the past year in economic metrics like retail sales, which have helped drive inflation higher, have been driven by the epic surge in government transfer payments as part of the aforementioned three rounds of fiscal stimulus, as you can see in the chart below. With those “stimmy” checks now in the rear-view mirror, this inflation tailwind is set to lose some force.
Stimmy Checks’ Impact 
Source: Charles Schwab, Bloomberg, as of 3/31/2021.
Longer-term influences
As detailed in Kathy’s report linked above, so far what we are seeing is not reminiscent of the 1970s era of “stagflation” (when both the unemployment and inflation rates were in double-digit territory). For now, it is more reminiscent of the 2005-2006 period of rising inflation, which triggered tighter monetary policy under the Alan Greenspan Fed regime via rate hikes. Although Jerome Powell and other Fed members have been selling the “transitory” narrative; it doesn’t mean markets might not have continued volatility eruptions until the narrative is clearer.
In addition, globalization was a contributor to the disinflation trend of the past few decades, with deglobalization appearing structural and is set to do the opposite. As BCA Research noted in a recent report, all three pillars of globalization—free movements of goods, capital and people across national borders—are expected to be in shorter supply in the future.
There are countervailing forces acting as headwinds for inflation as well; helping to explain why the debate about the stickiness of inflation rages on. One is “creative destruction (disruptive technologies),” especially with regard to technology-related innovations and disruptions. Interestingly, the wealth divide—which has been exacerbated by the pandemic—is also an inflation headwind. Lower income households have much less ability to save and often live (and consume) paycheck-to-paycheck; while the upper echelons of the wealth spectrum have a much higher propensity (and ability) to save, and tend to spend less as a portion of their income.
Fed reaction function
Fed vice chair Richard Clarida recently said the latest CPI release shows that reopening the giant U.S. economy is actually much harder than shutting it down, with the restart phase bumpy and highly unpredictable. Clarida noted that the stronger inflation data—alongside the weak April jobs report—underlines the value of the Fed’s new “outcome-based” vs. “outlook-based” approach to monetary policy. I like to think of it as the Fed having changed from driving the policy bus using the windshield to driving it using the rear-view mirror. The Fed has been clear about telegraphing a coming tightening of policy with a reasonable span of time; however, the markets could force the Fed’s hand (or at least voices) with a shorter time frame.
Implications for stocks Over the past few decades, inflation has not (obviously) been a hindrance to the stock market as it’s been “pro-cyclical” in nature. Demand-pull inflation (upward pressure on prices that follows a shortage in supply), which has defined the bouts of inflation over that period, is generally benign for risk assets. On the other hand, cost-push inflation (upward pressure on prices due to increased costs of wages and production), which is “counter-cyclical,” has historically been associated with weaker performance by risk assets.
Looking at history, there is a connection between inflation and stock market—as well as economic—performance. As you can see in the table below, using four broad ranges for CPI, you can see that higher inflation has led to diminishing growth rates for productivity, real gross domestic product (GDP), the S&P 500 and the S&P’s price/earnings (P/E) ratio.
Source: Charles Schwab, ©Copyright 2021 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html. For data vendor disclaimers refer to www.ndr.com/vendorinfo/. Past performance is no guarantee of future results.
We can slice and dice the relationship between inflation zones and valuations in more detail. When inflation is high/rising, investors generally require a higher rate of return to maintain their purchasing power, which leads to lower valuations (and vice versa when inflation is low/falling). The table below shows that the “sweet spot” for CPI inflation is in the 0-2% range, when the S&P 500 has historically had the highest average P/E. Conversely, as inflation takes hold and moves into its higher zones, downward pressure on P/Es has occurred (with the lowest average P/E accompanying the “hyper-inflation” zones).
We can also look at the relationship between inflation zones and subsequent stock market performance. For fine-tuning purposes, we used 1% zones for the CPI and looked at returns for the following three, six and 12 months. As you can see, the strongest returns were actually during mild deflation; with generally descending performance as inflation rose. Caveat: there was less of a correlation historically a full year out, given that the stock market is a discounting mechanism and as inflation rises, stocks eventually anticipate that the monetary policy response will ease those inflation pressures.
Inflation Zones vs. S&P Performance
Given the surge in inflation recently, it’s already had an impact on the “real (inflation-adjusted) earnings yield” of the S&P 500; which is earnings divided by price (in other words, the inverse of the P/E). Earnings yield is an indication of “value,” with a low ratio indicating an over-valued market. That certainly confirms other valuation metrics, which are generally in lofty territory historically.
Plunging Real Earnings Yield 
Source: Charles Schwab, Bloomberg, as of 4/30/2021. Real earnings yield is defined as S&P 500 current earnings yield minus y/y % change in CPI.
What to watch
Some of the pandemic’s impact on inflation are set to wane, at the same time as direct stimulus is ebbing as an economic driver. Inventories need to be rebuilt, which could take some time, with shortages and price spikes persistent. Housing rental inflation is also set to accelerate as higher home prices make renting more attractive for many. The question remains as to how long these forces will continue to push inflation higher.
There are factors to keep an eye on to gauge whether a cost-push style of inflation is taking hold. We need to watch whether the cumulative impact of several months of price spikes leads consumers, workers and/or businesses to change their expectations about the pace of future price increases. We need to watch for any continued acceleration in wage pressures—with our preferred metric being the Employment Cost Index (ECI), shown below. On a quarter/quarter annual rate, the ECI has spiked to its highest level since 2006; yet on a year/year basis, it remains more subdued.
ECI (Q/Q) on Upswing…
Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics, as of 3/31/2021. The Employment Cost Index (ECI) is a quarterly economic series published by the Bureau of Labor Statistics that details the growth of total employee compensation. The index is prepared and published by the Bureau of Labor Statistics (BLS), a unit of the United States Department of Labor.
…ECI (Y/Y) Still Subdued 
Source: Charles Schwab, Bloomberg, Bureau of Labor Statistics, as of 3/31/2021. The Employment Cost Index (ECI) is a quarterly economic series published by the Bureau of Labor Statistics that details the growth of total employee compensation. The index is prepared and published by the Bureau of Labor Statistics (BLS), a unit of the United States Department of Labor.
The NFIB data, some of which was discussed above, is also key to watch; along with regional Fed and PMI employment/price data, as well as job openings and labor supply. If wages and prices start to rise across the board in a damaging and self-sustaining spiral; it would mean the “psychological” implications for inflation may be taking hold. A key development that would offset upside wage pressures would be a continuation and/or acceleration of recent strong productivity readings.
In the meantime, in terms of stock market leadership, value “factors” have been outperforming growth “factors” year-to-date—including over the past month and even the past week. Stocks that screen well on value characteristics are also generally outperforming even within growthier sectors; with some of the hardest-hit segments of the market being those with the loftiest valuations. We believe those trends will persist at least until the trajectory for inflation becomes clearer.
Key Points
- Inflation is the topic du jour; with raging debates as to whether it’s a short-term (or transitory) effect of the pandemic, or something more sinister and longer-lasting.
- There are headwinds and tailwinds for inflation, both short-term and long-term.
- History shows the impact on stocks of higher inflation tends to be felt more within the higher-valuation segments of the market.
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