How will inflation impact investors in 2021?

Inflation has been notably lacking as a concern for the economy and investors for most of the past three decades. 1991 was the last calendar year in which the annual inflation rate topped 4 percent, as measured by the Consumer Price Index. The annual inflation rate has not even surpassed 3 percent since 2011. That may explain why eyebrows were raised when the U.S. Bureau of Labor Statistics reported that inflation as measured by the Consumer Price Index (CPI) topped an annualized rate of 5 percent for three consecutive months from May through July. It was the largest spike in inflation since 2008.

There’s speculation that the current economic environment may result in a revival of a sustained uptick in inflation in 2021. Fueling this concern is the convergence of three factors – significant federal government stimulus programs, monetary easing policies by the Federal Reserve (the Fed), and the potential for a more organic economic rebound as the COVID-19 pandemic plays less of a role in driving the direction of the economy.

“Inflation is always about the difference between supply and demand,” says Tom Hainlin, national investment strategist at U.S. Bank Wealth Management. “In this kind of environment, people will be in a position to spend money on things they wouldn’t normally buy, driving up demand.” Hainlin points out that rising inflation often results in such scenarios.

What’s the likelihood that inflation will stay persistently high in 2021 and beyond? “Vigilance is key,” says Lisa Erickson, senior vice president and head, traditional investments group at U.S. Bank Wealth Management. “We need to see progress in areas where supply is not keeping up with demand, which drives prices higher. The same is true in the recovery of the labor market.”

Two time horizons

The past year’s pandemic-driven economy led to significant job losses and even a near shutdown of the U.S. economy. The result was a deep but short-lived recession. However, in 2020, the economy bounced back strongly in the second half of the year. The trend continued in the opening half of 2021. Gross Domestic Product (GDP), a measurement of the economy’s strength, grew at an annualized rate of 6.4 percent in the first quarter and 6.5 percent in the second quarter.

What is the chance that an “overheated” economy could trigger a more dramatic surge in inflation? Eric Freedman, chief investment officer at U.S. Bank Wealth Management, thinks we aren’t likely to see a straight upward climb in economic growth. “We’ve anticipated a recovery spanning two horizons as we move forward,” says Freedman. “The first may last into the third or fourth quarter of 2021, where we see the more immediate impact of a return to normalcy in the economy with the added boost of federal stimulus dollars.

“The second horizon comes after that. We think there’s a realistic chance that the same kinds of economic headwinds that existed prior to the emergence of COVID-19 will return in the post-pandemic period.” Prior to February of last year, the economy was growing, but at a modest rate. In this second horizon, positive economic growth continues, but at a more subdued rate similar to the pre-pandemic period. Freedman notes that the U.S. economy has grown at a “below-trend” level for a number of years. In other words, economic growth over time has slowed compared to historical averages.

Given this two-horizon scenario, Freedman suggests that we aren’t likely to experience a sustained rapid acceleration of the economy going forward. “It’s a question of how durable and sustainable the economic rebound is,” says Freedman. “This is not the post-World War II period all over again,” which refers to the span from 1946-1948, immediately after the war. At that time, new families formed at a rapid pace, consumer demand was high and the inflation rate averaged close to 10 percent per year.

Rob Haworth, senior investment strategy director at U.S. Bank, also believes we’re not facing a repeat of the late 1970s and early 1980s, when inflation was last an overriding economic issue. “In most circumstances, inflation spikes are transitory. Companies ramp up production to meet demand or consumers reduce demand or substitute other items for those priced out of their range,” says Haworth. He also notes that in the 1970s, sustained higher inflation was partly the result of a larger percentage of the workforce having wages boosted by automatic cost-of-living adjustments.

A short-term inflation bump

The rate of economic growth is not the only contributing factor to inflation. In recent years, there have been other inflation-dampening contributors at play.

One is the ongoing impact of emerging markets (such as China, India, Vietnam and Thailand) as cost-efficient providers of goods and services ranging from mobile phones to call center services. Another is the influence of technological developments, such as increasingly automated factories, on productivity. “While some adjustments may occur in terms of how these contributors to cost efficiency impact the economy in the future, they remain important factors that help keep inflation in check,” says Hainlin.

Also notable is that demographics have changed. “During the high inflation era of the 1970s, we had a surge in the working age population, people forming households and buying a lot of goods as a result,” says Haworth. “Today, our population is aging and households are shrinking in size. The economic underpinning has change.”

In the near-term, the inflation rate may continue to trend above recent averages. “Part of this is just the math,” says Haworth. “We had deflationary pressures in the early months of the pandemic in 2020, so in comparison to that period, inflation numbers are likely to tick higher.” Haworth says that the situation in the second half of the year bears close watching. He’s confident that by later in 2021, we’ll see the “year-over-year” change in the rate of inflation slow.

The Fed’s watchful eye

Investors always pay close attention to the Fed to see if the central bank will alter its policy course in response to economic developments. Along with using its assets to purchase bonds as a way to add liquidity to the fixed income markets, the Fed currently maintains a zero interest rate policy. It’s Federal Funds target rate (set as a guide to the overnight lending rate banks charge each other) is set at near zero, to help grease the gears of the economic engine. Federal Reserve Chairman Jerome Powell continues to indicate that the Fed will hold the line on the Fed Funds rate into 2023. This is considered an “easy money” policy.

One measure that the Fed closely follows is the Personal Consumption Expenditure (PCE) rate, another way to track changes in the cost-of-living. That rate held relatively steady dating back to 2012, but has trended higher in recent months compared to the previous year.

There’s speculation that a sudden jump in the PCE could cause the Fed to change course and begin taking tightening measures, including a move to bump interest rates higher. Yet the Fed may hold the line even if signs point to a temporary inflation rise. “The Fed is likely watching to see more significant, structural changes in the inflation scenario before it makes any adjustments to its interest rate policy,” suggests Hainlin.

That may require improvement in the job market. The nation’s unemployment rate has dropped from a peak of 14.7 percent in April of 2020 to 5.4 percent in July of this year. That’s still above the 4-4.5 percent level that many would consider a “full employment” scenario. More important, says Haworth, is that the U-6 measure, which reflects the number of unemployed, underemployed and discouraged workers who have stopped pursuing a job, remains elevated. “It will take a long time to bring these rates down,” says Haworth, another sign of the Fed’s hesitancy to take significant action in the near term.

Another inflation consideration is the housing market. “Shelter is a big component of consumer price inflation,” notes Erickson. “We’ve seen some increase in rents and housing prices in recent months that contributed to the recent uptick in CPI.” She suggests that price trends in that market bear close watching to help get a read on the future direction of the overall inflation rate.

While the Fed maintains a target inflation rate of 2 percent, it’s indicated it will follow a more patient approach, allowing inflation to “average” 2 percent over a period of time before making any changes to its interest rate policy. Because of this, it is expected that the Fed will avoid acting too quickly in altering its policy stance even if there is a temporary spike in inflation.

Freedman anticipates that before changing course on interest rates, the Fed’s first step will be to taper off its purchases of bonds. “The Fed is currently buying about $120 billion worth of bonds per month, and if any action is taken, it might be to scale back those purchases, at least modestly.” He suggests the Fed will want to take only incremental measures and gauge the market’s reaction.

The outlook for investors

Freedman believes the environment remains reasonably favorable for equity investors. In the “first horizon” of the economy’s recovery, expected to continue during the second half of 2021, he anticipates that cyclical stocks including energy, consumer discretionary and financial stocks, will be among the most attractive. Over time, as the “second horizon” of the recovery emerges in 2022 and beyond, technology and select healthcare stocks may again take center stage as they did in the earlier months of the pandemic.

Expect markets to continue to watch the Fed closely for signs that it’s concerned about inflationary pressures. Reaction to Fed comments or actions may trigger short-term swings in the market. Freedman says investors should not be surprised to see market volatility escalate in the remaining months of 2021.

The interest rate environment is also drawing close attention. Early in the year, yields on the benchmark 10-year U.S. Treasury bond rose significantly, but since that time, they have again dropped to historically low levels. It reflects the challenges existing in today’s bond market.

Another variable centers on infrastructure legislation out of Washington that would invest trillions of dollars in upgrading roads, bridges, telecommunications architecture and a wide range of other projects and initiatives, which could bolster economic growth. That creates the potential for more inflationary pressure, but much will depend on the final details of the package and the timing of the government expenditures.

As investors consider the impact of fiscal and monetary stimulus on the unfolding economic recovery, other factors may come into play. One of the more notable risks today is the recent resurgence of COVID-19, triggered by the so-called Delta variant. A large segment of the population remains unvaccinated, complicating efforts to put the virus in the rear view mirror. There are worries that additional variants may arise in the future, creating additional challenges. Depending on the potential economic ramifications, it could be another factor altering the inflation landscape in the months to come.