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Economic recoveries are supposed to be a time of celebration for investors, and the recovery from Covid-19 now underway should be no different. The economy is growing again; business activity is picking up; deflation is a distant threat; cheap money is goosing the recovery; and stocks are surging on hopes of higher profits.
And yet, rather than cheer their good fortune, many investors appear to be tormented by the recovery’s potential pitfalls. One of the most feared scenarios is that inflation will spike, pushing interest rates higher and tanking the stock market. While it can’t be ruled out of hand, there’s little indication that a worrisome jump in inflation is coming.
Sure, in theory, the table is set for higher prices. Supply lines are strained. Congress and the Federal Reserve have spent or committed about $9 trillion to fight the pandemic, the largest stimulus and relief effort in history. And the personal saving rate has never been higher, so those who have prospered during this pandemic have money to spend. If inflation picks up, higher interest rates and lower stock prices could follow. Inflation and interest rates moved in close step during the 1970s, the last time the US experienced a surge in prices.
Also, the US stock market is priced for perfection, with a forward price-to-earnings ratio only slightly below the peak of the dot-com bubble, so it’s vulnerable to bad news.
That may explain the nervous gasps in response to recent market moves.
The 10-year breakeven rate, a widely cited gauge of expected inflation that tracks the difference in yield between nominal and inflation-protected Treasuries, rose modestly above the Federal Reserve’s inflation target of 2% recently, up from about 0.5% last March. Seemingly on cue, the yield on 10-year Treasuries climbed to 1.6% from 1% roughly a month ago. At the same time, once unshakable tech-related stocks have taken a small dive. The venerable NYSE Fang+ Index is down about 9%, and the Nasdaq 100 Index is off roughly 4% since mid-February.
Pull back the lens, though, and those moves look benign. Consider, for example, that annual inflation has averaged 2.2% since 1871, according to numbers compiled by Yale professor Robert Shiller. In that light, the breakeven rate appears merely to have inched closer to the long-term inflation rate, which seems appropriate given that the economy is returning to normal, too.
—Bloomberg