The biggest ‘inflation scare’ in 40 years is coming: what stock market investors need to know

‘s unclear whether inflation will see a lasting return, but a stimulus-fueled booming economy rebounding from the COVID-19 pandemic looks almost certain that it will send some short-term inflationary shockwaves to financial markets in the coming months. . Rising demand after a supply shock is a “classic recipe” for a rebound in inflation, Christopher Wood, Jefferies’ global head of equity strategy, wrote in an April 4 note.

“The upshot is that investors should be prepared for America’s biggest inflation scare over the reopening of the economy since the early 1980s, when former Fed Chairman Paul Volcker crushed double-digit inflation. in the late 1970s by imposing high real interest rates on the American economy. ”Wood said. The subject of debate is how long an inflationary episode is likely to be, and exactly how the Fed will respond. The answers to those questions have implications for the broader stock market and individual sectors. Data for the next few months will be closely watched, but any sort of short-term inflationary alarm is likely to be more of a “data freak” tied to base effects, the recent surge in commodity prices or kinks in supply chains. Brian Nick, Nuveen’s chief investment strategist, said in a telephone interview. The base effects are the comparison with prices a year ago, which were often abnormally low as a result of the pandemic. That means inflation will appear steep even if prices are simply returning to pre-pandemic levels or moving slightly above. Meanwhile, the Fed has made clear that it does not expect inflation to be stubborn and is willing to tolerate an economy that heats up and pushes inflation above its usual 2% target for an unspecified period before withdrawing its windfalls. monetary stimulus efforts. . The 10-year break-even rate, sometimes seen as what holders of inflation-protected Treasury securities anticipate consumer prices will average over the next decade, stood at 2.32% on Tuesday. That marks the highest level since mid-2013. But the inflation outlook on a shorter-term horizon is even higher. The 5-year equilibrium rate was at 2.52% on Tuesday, around its highest level since 2008. Such equilibrium curve reversals, where short-term inflation expectations exceed long-term expectations, are rare and suggest These investors expect a spike in inflation that later fades, Michael Arone, chief investment strategist at State Street Global Advisors, said in a note. But should investors share the confidence of the Fed? “It may be easy for the Fed to dismiss the price increase as temporary, but with aluminum, copper, oil, wood and housing rising in recent months, it is risky for investors to ignore the possibility that this could be. a more permanent upward shift in prices, ”Arone wrote. Not all investors are convinced that the Fed will sit in their hands as inflationary pressures mount. Fed funds futures traders have begun pricing rate hikes by the end of 2022. Meanwhile, the yield on the TMUBMUSD10Y 10-year Treasury note, 1.654% has risen significantly since February, trading as high as 1.77 %, its level before the pandemic. . Yields move in the opposite direction to prices. The yield on the TMUBMUSD05Y 5-year Treasury note, 0.851%, seen as more responsive to Fed expectations, had led the way to the upside before moderating this week. If expectations of an early takeoff from the Fed continue to rise, it could force a “reckoning” this summer, Nick de Nuveen said. “The market is almost always ahead of the Fed and it is almost always wrong,” he said, but policymakers will need to be vigilant to communicate frequently if inflation data turns hot. The Fed will have to explain in “a clumsier way” that the increase is occurring for transitory reasons and that a policy tightening is still 18 months to two years away, he said. The environment created by the uncertainty related to the Fed offers investors a “ray of light,” said Kristina Hooper, Invesco’s chief global market strategist, in a March 29 note. Other investors “can take advantage of ‘Fedspeak’ related sell-offs, which can create tactical buying opportunities for investors with a longer time horizon,” he wrote. “And if the markets really get messy, I think Powell will probably step in.” Jefferies’ Wood argued that the Federal Reserve would be willing to “lock in government bond yields by adopting some version of control of the yield curve, with the key question of timing whether this is done preemptively or after a risk reduction movement in the markets “. In yield curve control, a central bank targets a longer-term rate and agrees to buy whatever amount of long-term bonds is necessary to keep the rate below its target. “Such imposition of price controls on the US Treasury bond market will formally introduce a regime of financial repression. It will also send the unspoken message that the Fed understands that the system can no longer politically support higher interest rates, ”Wood wrote. Meanwhile, any hint of an anticipated reduction by the Fed would trigger a strong sell-off in stocks, he said. But as long as the Fed doesn’t appear to be backing down on its promise to postpone the adjustment, the rate hike will likely remain relatively benign, Nick de Nuveen argued. While there was an opportunity to rally some growth-related stocks that seemed oversold during the first-quarter rotation, improving data on the economy and vaccines should continue to benefit cyclicals, he said. State Street’s Arone argued that investors should take some precautions. “To guard against the possibility of rising inflation, investors might consider replacing traditional bonds and growth stocks with growth-sensitive bonds and rate-sensitive stocks to ensure portfolios remain diversified and meet their investment objectives. “, wrote. Sunny Oh contributed to the reporting of this article.