Demand Pull Inflation is Goldilocks for Stocks

In our College econ classes we often referred to Demand Pull Inflation where production supply capacity was unable to keep up with an increase in consumption. Inflation has been the news de jour every day for months, reaching 30 year highs, yet stocks continue higher and inflation sensitive commodities remain dead in the water. When consumer prices and wages are rising rapidly, economists expect surging interest rates and soaring precious metals alongside an increasingly risky outlook for stock market earnings. The opposite has been the case.  

The classic hard asset inflation hedge, Gold has been falling this past year along with all precious metals. However, Gold is well correlated inversely to the Dollar. With our currency moving higher in 2021 on US economic strength and in anticipation of rate hikes, there has been no reason for Gold to appreciate. When Emerging Markets can get Covid under control, the Dollar will fall as Gold and Emerging Market countries rebound.

Also counterintuitive has been that borrowing costs and Bond yields have been sideways to lower the past 7 months as inflation rates jumped. Normally after a panic Recession the Government and the Fed stimulate the economy until unemployment falls and the GDP recovers. Then inflation returns causing interest rates to rise as a credit tightening cycle kicks in to find an equilibrium between growth and consumer prices. In the current recovery the Government and Central Bank stimulus have continued at deep Recession level rates of stimulus even though Unemployment is low and inflation is high. 

With the Fed buying $120 Billion dollars of various Bonds every month, it certainly reduces supply, keeping bond prices high and yields lower than fair value. Our Federal Reserve (Central Bank) owns $8.5 Trillion dollars of Bonds as they embrace the Modern Monetary Theory of permanently removing debt and adding trillions in liquidity out of thin air to the banking system.

 The Fed liquidity injections of $4.3 Trillion will continue to grow by another $400+ billion into next Summer, despite Fed tapering, providing fuel for higher stock prices. Where will the $1.25 Trillion in endowments and pension funds send their cash? With low Bond yields being unattractive to investment fund managers, this excess money sloshing around will keep a tailwind behind stocks into 2022. The recurring waves of Covid and excess of artificially stimulated consumption remain the primary risks to the fragile supply chain and a full economic recovery.

The September swoon in stocks we expected arrived again this year with an emphatic bottom in early October. A test of all time highs is arriving this week and we would expect a minor pullback near the end of October followed by another leg to record highs in November.  Financial and small cap stocks should benefit from inflation cost pass throughs as therapeutics and vaccines increasingly tamp down virus risk and encourage labor to return to work. High inflation and stimulus with low interest rates continue to benefit profit margins and stock prices.

 

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