Prices are increasing at a pace not seen in decades!
Many drivers of higher prices appear to be transitory.
Potential for inflation to remain elevated beyond 2021.
THE GREAT REOPENING
Following a year of quarantine, many Americans are looking to make up for lost time this summer. Early evidence of a reopening boom can be seen in our own backyard with Sarasota Bradenton International Airport breaking all-time passenger records in consecutive months.
As the reopening accelerates, the big question is whether supply can keep pace with demand. In the short-term, the answer is NO.
Figure 1 shows that the year-to-year change in the Core Consumer Price Index, which measures changes in prices paid for a basket of goods and services, rose to levels last seen in 1992. If inflation continues to grow at the pace seen in May, the Fed will be forced to raise interest rates before the labor market fully recovers.
Fortunately, the Federal Reserve expects the recent surge in inflation to prove transitory. Details from the May inflation report support this view. Over half of the rise in inflation can be attributed to a few reopening-sensitive categories (Figures 2-4). These price gains were driven by short-term supply limitations, rather than a structural increase in long-term demand.
Early evidence of supply catching up with demand can be seen in the price of lumber. While still elevated relative to history, lumber prices have fallen 50% in the last six weeks (Figure 5).
Additionally, both Ford and GM expect the impact of the global semiconductor chip shortage to ease in the second half of the year. This is consistent with recent Federal Reserve manufacturing surveys. Current delivery times are at record highs, but surveys of expectations for future delivery times are within their normal ranges (Figure 6). This suggests that many of the supply-chain constraints that have plagued the reopening should sort themselves out by the fall.
While many of the current supply/demand imbalances should ease by the end of the year, others will take more time to resolve. The most significant of these areas is housing. Between 1959 and 2005, there were an average of 1.5 million new housing units started each year in the United States. Since 2005, the average number of new housing units has fallen to 1.1 million (Figure 7).
Given the tepid pace of new construction over the last 15 years, housing inventories are at historically low levels (Figure 8). We are not looking for inventories to recover anytime soon. Freddie Mac recently estimated that the U.S. has a housing supply deficit of 3.8 million units!
Demand for housing should continue to outpace supply for the next few years, keeping upward pressure on home prices. With shelter being the largest component of the Consumer Price Index, above-average inflation could linger even after pandemic-related supply constraints fade.
(For more on the pandemic's impact on demand for local real estate see: Is Everyone Really Moving to Florida?)
The Federal Reserve will let inflation run above their 2% target this summer with the expectation that many supply-chain issues resolve themselves by the fall. If higher inflation persists into 2022, the Fed could be forced to hike interest rates next year.
This would put upward pressure on interest rates and weigh on the performance of bonds with longer maturities. For this reason, Allegiant has tried to limit clients’ exposure to long-dated bonds. Given the current economic backdrop, we prefer taking credit risk (i.e. lower-rated bonds) rather than interest-rate risk (longer-dated bonds).
Yes, recent inflation headlines have been scary, but as an Allegiant client, there’s no need to worry. Our comprehensive team takes inflation and other macro risks into consideration as we construct and manage your portfolios.
240 South Pineapple Avenue, Suite 200
Sarasota, Florida 34236
Telephone (941) 365-3745
Toll Free (800) 926-5237
Advisory Services offered through Allegiant Private Advisors, LLC, a Registered Investment Adviser