Current Sector Views: February 2021
The whispers of inflation concerns are growing louder. While the economy is certainly not out of the woods, near the end of February, the 10-year Treasury yield reached a 1-year high. With expectations of fiscal stimulus and infrastructure spending, Treasury yields have risen sharply YTD. The 10-year Treasury yield has increased 64.9% YTD to 1.51%.1
High levels of stimulus combined with steady progress on the vaccine rollout has resulted in U.S. economic growth expectations being revised upward. Both Merrill Lynch and Morgan Stanley recently increased their GDP growth forecasts from 6.0% and 5.9% respectively to 6.5%.2, 3 Following the December stimulus, January’s retail sales surprised to the upside. Following three consecutive months of declining month-over-month (m/m) sales growth, retail sales increased 5.3% m/m, significantly outpacing the 1.1% increase expected by the market.4 This unexpectedly high level of demand potentially reflects key differences for this recovery:
- Financial and housing markets remain strong: As such, coming out of this recovery, those with savings and assets are less likely to be cautious about how they spend. This could unleash pent-up demand into the second half as the U.S. approaches herd immunity.
- Fiscal policy highly supportive: With previous rounds of stimulus, there was less expectation that further stimulus will be around the corner. As such, there was typically a greater focus on saving rather than spending. The expectation for future stimulus is a good way of encouraging existing stimulus money into the economy.
- Vaccine distribution provides clear path to ‘normality’: Building on the fiscal stimulus discussion, having a clearer view to when the economy is likely to be more normal is also a factor encouraging people to spend during the final portion of this crisis.
The increased willingness to spend may place the economy in a strong position as the U.S. approaches herd immunity. This factors into the stronger GDP growth expectations and has driven expectations for higher inflation. What we’ve discussed above has the potential to contribute to demand pull inflation. This type of inflation is preferable as higher prices are being driven by increased demand for goods and services outweighing supply – thus reflecting improvement in the underlying economy.
Within the current environment there is also the potential for some cost-push inflation. Global manufacturing activity has recovered its pandemic-related losses and by November 2020, merchandise trade volumes were 1% higher than their prior year levels. This resulted in a surge in commodity demand, pushing up commodity prices.5 The Bloomberg Commodity Index is currently at its highest level since mid-2018 with WTI crude oil prices back at levels last seen at the end of 2019 while copper is at its highest level since 2011.6 Higher commodity costs feed through into higher production costs. This is especially true for industrial commodities such as copper.
Due to the pandemic-driven nature of the current crisis, demand for goods has held up while demand for services remains weak. The strong demand for goods is helping to drive a global manufacturing led recovery. This has boosted demand for raw materials as well as intermediate items including semiconductors while stretching the capacity of freight and logistics system.7 Restoring services spending in the second half has the potential to create an environment with strong demand and some higher input costs.
The big unknown remains the employment situation. Within the U.S., more than 10 million people remain unemployed. This slack in the economy should weigh on inflation expectations. However, given that majority of these jobs are in the service sector, especially leisure and hospitality, there is the potential that strong demand in key pandemic affected areas, such as travel and restaurants, may remove this slack sooner than initially expected.
Into March and April there is the potential for a spike in year-over-year inflation driven by the deflationary pressures reflected in the prior year’s data. However, supply constraints could result in higher prices into the second half of 2021 as demand comes back online.8 While we expect higher inflation into the second half, we do not at this stage expect rampant inflation. Rather, we are expecting the higher prices that come with a recovery in demand.