Hot Air Lifts Inflation Concerns - Adviser Investments

Hot Air Lifts Inflation Concerns

February 16, 2021

Please note: This update was prepared on Friday, February 12, 2021, before the market’s close.

The S&P 500 logged its ninth record high of 2021 Thursday on the back of expectations for a new round of stimulus spending, better-than-expected corporate earnings and the Federal Reserve’s reaffirmed commitment to low interest rates.

Despite news that the Biden White House secured an additional 200 million doses of COVID-19 vaccines, the economy still has a significant slog ahead to repair the pain inflicted by the pandemic. Continuing job losses remain stubbornly high—nearly 800,000 people filed new claims for unemployment benefits last week. Job openings came close to pre-pandemic levels in December, yet there are still more than four million fewer jobs available than the number of Americans who are seeking work.

As noted, the stock market has continued to march higher in 2021. On a total return basis, the Dow Jones Industrial Average is up 2.9% for the year through Thursday, while the broader S&P 500 index has gained 4.4%. The MSCI EAFE index, a measure of developed international stock markets, has returned 3.5%. The Bloomberg Barclays U.S. Aggregate Bond index’s yield stood at 1.20%, up from 1.12% at the end of 2020. The U.S. bond market has declined 0.9% this year.

Puncturing Inflated Headlines

On Wednesday, the Labor Department reported its latest inflation numbers, showing the price of U.S. goods and services were 1.4% higher in January than they were a year ago. Our reaction is meh. A mere 1.4% increase over the last 12 months strikes us as pretty low. So why have we seen so many headlines this week fanning the embers of inflation concerns?

In one camp, you’ve got those making the “supply-side” argument. Production and manufacturing have been disrupted, the pessimists say, resulting in both lower output and higher commodity prices. Steel prices are up 25%; copper goes for 50% more than it did a year ago—commodity inflation at the source leads to higher prices for consumer goods.

Others are fretting about demand—stimulus policies and consumers’ pent-up desire to spend after nearly a year of pandemic restrictions have set the stage for a “return to normal” that would be anything but normal, driving prices up at a faster pace than expected.

This all sounds ominous until you break the arguments down a bit.

First of all, based on simple math, we do expect to see some higher inflation in the months ahead. Even if prices don’t move a whit from where they stand now through the end of May, inflation will rise to 2.5% over the next three months. And if prices rise at the same monthly pace they have since September 2020—a 0.2% average—then inflation will approach 3.5%.

But that 2.5% or 3.5% is the headline number—which is the eyeball-grabbing figure the media will tout. Core inflation, which excludes volatile food and energy prices, will be lower in these hypothetical scenarios; less jarring and therefore not what the media focuses on.

 

Note: Chart shows monthly percentage changes in inflation (represented by the Consumer Price Index) over the past 12 months. Source: U.S. Bureau of Labor Statistics.

But there’s more to the mathematics. Yes, the inflation hawks are right, inflation will rise in the months ahead. But what they are ignoring is the fact that the math will also cause inflation to fall after May. The same calculation that gets us to a 3.5% year-over-year inflation rate in May also suggests that we can expect the inflation rate to come down over the summer. The inflationary jump we expect over the next few months will be transitory.

The Upside of Inflation

We also have another perspective on inflation that’s worth considering. Rather than fearing inflation, we think it’s worth welcoming, to a degree.

Rising prices typically go hand-in-hand with increased economic activity. In fact, that’s part of the inflation-worriers’ arguments: As the economy opens back up, demand for goods and services will outstrip the supply available.

Even if we bought this theory, which we don’t, that’s far better than the alternative of continuing to live under an economic malaise.

Manufacturing is already on the rise and inventories are building. Of course, there will be some bottlenecks—as we’ve seen recently with computer chips—but worries about lack of supply because of a surge of demand are overdone. Simply put, we’re not going to wake up one day and see the entire U.S. population vaccinated and spending like sailors on shore leave. Expect more of a slow build that will be matched by increased production rather than shortages.

One other important inflation truism: Higher prices are often the solution to higher prices. For example, as oil prices rise, so too does the incentive to produce more oil; supply increases, scarcity declines, oil prices come down. If oil prices are too high, conservation can kick in; demand drops, as do prices. Supply and demand are a seesaw, plain and simple.

What About Debt-Fueled Inflation?

Fiscal and monetary stimulus have renewed concerns about our growing national debt. But we haven’t seen a strong contemporary example that connects high debt levels with runaway inflation in a developed nation. Look to Japan, where the debt load has been massive for decades without sparking inflation. In fact, Japan’s problems have stemmed from deflation, rather than inflation.

Rising debt levels in the U.S. and Europe haven’t generated much inflation either. We’re not suggesting that piling on debt is a good thing—but we haven’t seen a convincing connection between rising debt and rising inflation.

In a virtual speech to the Economic Club of New York on Wednesday, Federal Reserve Chair Jerome Powell tried to take some air out of inflationary concerns. Powell and his colleagues are focused instead on achieving and maintaining maximum employment in the economy, he said. To get there, the Fed will keep rates low, continue to buy debt and aim for inflation running slightly higher than the policymakers’ traditional 2% target.

Denizens of the multi-trillion dollar bond market tend to be the most sensitive to inflation concerns, yet traders don’t seem overly anxious. The 10-year breakeven inflation rate, a bond market gauge of inflation expectations that shows in real time just how worried those traders are, sits at 2.2%. In effect, investors in the bond market are anticipating inflation running at 2.2% for the next decade—almost matching the Federal Reserve’s objective.

Podcast: What Corporate Earnings Tell Us About the Economy

We’re in the midst of earnings season, when corporate managers report on how well, or poorly, they performed in the final months of 2020 and give insight into prospects for the year ahead. Two of Adviser Investments’ portfolio managers took some time to sit down and give us the scoop on how the nation’s biggest firms are faring—and what that tells us about expectations for 2021. In this edition of The Adviser You Can Talk To Podcast, Vice Presidents Steve Johnson and Charlie Toole discuss:

  • The sectors that are surprising to the upside
  • Why a company’s stock may fall even when its earnings growth is strong
  • Why this tech-dominated market is notDot-Com Bubble 2.0
  • …and much more

The pandemic isn’t over—but we are beginning to see some light at the end of the tunnel. Click to listen now for a perspective on how the recovery is shaping up!

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Financial Planning Focus:

5 Tax Deductions You Need to Know

Tax season is upon us and while tax rates haven’t changed, the past 12 months have brought a flurry of legislation from Congress on how you may—or may not—be taxed. To put you in the right frame of mind to file your 2020 returns, we found five deductions and credits that could make a difference to your bottom line.

  1. Cash Contributions.Prior to 2020, claiming a charitable deduction on your tax returns was only available if you itemized. In other words, you had to claim more than the standard deduction to get a tax benefit for your charitable contributions. However, recent legislation has made it possible to take a deduction for cash donations (which includes checks, credit card payments or electronic fund transfers) to qualified charities—even if you do not itemize. The upshot: Cash contributions of up to $300 made in 2020 are deductible on your tax return as an above-the-line deduction.
  2. Student Loan Interest. In past years, student loan interest could only be deducted if the tax filer was liable for the debt and paid it back themselves. Now there’s an exception. As long as you are not claimed as a dependent on someone else’s tax return, you can deduct up to $2,500 of interest on your student loans—even if someone else is making the payments on your behalf.
  3. Child and Dependent Care Tax Credit. Tax credits are more valuable than tax deductions because they reduce your tax bill dollar-for-dollar—so you’ll want to take every credit you can. If you paid someone to care for your child or dependent so you could work or go to school in 2020, then you may be eligible to claim this credit. The size of the credit you qualify for depends on your income and how much you spent. The maximum claim is $3,000 for individuals or $6,000 if you file as a couple.
  4. Home Office Deduction. COVID-19 reshaped our economy in a lot of ways, including accelerating entrepreneurship and home-based businesses. Although this tax deduction is not new in 2020, it will arguably apply to more of us. If you are a small-business owner or entrepreneur using a room in your home as your principal workspace, you may be able to write off items like utilities, rent, mortgage and real estate taxes—but remember, it’s critical to keep accurate and verifiable records. (Note, if you are not self-employed, under current tax law, you cannot claim this deduction.)
  5. Prior Year State Tax Deduction. If you owed state taxes when you filed in 2019, be sure to incorporate that amount into your itemized deductions. And if you paid more in state and local sales tax than state and local income tax, you can opt to deduct the former. (You are not allowed to deduct both.) Also, remember that, starting in 2018, the deduction for state and local taxes was limited to $10,000 per year.

Tax obligations vary from person to person, so we recommend checking in with your accountant or tax preparer if you have questions.

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Strategy Activity Update

Please see below for a summary of the trades we executed over the week through Thursday and our current tactical strategy allocations.

Dividend Income

No trades this week. 

AIQ Tactical Global Growth 

Sold  iShares S&P 500 ETF (IVV). Bought Fidelity MSCI Communication Services Index ETF (FCOM)

AIQ Tactical Defensive Growth

Sold cash. Bought iShares S&P 500 ETF (IVV)

AIQ Tactical High Income

No trades this week.

AIQ Multi-Asset Income

No trades this week.

Adviser Investments’ Market Takeaways

You can find two new Market Takeaways videos on our website. Research Analyst Liz Laprade offered her thoughts on Tesla’s investment in bitcoin and Steve Johnson discussed straightforward ways to teach young people how to invest rather than speculate.

Looking Ahead

Markets (and Adviser Investments’ offices) will be closed Monday in observance of Presidents Day. We’ll be back at our desks on Tuesday morning ready to help you.

Despite the markets’ abbreviated week, we’ll have numerous economic reports coming, including reads on retail sales, homebuilding, housing starts, existing home sales, manufacturing, the service sector and the minutes from the Fed’s January meeting.

As always, you can visit www.adviserinvestments.com for our timely and ongoing investment commentary. In the meantime, all of us at Adviser Investments wish you a safe, sound and prosperous investment future.


Please note: This update was prepared on Friday, February 12, 2021, before the market’s close.

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