The first quarter of 2021 has seemed to have started off as a transitionary period for markets. The overall theme has migrated from economic uncertainties due to COVID-19 related lockdowns to concerns that the economy may overheat with a potential faster-than-expected economic recovery coupled with record fiscal and monetary stimulus supplied by the Federal Government and Federal Reserve (The “Fed”), respectively. This has caused investors to wonder (and rightfully so) whether the Federal Reserve ought to let their foot off the breaks and raise the Federal Funds rate and slow down their current monetary stimulus programs to mitigate a potential spike in inflation. The Bureau of Labor statistics recently divulged that inflation grew year over year by 2.6% for the period ending 3/31/21. This is the first time year over year inflation grew by over 2% since February 2020, which was the month preceding the U.S. falling into recession due to COVID-19 related lockdowns.
However, Fed Chair Jerome Powell remains quite dovish. In fact, he has indicated that the Federal Reserve believes any inflation to occur would be “transitory”. The question is: what if the Federal Reserve is wrong about its outlook? What if they are too conservative, and the U.S. economy does see significant and sustained inflation? Although the 10-year treasury yield has only rose to levels observed as recently as December 2019 (source: FactSet Research Systems), it is fair to wonder whether the financial markets are on to something. The period of rising rates and extraordinary inflation that was observed through most of the 1970s probably serves as the most infamous period of rapid inflation generally due to an overly accommodative Federal Reserve. Of course, it certainly was not the only instance over the past 50 years where this occurred. There have been several instances where varying levels of inflation were realized when the Federal Reserve was too dovish relative to the sentiment of the market, which is where we seem to find ourselves currently.
The question then becomes the magnitude of inflation. Do we see 1970s level inflation or something closer to what we saw coming out of the tech wreck in March 2001, which lasted up until the beginning of the financial crisis in December 2007? Global Beta suspects that it is most likely closer to the latter. While there is certainly a lot of pent-up demand as we begin to come out of the COVID crisis with the backdrop of significant stimulus, recent history seems to suggest that some of the technological efficiencies that have been achieved through innovation over the past 10-15 years have reduced some of the impact that demand has historically had on inflation. We can infer this from analyzing the long term versus short term cause and effect of accommodative monetary coupled with rising rates. Below is a chart contrasting the instances where we observed inflation within 12 months of rising rates, in the face of accommodative monetary policy, from February 1971 through January 2021 versus March 2009 (i.e.: post market bottom during the financial crisis) through January 2021:
Source: FactSet Research Systems (“Long Term”: 02/26/71 through 01/29/21. “Post Financial Crisis”: 03/31/21 through 01/29/21)
Over the long term, there were 145 months where the Federal Reserve reduced its Fed Funds target rate while the 10-year yield was rising. As illustrated above, 133 of those occurrences (or nearly 92% of occurrences) observed inflation within 12 months. In contrast, following the market bottom of the financial crisis (i.e.: March 2009), there were 49 months where the Federal Reserve reduced its Fed Funds target rate while rates on the 10-year were rising. Again, as illustrated, only 32 of those occurrences (or roughly 65% of occurrences) observed inflation within 12 months. We defined inflation as any period where the consumer price index’s (“CPI”) year-over-year growth was greater than 2%. However, as it is important to show how the evolution of technology has seemingly reduced the frequency of inflation based on the above illustrated relationship, it is also important to evaluate both the magnitude and the duration to which we observed inflation during each period. Below is a chart illustrating the average inflation observed over each period under this circumstance:
Source: FactSet Research Systems (“Long Term”: 02/26/71 through 01/29/21. “Post Financial Crisis”: 03/31/09 through 01/29/21)
As you can see, even during inflationary periods throughout the post financial crisis period, the average inflation observed was quite low compared to the long-term average. In fact, the long-term average observed an inflation rate that was nearly double what we observed in the short term. You will also notice that the average inflation rate during the post financial crisis period is below the 2% benchmark that we set in this analysis to determine inflationary periods. Of course, this impacted by the lack of sustainability that inflation had during that period. As we have heard Fed Chair Jerome Powell discuss often is the idea that their vision of inflation is expected to be “transitory. Based on the next chart that we will illustrate, he and his counter parts may have basis for that presumption. Below is the average duration in which inflation lasted from each point described:
Source: FactSet Research Systems (“Long Term”: 02/26/71 through 01/29/21. “Post Financial Crisis”: 03/31/09 through 01/29/21)
You will notice from the above illustration that, in the long-term, we generally observed inflation for nearly 36 months, which is about 18 times longer than the nearly 2 months of inflation that we observed in similar periods during the post financial crisis period. We believe this explains two things: 1. Why the average inflation rate during the post financial crisis period is so low and 2. Why the Fed may think that inflation could be transitory.
Contrasting long term history with short term history provides context to where we may be heading in the short and medium term with regards to inflation. Based on our findings, we are likely to see modest inflation that lasts for a short period of time. Inflation may also recur after retreating for a period. However, it is important to consider that the record amount of stimulus provided by the Federal Government coupled with a record amount of monetary stimulus provided from the Federal Reserve may change the calculus in terms of the level of inflation we can expect and the durability of that inflation. Even so, Global Beta believes that the evolution of technological innovation will at least, in part, curb inflation to some degree.
How should investors proceed? As mentioned, we believe it is fair to operate under the assumption that some inflation will come into the economy for some period and investors ought to proceed accordingly. With that in mind, we looked at the investment landscape by factors to determine what parts of the market may benefit from periods of inflation. Below is a chart illustrating the short and medium term forward looking return horizons following periods where the economy realized inflation (as discussed, we define inflation as a year over year growth rate of 2% or greater):
Source: FactSet Research Systems (12/31/08 through 03/31/21). “Low Volatility” is represented by data from the S&P 500 Low Volatility Index, “Growth” is represented by data from the S&P 500 Growth Index, “Value” is represented by data from the S&P 500 Value Index, “Yield” is represented by data from the Dow Jones US Select Dividend Index, “Quality” is represented by data from the S&P 500 Quality Index, “Momentum” is represented by data from the S&P 500 Momentum Index, and “Size” is represented by data from the S&P 600 Index low valuation etf
Source: FactSet Research Systems (12/31/08 through 03/31/21). “Low Volatility” is represented by data from the MSCI US Minimum Volatility Index, “Growth” is represented by data from the S&P 500 Growth Index, “Value” is represented by data from the S&P 500 Value Index, “Yield” is represented by data from the Dow Jones US Select Dividend Index, “Quality” is represented by data from the S&P 500 Quality Index, and “Size” is represented by data from the S&P 600 Index.
In the short-term following periods of inflation, growth and quality were the largest benefactors. However, in the medium-term following periods of inflation, yield and volatility benefited most. Thus, an investor’s investment horizon certainly impacts how one would view their asset allocation under this circumstance. Global Beta is a firm believer of longer-term investment horizons; therefore, we tend to look at medium- and longer-term investment horizons when contemplating investment decisions.
As always, Global Beta believes it is important to balance your factor exposure in your portfolio. It is important that investors consider valuation within each segment of the market. However, as we observe current macro trends, we believe investors may benefit from allocations to the above-mentioned factors.
By: Justin Lowry
President & CIO, Global Beta Advisors, LLC
Published: 04/20/20
The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Indexes are available for the U.S. and various geographic areas. Average price data for select utility, automotive fuel, and food items are also available.
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