Inflation & Employment Concerns

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com
May 16, 2021

Summary

The financial markets are grappling with both a rise in the inflation data reported last week, as well as a huge miss last week in the new jobs report kindling long-suppressed memories of the 1970’s period of “stagflation”.

After considering the incoming data, we continue to believe that the current period of rapidly increasing inflation will be transitory. Rapid employment gains will resume when small businesses in lower labor unit cost industries do not have to compete with the federal government paying workers close to $21/hour NOT to work.

We continue to favor investing in companies leveraged for global economic expansion.

Inflation Concerns

The financial markets reacted this past week negatively to the inflation data reported that was, for the most part, expected. A record number of businesses say they cannot find workers, inventories are ultralow, and a near-record number of companies say they plan on raising prices as commodity and other input prices continue to rise. In addition, the recovery to pre-pandemic pricing in areas such as airfare and hotels are putting pressure on prices, and the price at the pump is now over $3.07/gallon. Finally, there are growing indications of wage inflation even if the official wage inflation measures are not yet sounding alarms.

After we dissected the inflation information, it became clear that the increases resulted from base effects (comparing this year versus negative prices during last year’s pandemic) and the surprising speed of the economic recovery without sufficient supply causing shortages and higher prices.

One risk that we are closely monitoring is it that the current inflation data may affect how Congress views additional stimulus, fearing that too much may fuel inflation which hurts all Americans, and more importantly for the markets, may cause the Fed to act sooner, impeding the economic expansion.

However, Fed officials were sticking to their narrative last week that higher inflation will be transitory. They acknowledged that inflation would run hot for several more months as the economy opens and shortages, supply line issues, and year-over-year comparisons inflate current numbers.

The Fed has cited several reasons why longer-term inflation will stay contained: There is vast labor slack, with current employment nearly 9 million below pre-pandemic levels. Disruptive technologies and global competition will continue to pressure pricing. Pricing power for many sectors of the economy is weak due to heavy competition. Base effects are impacting current numbers.

Another data point that gives us confidence in the transitory nature of the current increase in inflation is the bond market reaction to last week’s inflation news. After a sharp initial move in bond yields, they settled back and ended the week with the 10-year Treasury yielding around 1.62% and the 30-year Treasury yielding approximately 2.32%. Certainly, bond investors would have bid up bond yields much higher and kept them there if they felt that inflation was breaking out to higher levels, much above 2%, and staying there for years above the Fed targets.

Finally, we would expect that when the Fed begins to shift policy, which we see happening by early next year, it will begin by slowly reducing bond purchases over many months before considering hiking rates that may occur by the end of 2022 early 2023. Then, when the Fed starts to raise rates, it will be a strong indication from our central bankers that our economy is sound and on solid footing.

A Big Miss on Employment

Last week we had a highly unexpected and disappointing new jobs figure of only 266,000 when economists expected 975,000 new jobs. We looked at the underlying data and found that the biggest misses in new employment centered around industries with relatively lower unit labor costs.

These industries include restaurants/bars, hotels, home health, and personal care services, amusement & entertainment, textiles, laundry/dry-cleaning, childcare, and agriculture. The average annual salary in these industries is $25,570. Presently the federal government is paying workers the yearly equivalent of $41,500 per year NOT to work. If you own a business that relies on hiring workers that earn less than $20.75/hour, you are having trouble staffing your open positions.

Now, suppose we want to truly re-open our economy. In that case, we need to eliminate this structural impediment hindering our progress towards full employment and allow our favorite local businesses to get back to adequate staffing levels.

Coronavirus Vaccination Rates are Still Key

We continue to monitor the coronavirus closely, as getting vaccinations into arms will impact the sustainability of the global economic recovery.

Domestic news gets better by the week:

1. The number of cases/deaths continues to fall.

2. We are vaccinating over 2 million per day.

3. At this pace, we will reach herd immunity over the summer.

4. The FDA recently approved vaccinating adolescents as young as 12.

5. The CDC lifted the indoor mask mandate, which will accelerate openings.

6. The vaccines are showing efficacy against all variants in testing.

7. We will have billions of doses available next year if we need booster shots, just like our annual flu shots.

8. Finally, as of this morning, we are approaching 50% of all Americans that are fully vaccinated or have at least one of the Pfizer or Moderna shots.

News in the Eurozone is getting better, too, as country by country is opening as the number of cases/deaths decline while vaccinations increase meaningfully. However, news in India and parts of Africa continue to be devastating, but the number of vaccinations is finally growing meaningfully.

We remain optimistic that the coronavirus will be highly contained by the end of the year, allowing the sustainability of the global economic expansion for 2022 and 2023.

Fiscal Spending

Chances for a more focused/limited infrastructure bill appear to be increasing as President Biden meets with both Republicans and Democrats this week. We expect the passage of a traditional infrastructure bill close to $1.2 trillion, including roads, bridges, ports, broadband, pipelines, trains, waterways, and supply lines for essential goods. The package will be financed by raising the corporate tax rate to 25%, higher user fees, closing tax loopholes, and increased tax collections. However, we believe that major parts of Biden’s social agenda within his proposed infrastructure bill will be put off for another day.

The Reports of Tech Death are an Exaggeration

Investors have been climbing on the bandwagon of a style shift between growth and value-oriented stocks. The latter benefitted from current investor enthusiasm after spending over a decade adrift at sea. The market is all about style rotation this year, but what never goes out of style in our book is increasing revenues, wider profit margins, and robustly growing bottom lines. And this is exactly what our core technology stocks have continued to deliver this year. Facebook (FB) recently reported revenue increases of 48% year-over-year, and Microsoft (MSFT) was up 19% on this measure which was their fastest top-line growth in any quarter since 2018. Apple (AAPL) was up 54%, and Alphabet (GOOGL) was up 34%, which was their best quarterly performance since 2012. Finally, Amazon (AMZN) hit a ten-year high with a 44% increase.

These gains will continue when you consider the trends and fundamental factors that favor these large technology companies; namely, cloud storage and computing, E-commerce, the resurgence of the at-home PC, new demand for 5G enabled services and hardware, and on-line advertising that continues to take market share away from more traditional advertising verticals.

So, to twist a famous Mark Twain quote, the reports of the death of technology stocks have been grossly exaggerated.

Investment Outlook

We will continue to invest in companies with high and sustainable free cash flow returns on investment relative to their cost of capital and favor investing in companies leveraged for the global

economic expansion. Markets are, first and foremost, driven by liquidity, and we have never had more excess liquidity in the system than now. These are fundamental conditions that should result in a “buy-on-the-dip” attitude that I believe we saw towards the end of this past week.

We continue to favor investing in companies leveraged for global economic expansion. They are in the early innings of above-average earnings growth, record levels of cash flow generation, and much higher returns on invested capital. However, defensive stocks and companies that benefitted from the pandemic have seen their best relative days. Many of these firms are great companies that will continue to grow. Still, they are over-owned and should be sources of funds as you invest in the following areas:

1. Value

2. High-quality growth

3. Cyclical areas such as industrial, machinery, and capital goods companies 4. Industrial and agricultural commodities

5. Financial

6. Technology tied to broadband and 5G

7. Transportation

8. Chemicals.

Finally, we continue to avoid or underweight bonds as we expect the yield curve to steepen over the next few years.

Catching Up

We look forward to catching up with each of you, and we will be reaching out to schedule a time to meet over the phone or by a Zoom/MS Teams video link. If you would like to get something on the calendar in the interim, please send me a note with some dates and times.

John