Investor Michael Farr: Inflation worries are mounting, however the markets could nicely have a brilliant future

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After a wild last week of a volatile month, it is becoming increasingly clear that something is terrifying investors. That is the potential for inflation to rise later this year.

Investors are rightly concerned that the combination of the Fed’s continued rate cut and trillions of additional fiscal stimulus will result in a surge in pent-up demand that exceeds the supply of discounts to airfare. The evidence for this possibility is mounting.

Longer-term rates have risen sharply, and the 10-year return has increased from around 0.91% at the start of the year to around 1.40% today. The prices of raw materials have also risen. The Invesco Deutsche Bank Commodity Index is up 14% this year, with critical engines of economic growth such as oil, copper and steel rising.

We are seeing a long overdue rotation in the stock markets. The high-growth, high-P / E stocks, which are benefiting the most from low interest rates, have started to decline in recent weeks, while companies operating in COVID-affected industries have seen a surge.

Fears of inflation realized?

Investors have been afraid of inflation for 25 years, and it hasn’t. That’s all?

The Fed certainly doesn’t think so. Federal Reserve Chairman Jerome Powell and other Fed members went to great lengths to convey their belief that 1) changes in inflation take time to develop; 2) A rise in inflation related to the reopening of the economy is likely to be temporary. and 3) given numbers 1 and 2, the Fed will not be alarmed by the temporary spike in price levels expected later this year.

The much more important consideration regarding monetary policy, according to the Fed, is the fact that up to 10 million people are working less than before the arrival of COVID. It’s hard to argue with that, especially when inflation has been so tame for so long.

What do i think will happen?

I see the potential for price increases, especially for services, as consumers gain the confidence to spend some of the record savings accumulated over the past year. I also see the potential for a wave of business investment after an extended period of investment postponement.

But I tend to agree with Powell that we won’t see a return to 1970s inflation.

Rather, I think we’re likely to see a temporary spike in price hikes that is more indicative of a “snapback” than something more consistent. It will likely exceed the Fed’s target at certain points, but I expect it will settle in an acceptable range.

Where do equity investors stand?

But even if I’m right, that doesn’t mean stock investors should start securing the truck.

It is true that equity investors can count on the continuation of accommodative monetary and fiscal policies for the foreseeable future.

Equity investors have been encouraged by this support since the global financial crisis, and there is no clear end in sight. However, equity investors need to be aware of the substantial spike in expectations and the potential for disappointment if rising earnings estimates are not met.

The earnings estimates for the S&P 500 have increased every month since the middle of last year. According to current consensus estimates, the S&P 500 earnings are now expected to grow at an average annual growth rate of nearly 8.5% from the previous 2019-2023 high.

This is well above the long-term historical average of around 7% and well over twice the expected growth rate of gross domestic product in this period. It’s like the pandemic never happened.

I have concerns that rising raw material costs, labor costs and interest rates associated with the reopening of the economy could reduce profit margins and make these estimates very difficult to achieve.

Given that today’s high stock valuations are based on those aggressive earnings growth projections, it wouldn’t surprise us to see a revaluation in the months ahead.

This kind of change is making Wall Street nervous, and it should be.

How things can develop for the economy

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The economic and market script is as follows:

  • Current and proposed government incentives will keep the US economy cash for the next year or two or three.
  • Consumers have higher savings and have dry powder for additional expense. You’ll get even more cash in the next stimulus deal from DC.
  • Successful vaccines will result in a recovery from normal activity, which is also likely to generate a lot of money in motion. This increase is expected in August.
  • This increase in social and spending pace is likely to result in a temporary rise in inflation.
  • The Fed and Treasury Department will avert their eyes and whistle loudly to ignore the warning clauses and detract from the calm demeanor of their usual pilot.
  • Unemployment will decrease in part for al fresco dining and other fair weather activities, but not so much that full employment is achieved or wage inflation occurs. Unemployment and wage inflation are the Fed’s hot buttons.
  • The situation is expected to calm down in the autumn months and the spike in GDP growth in 2021 will approach the old rate pattern of 2% over the past decade.
  • Stocks couldn’t imagine a more dreamy scenario. More state cash plus a central bank committed to low interest rates plus a consumer with cash willing to spend plus a reopening of closed and closed stores.
  • Perfect! Right?

Happily ever after?

Maybe that’s how the world works. If not, it’s hard to see what could be hard to derail so much positive drive. But I’ve seen too many plans not to be missed.

Although I doubt the script I have enumerated will work perfectly, the balance sheet for the next year or two looks positive. Is $ 30 trillion in debt a problem? Yes, at some point, but maybe not quite yet. Debt servicing costs are still manageable with a 1.5% return on 10-year treasury bills.

Ultimately, the monetary and fiscal stimulus of recent years has not led to increased demand and thus increased inflation. It may be almost ready to pop, but time will tell. If it pops it is expected to be temporary.

The key is the consumer and the consumer faces high unemployment and low wage increases. After the restart, GDP growth should return to 2% in the longer term.

This is a Goldilocks prediction and I hope it is correct. I remember two children’s stories about little girls who went into the forest: Little Red Riding Hood and Goldilocks. One of them was scary and violent. Let’s get this “happy to the end” after the nicer plot.

– Michael K. Farr is a CNBC employee and the President and CEO of Farr, Miller and Washington.

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