Inflation and Economic Growth Aren’t Transitory

Central banks are curtailing their pandemic stimulus measures, and investors need to assess how that will affect different investments. As expected, the Federal Reserve announced that in November it would begin reducing its monthly asset purchases of $120 billion with the goal of eliminating those extra asset purchases by June 2022.

That doesn’t mean the Fed will engage in a true tightening by draining money from the economy or raising interest rates. Those actions aren’t likely until late 2022 or early 2023, depending on the economic data. Most assets benefited from the additional liquidity the Fed has been pushing into the economy, but some benefited more than others.

The investments that benefited the most are likely to lag as Fed policies change. U.S. stocks were the big winners of the monetary stimulus, but growth stocks in general and three market sectors, in particular, did better by far: technology, communications services and consumer discretionary. Technology stocks did so well that the sector has grown to its highest percentage of the S&P 500.

Also outperforming were the so-called story stocks and meme stocks, the companies with little or no earnings but high market valuations. There’s little or no margin of safety in these top performers. Also, a lot of their outperformance was due to the excess money created by the Fed gravitating to them. They’re likely to be hurt as the Fed reduces the extra liquidity. That’s why our portfolios are focused on investments with growth potential but higher margins of safety.

The economy remains very strong and has significant momentum. The change in monetary policy won’t curtail economic growth significantly any time soon. Growth is likely to slow a bit, but it will be healthy. Inflation’s also going to remain elevated for a while. There are supply chain problems, but shortages of workers and goods are only part of the problem.

The real problem is very high demand. The pandemic stimulus measures exceeded the income households and businesses lost during the crisis. On the whole, balance sheets of both households and businesses are in much better shape than before the pandemic. Wage and salary increases are at multi-decade highs. That, plus strong balance sheets, will keep demand strong for goods and services. A review of the data reveals that the production of many goods exceeds pre-COVID-19 levels.

Even so, businesses struggle to meet demand. Increasing supply often requires significant investment capital and takes time, often years. Demand that exceeds supply will push prices higher. There were some anomalous price increases, such as for used cars.

Those largely are resolved or being resolved, and that will reduce the monthly inflation data a little. But inflation will remain elevated until supply increases substantially to meet demand.

In the decades before the pandemic, inflation was kept below 2% because of deflation in commodities and finished goods. We won’t see that again any time soon. Shortages of goods and commodities will continue. Inflation for services was high before the pandemic, and that’s going to continue.

Of course, this outlook isn’t set in stone. It always could be altered by wars, another pandemic, a change in the pandemic, cyber disruptions and other events outside the markets and economy. The Fed also could tighten the monetary supply too quickly and throttle the economy. I think that’s unlikely. The Fed wants to lag the economy and avoid disrupting growth.

Yet, when I look at market prices, they say most investors expect we’ll soon return to a repeat of the pre-pandemic economy: low inflation and moderate growth. Investors also seem to expect a continuation of high profit margins and rapid earnings growth. The markets seem to view the changes of 2021 as temporary, caused by one-time events that will be re- solved fairly quickly. I think they’re more long-lasting, and that should be reflected in your portfolio.