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Institute Alert

Wells Fargo Investment Institute strategists provide insights on this week’s market volatility and guidance for what may be ahead.

November 15, 2021

Paul Christopher, CFA, Head of Global Market Strategy

Scott Wren, Senior Global Market Strategist

Managing portfolios before inflation peaks

Key takeaways

  • We believe inflation will moderate in 2022, but we expect the path to lower inflation to begin with higher inflation in the front half of the year.
  • The stickier drivers of inflation are likely to persist, but our base case is that they will not outweigh the improvement we expect in the transitory elements.

What it may mean for investors

  • As long as the economy remains strong, the asset classes that we expect to outperform are those factors that drive both the economy and inflation. Our guidance aligns with favoring those sectors that we expect to outperform — and to avoid those that we expect to underperform — as inflation rises.

The U.S. Consumer Price Inflation report for October showed a 6.2% gain from October 2020 and was broad-based across categories according to the U.S. Bureau of Labor Statistics. Index components for food, energy, shelter, and used and new cars and trucks were major contributors to the rise.

We believe inflation is one of the most prominent risks to portfolios today, and questions about inflation frequently ask whether it is temporary or persistent. We do not view the question as either-or, but as parts of both. Some factors likely are temporary while others may be stickier.

There are transitory elements. Strong demand for food, energy and automobiles has aggravated global supply disruptions. Whether the result of policies in China (to cut coal usage), factory closures that limited microchips for automobiles and electronics, limited OPEC1 oil supply, or transportation bottlenecks at home and overseas, the supply of goods has trailed demand and aggravated inflation. Most consumers are painfully aware that automobiles, gasoline, and dinner out are dramatically more expensive and may be difficult to find.

These categories account for most of the gain in inflation, but they could see more balanced supply and demand conditions by the middle of next year. Demand is set to cool. Federal COVID-19 payments dried up in mid-2021, and households are increasingly likely to run down savings while the prices of food and fuel outpace wage growth. Finally, we believe the slowing in COVID-19 infection rates will hasten the rebalancing into services spending in 2022, thereby easing some of the strength in demand for goods.

From the suppliers’ side, factories in Asia are reopening and some transportation costs are peaking.2 Raw materials prices also are important because their changes have tended to predict consumer inflation 12 months ahead (Chart 1). Lumber, copper, and soybean prices, for example, are significantly lower than they were earlier in the year and holding. If the broad trend continues, we expect consumer inflation to slow somewhat by midyear and materially by year-end 2022.

Chart 1. Inflation in producer raw materials leads inflation in producer finished goodsThis chart shows measures of finished goods less food and energy and of unprocessed nonfood materials except fuel as a three month average of year-over-year percent change. The unprocessed nonfood materials measure leads the finished goods measure by approximately 12 months.Sources: Bureau of Labor Statistics and Wells Fargo Investment Institute. Monthly data, October 2005–October 2021. Data shows seasonally adjusted, 12-month percentage changes, smoothed with a three-month moving average to show turning points more clearly. YOY = year-over-year.

Price gains in wages and rents may be more persistent, although this is not our outlook. If workers and landlords can continue to drive their prices higher, the spillover to the rest of the economy could become self-perpetuating and a more serious threat to equity and fixed-income prices. However, the growth in housing prices appears to be peaking, and we expect that to slow rent gains.3

We expect wage growth to finally peak as workers return in larger numbers to the work force. Two-thirds of the roughly 10 million open jobs in the U.S. are in relatively low-wage services sectors: retail trade, hospitality and leisure, and health care and education. We believe that today’s higher wages and consumer prices will accelerate the reentry of workers into these industries. Labor force participation rates are rising slowly among workers aged 16–54.

Our fundamental conviction is that pricing pressures will ease before they drive expectations and become self-perpetuating. That happened in the 1970s, but today is different in important ways. During that earlier era, worker efficiency suffered because businesses lacked technologies to cope with higher commodity prices. Factories closed and corporate earnings struggled while commodity prices drove production costs and expectations for even more inflation. Today, energy prices are rising, but businesses are adding new technologies that increase production capacity to blunt the impact of higher material costs and the labor shortage. We expect profit margins to hold and for corporate earnings to rise with economic output in 2022.

Investment implications

For investors with a primarily long-term investment focus, we believe that trends such as technological change, an aging workforce, and shorter global supply chains will exert downward pressure on production costs. We do not believe that inflation is a long-term issue and favor staying with strategic allocations.

Over a shorter, tactical investment horizon, our preference to position allocations for above-average economic growth also aligns with our view of how best to position the portfolio for above-average inflation. We expect Commodities and cyclical equity sectors (for example, Industrials and Financials) to outperform with growth and inflation near a peak. The sectors we prefer to avoid tactically are those that we expect to underperform under a strong economy, rising interest rates, and inflation that has not yet peaked. One important example is long-term fixed income. We also have an unfavorable rating on short-term fixed income while investors price an eventual Federal Reserve response to inflation.

1 Organization of the Petroleum Exporting Countries.

2 According to Bloomberg (November 12, 2021), international dry freight costs appeared to peak in October, and the U.S. cost of transporting grain by truck or barge also peaked in the past two months.

3 The S&P CoreLogic Case-Shiller 20-City Index of U.S. single-family housing prices appeared to peak in July, according to Bloomberg. We expect the impact on rents to follow.

Risk Considerations

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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