March 31, 2022
Gary Schlossberg, Global Strategist
Wells Fargo Investment Institute strategists provide insights on this week’s market volatility and guidance for what may be ahead.
March 31, 2022
Gary Schlossberg, Global Strategist
Price increases seem to have taken on a life of their own this year, turning decades of low and declining inflation into a distant memory. Wrenching adjustments during the pandemic have been compounded by supply-chain disruptions and soaring goods demand tied to it. Soaring commodity prices, wage increases, and added shortages created by the war in Ukraine have propelled inflation — already at a 40-year high — even higher.
Inflation inevitably is topic number one among investors aware of its role at the heart of asset performance. Inflation pressures directly influence bond prices through their effect on interest rates. Commodity prices have risen, propelled by the asset’s role as a potential inflation hedge. And inflation can influence companies’ selling prices, costs, and interest rates, which has an impact on revenues, margins, and ultimately the market valuations in investors’ portfolios.
Our stark outlook on inflation through 2023 contrasts with a more sanguine longer-term view, which can be even more important to asset performance. “Transitory” now may be a dirty word at the Federal Reserve, but households’ longer-term inflation expectations have been edging higher far less rapidly than their short-term (12- month) expectations. In fact, the gap between the two is greater now than at any time since at least 1990, according to a University of Michigan survey for late March.
Much the same message is coming from investors through so-called breakeven rates in the market for Treasury Inflation-Protected Securities (TIPS). The breakeven rate is the yield on a conventional security less the all-in yield on an inflation-protected security of comparable maturity and is widely viewed by market analysts as a gauge of investors’ inflation expectations. Long-term inflation expectations measured this way are close to the current 3% rate reported in the University of Michigan’s late-March survey.
Note in Chart 1 the steepening breakeven curve as of March 25 (purple line) compared to the curve at the end of last year (red dotted line). This chart shows inflation expectations keyed to specific Treasury debt maturities. The widening gap between short and long-term inflation expectations signals a view that inflation’s latest run up largely is the result of shocks from the pandemic and the war in Ukraine.
Lower long-term inflation expectations in the U.S. Treasury market have not prevented an ongoing debate over the ultimate impact of these short-term shocks on long-term inflation. On many investors’ minds is whether we can expect a repeat of the great inflation during the 1970s through the early 1980s —double-digit interest rates, a struggling housing market, and pressure on household budgets. Much of the period also was marked by poor stock and bond performance and by a deep recession.
Stagflation — a combination of rising inflation and slowing economic growth — has resurfaced for the first time in over 40 years. However, the term has a different meaning now than when it first was coined during the great inflation of the 1970s and early 1980s. Worries over a period of rising inflation and weakening economic growth raise legitimate concerns over the outlook, and we believe they can complicate the Federal Reserve’s efforts to achieve an economic soft landing while cooling inflation.
Fifty years ago, the term stagflation described more of a chronic condition, in which high inflation showed little response to extended periods of modest or even stagnant growth. Whether or not economic growth and inflation morph into the kind of stubborn stagflation seen in the 1970s will depend on the extent to which structural changes prevent inflation from responding to weakening growth. We believe the influence of market forces ultimately will be strong enough to pull inflation lower if economic growth cools.
So, do we think history is about to repeat itself? The latest inflation cycle checks off some of the boxes explaining uncomfortably high inflation 40 to 50 years ago:
So why not throw in the towel and state that higher inflation is here to stay? Our view is that there are compelling reasons for households and investors to expect subdued longer-term inflation.
The debate over inflation’s longer-term outlook hinges essentially on structural changes shaping the economy’s performance in the decade ahead. Our view is that similarities to the 1970s are not as strong as current secular trends. As outside shocks subside, we believe inflation will return to what we view as historically moderate levels.
The great inflation of the 1970s and early 1980s, peaking at 8.8% in the 10 years to August 1982, was a 20thcentury anomaly, as Chart 2 illustrates. The rate soared higher and for longer than at any time since at least the early 1920s, approached only when the U.S. lifted price controls after World War II. Even a more moderate, but elevated average rate exceeding 4% a year is an exception to the rule, occurring little more than one-third of the time since the beginning of 1946.
A return to more moderate inflation is critical to a positive long-term outlook for stocks and other financial assets. Viewed strategically (10 to 15 years), we believe long-term interest-rate restraint should ease pressure on equity valuations and dividend-oriented stocks. Moderately higher, longer-term inflation also fits well with our constructive long-term outlook for higher-quality, more liquid U.S. Large Cap Equities, best positioned to deal with incremental improvement in pricing power and moderately higher interest rates.
Finally, we anticipate higher but still moderate interest rates also should support bonds after years of low yields. More specifically, our expectation for bond market’s longer-term stability ultimately can support a return to favorable ratings on longer-term U.S. Treasury issues, preferred and tax-exempt securities, and other higherquality, yield-advantaged sectors of the market.
1 For more on how globalization is not ending but changing, please see our report, “The Future of Globalization: Investing in an Interconnected World”, September 2021.
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. Dividends are not guaranteed and are subject to change or elimination. 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. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income. Although Treasuries are considered free from credit risk they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate. Treasury Inflation-Protected Securities (TIPS) are subject to interest rate risk, especially when real interest rates rise. This may cause the underlying value of the bond to fluctuate more than other fixed income securities. TIPS have special tax consequences, generating phantom income on the “inflation compensation” component of the principal. A holder of TIPS may be required to report this income annually although no income related to “inflation compensation” is received until maturity. Preferred securities have special risks associated with investing. Preferred securities are subject to interest rate and credit risks. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer's capital structure, subjecting them to a greater risk of non-payment than more senior securities. In addition, the issue may be callable which may negatively impact the return of the security. 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.
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