By Daren Fonda
May 4, 2021
Visit IKEA and you might find empty shelves in the kitchen department. One of the retailer’s stores in Maryland didn’t have any bread knives—and more than likely won’t until container ships from China break through the logjams at U.S. ports.
But whatever you’re shopping for these days is probably either hard to find or a bit more expensive. The reason: Massive pent-up demand from the pandemic, for all sorts of things, is cutting into supplies. And those shortages are driving up prices.
Whether inflation hangs around or eases up could go a long way to determining the path of the equity market and which sectors will be winners or losers.
The consensus view seems to be that inflationary pressures will decrease as we gradually go back to living more like we used to. And Federal Reserve policy makers, at least, are trying to convince the markets that the pressures won’t last.
Last week, for example, Fed Chairman Jerome Powell said that while the Fed is seeing “significant increases” in core inflation for April and May, “they’ll disappear over the following months. And they’ll be transitory.”
But some analysts are reading the inflation tea leaves more ominously, seeing signs that upward price pressure may not ease all that quickly.
“We expect both headline and core inflation readings to surpass consensus expectations in the weeks ahead,” wrote analysts at Wolfe Research in a note on Monday. “If our thesis is correct and inflation readings come in hotter than expected, you should prepare for another ‘Risk Off’ episode.”
Worrisome signs of inflation are popping up in sectors like automobiles, industrial heavy equipment, and agricultural chemicals, Wolfe notes. Industrial commodity prices should rise for another six months, Wolfe predicts. And food prices are “off the charts,” including a 138% spike in corn and 85% gain in soybeans year-over-year. Energy is also surging, and housing is gaining steadily.
Food and energy prices aren’t all that troubling to policy makers since they are volatile and make up a relatively small component of core inflation. But the other inflation areas may be more persistent, especially if the economy roars back at anything close to the 6.4% annualized pace recorded in the first quarter.
One key test will be the labor market—how fast the unemployment rate falls and how much wages increase. Much of the inflation we’ve seen so far has been in asset prices, more than labor, but if wages start rising, it could trigger a new inflationary cycle.
Bond investors are already feeling the inflation heat with Treasury yields rising sharply–moving inversely to bond prices. For equity investors, there are a few potential outcomes.
One is that the markets retreat in the near term if inflation readings exceeds forecasts or expectations pick up sharply. That would be a “risk off” trade, and it would pressure the high-growth, high-multiple corners of the equity market, along with yield-sensitive sectors like real estate.
But the reflation trade has been a winner so far this year, and it could keep going if inflation doesn’t jump sharply and bond yields don’t spike again. Value could be a winner in that scenario, led by financials, according to Wolfe. Other potential winners could be energy, materials, and industrials—all beating the S&P 500 so far this year.
And what if bond yields spike with the 10-year Treasury topping 2%? At that point, the Fed’s tolerance for higher yields may wear thin. Then the Fed could announce another round of asset purchases to try and support the bond market. That would be a liquidity signal to the stock market and it could trigger a rotation back into growth and high-momentum sectors like tech and consumer-discretionary.
We could get a “risk off” scare in the next few weeks, Wolfe predicts, but the Fed isn’t likely to let it last, keeping the bull market going with another soothing injection of liquidity, at least until the scare hits.
Write to Daren Fonda at email@example.com