Weekly Update

Inflation Worries Have Had Little Net Impact on Interest Rates

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Published November 12, 2021

This week’s inflation numbers put a little (temporary?) scare in the markets. But the one-day jump in interest rates did not even offset the past two weeks’ worth of yield declines. Rates remain at the low end of the pre-pandemic interest rate range as the chart below shows. The shorter-term interest rates are now firmly in the middle of their pre-pandemic range, reflecting upcoming rate increases from the Federal Reserve. The longer part of the curve (30-year rates) remain below their pre-pandemic range, a potentially worrying lack of confidence in the longer-term economic outlook.

Pre-pandemic interest rate range

As for the inflation scare, this writeup from Delta provides a good overview:

“The Federal Reserve, treasury bond traders and equity investors are some of the key players in the inflation game. On one side, there is the inflation-is-transitory team which includes the Federal Reserve. On the other side, is the team that expects inflation to be higher-for-longer than what is priced into current market expectations.

Who wins this game may have important ramifications for stock prices. If inflation is higher and lasts longer, commodities and value stocks should outperform. If inflation is transitory, growth stocks should maintain their winning streak.

The Consumer Price Index (CPI) was up 6.2% year/year in October, the highest yearly gain since November 1990. Excluding food and energy, the CPI was up 4.6%, the largest increase since August 1991. On Wednesday, when this information was reported, the 10-year treasury rate jumped 9% higher. Major bank stocks traded higher as the NASDAQ 100 lost about 1.7% for the day. The loss in the NASDAQ (mostly growth) was more than twice the size of the decline in the Dow Jones Industrial Average (blend of value and growth) on Wednesday. With the move higher in rates, bond funds performed poorly.

The chart below shows the spike in the core Personal Consumption Expenditures Index (PCE) which is the measure of inflation tracked most closely by the Federal Reserve.

Spike in the core Personal Consumption Expenditures Index

The primary argument for believing inflation will be transitory is it is being mostly caused by supply/demand imbalances (supply chain problems) that will be resolved in 2022/23. The leading causes of supply problems have been Covid-driven factory shutdowns, disruptions in semiconductor production, port closures and congestion and widespread labor shortages. The typical car today uses about 300 semiconductors versus about 100 ten years ago. Fed Chairman Powell believes the supply shortages will work themselves out and inflation should move down to roughly 2%.

Inflation Pull Becomes Inflation Drag

Inflation has been trending lower for decades as a result of globalization and technology. Below is the graph of the 30-year U.S. treasury rate which is partly driven by inflation.

30-Year US Treasury Yield

If you believe globalization and technology secular trends remain in place, it is much easier to believe inflation will be transitory.

No matter what the longer-term projections show, prices are rising very fast right now and the stock and bond markets lost some confidence this week that the transitory team will eventually win the inflation game.

Inflation becomes a problem for corporations/stocks if they are unable to pass-through higher labor and materials costs. In the third quarter, the blended net profit margin of the S&P 500 was 12.9%. This is higher than the year-ago profit margin of 10.9% and only slightly down from the record 13.1% achieved in the second quarter. Consensus analyst expectations are for S&P 500 net margins to be 13.3% in 2022 and 13.8% in 2023.

Stocks are an inflation hedge, especially if companies are able to pass on higher costs to consumers through higher prices. Transitory or permanent, stocks continue to be a relatively attractive investment in an inflationary environment.”

Market Update

Earnings reports continued to flow into investors in-boxes this week. It has been an outstanding earnings reporting season with over 80% of companies exceeding estimates. Stocks have responded with a nearly non-stop month-long rally. Another positive day Monday, though the gains were slim as the market begins to look a bit ready for a rest. Tuesday brought a -0.3% slip with a mixed bag of earnings and a producer price report that showed inflation remains elevated. Wednesday’s consumer inflation report unnerved markets with a reading of +6% annual growth in prices paid, the highest rate of growth in over thirty years. In response, interest rates sharply and abruptly reversed their recent downward trend staggering growth stocks to a -1.7% slide for the Nasdaq. The news was worse in China as their producer prices showed a +13.5% year-over-year increase. In true bull market form, investors swooped in to quickly right the market Thursday. Bond markets were closed for Veterans Day, with the lack of interest rate action perhaps helping to stabilize stocks. A disappointing earnings report from Disney (DIS) kept the rebound to a modest +0.1%. Friday saw stocks regain their footing with the Nasdaq bouncing upward by +1%.

Stocks fell back this week for the first time in a month. Still, the dip was minimal with the S&P 500 (SPY) giving back only -0.27%. The Nasdaq 100 (QQQ) ended -0.98% lower for the week. Smallcap stocks (IWM) held their recent breakout though giving back -0.96% this week.

Warm wishes and until next week.