Inflation and Future Growth

By Ketu Desai

Stagflation has moved to the forefront of risks in recent weeks. Stagflation is essentially high inflation with low economic growth. We are certainly seeing inflation, and the inflation has broadened out in recent readings compared to earlier in the year, when outlier items such as used cars or airfare were driving the numbers. Trimmed mean CPI, which adjusts for the extremes, came in at its fourth hottest since the data series began in 1983 at an annualized rate of 6.09%. More than 70% of the CPI categories are up. 5-year breakevens are approaching 3%, the highest since 2005. The ISM prices paid index continues to stay at historically high levels and is showing no signs of letting up. It seems likely that inflation numbers will remain hot until at least next year when the comps are better.

The growth side of the picture looks more promising, which is why I think we are likely to get inflationary growth, rather than inflationary stagnation. GDP will likely grow 5.5% this year and 4% or so next year, far above trend growth. Approximately two-thirds of growth comes from the consumer. The consumer is in great shape, savings are high, debt is low, jobs are plentiful, and wages are up. The consumer savings rate is 9.4% near some of the highest levels we have had since the data series began in 1959. They are sitting on $2.4 trillion in excess savings. At the same time, household debt service to disposable personal income is at the lowest levels since the data is available. There are over 10 million jobs available and wages are up 4.6%. This sets up for strong consumer led growth well into 2022.

Corporations are also in terrific shape. Earnings are growing and balance sheets are strong. Earnings grew 33.2% year-over-year, led by areas that indicate a strong cyclical recovery, energy, industrials, materials, and technology. Earnings are expected to grow another 9% in 2022. While rising costs are a clear concern, margins have actually expanded, up on average 30 bps. Corporations are sitting on a record amount of cash, $6.84 trillion, and they are ready to spend it. Goldman expects corporate spending growth of 19%. Goldman estimates they will authorize $965bn in buybacks this year. 2022 will likely be a year of inventory rebuilding and ramping-up capital expenditures. The ISM manufacturing new orders index is up 16 consecutive months, and 15 consecutive months above 60, beating the record set in the last expansion. The ISM backlog of orders is also at a historically high rate. At the same time, customer inventory levels are at historically low levels. The total inventory to sales ratio is at a level last seen during the depths of the financial crisis. The combination of strong earnings, healthy balance sheets, low inventories, and strong new orders and backlogs indicates that we are still early in this cycle.

Given this economic background, TINA (there is no alternative) remains in place. The earnings yield on the S&P is 4.5% compared to 1.6% yield on the 10YR, 2.5% on investment grade, and 4.3% on high yield. The latter three not only have a lower yield, but don't provide much inflation protection and have significantly less upside. I think the barbell you want currently is tech with the cyclicals. While many are concerned about how tech will perform with rising rates, historically there has not been a meaningful correlation. In the early 2000s, rates fell from 6.5% to 3%, and tech crashed. During the taper tantrum in 2013, tech outperformed the S&P, up 4.4%. From the summer of 2016 through the winter of 2018, interest rates more than doubled from 1.4% to 3.2%. Tech stocks rose around 60% over this time frame. I suspect that with fixed income unattractive that tech will receive a safe haven bid. Further, tech companies have the best balance sheets, are the biggest buyers of their shares, have high margins, and are among the fast growers. They are less long duration than most people believe. The case for cyclicals is simple, they benefit from economic growth, the reopening, have operating leverage, provide an inflation hedge, benefit from rising rates, and have the highest earnings growth rates this year and next. Areas that it makes sense to be more discerning are consumer staples, utilities, healthcare, real estate, and high growth / high multiple / unprofitable tech and biotech.

Looking forward, the Fed will announce its long-awaited taper, earnings and economic data will remain in focus, as well as the latest out of Washington.