Assuming all goes to plan, the US economy is about to get another huge cash injection. American president Joe Biden’s $1.9trn stimulus package, which looked set to become law this week, includes an extension of nationwide unemployment benefits alongside $1,400 cheques being sent to most American adults (the payments are means-tested, but the thresholds are well above the average US income). As Bloomberg notes, the scale of the stimulus has seen various analysts upgrade expectations for US growth this year, from already high levels. Investment bank Morgan Stanley reckons growth will now hit 7.3%, a level unseen since 1951, while the OECD group of wealthy countries “doubled its own estimate” to 6.5%.
The payouts are undoubtedly popular with the electorate, with strong support regardless of political persuasion (voters are split on lots of topics, but free money doesn’t seem to be one of them). However, the big question for investors is: will the stimulus combine with huge levels of pent-up demand to create an inflationary surge once Covid-19 is truly behind us? And will that surge be more than temporary? And if so, what might that mean for markets that have grown used to disinflation?
How much is too much?
On the inflation point, there are signs of nerves even among those who wouldn’t traditionally be viewed as overly cautious on public spending. For example, economist and Bill Clinton-era Treasury secretary Larry Summers reckons the stimulus goes “way beyond what is necessary”, meaning that “we risk an inflationary collision of some kind”. Economist and opinion columnist Paul Krugman on the other hand, who debated the topic with Summers in a Princeton University-hosted video call last month, basically conceded that while it’s possible, inflation is not as big a risk as Summers fears – and in any case it’s worth a shot to shore up the economic recovery.
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As Paul Ashworth of Capital Economics makes clear, no one really knows the answer. Economists favour a concept known as the “output gap” to try to put a figure on how far an economy is from running at full capacity. But it’s always been a controversial measure and it’s of virtually no use in helping anyone in practical terms (in other words, it’s useful for justifying decisions on a spreadsheet after they’ve been made, but hopeless in terms of predicting inflation).
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One thing, however, is for sure. Due to a combination of earlier stimulus packages and extended benefits, US “households have a lot of money set aside that could boost consumer demand later this year”, says Ashworth. As Chetan Ahya at Morgan Stanley points out in the Financial Times, “US households have lost $490bn in income, but received $1.3 trn in transfers”. That’s all before the latest stimulus.
From an investor’s point of view, the concern about inflation at this stage is that it might make central banks – led by the US Federal Reserve – tighten monetary policy. The Fed keeps arguing that it will let inflation rise above the 2% target level, with its main focus now being a return to full employment. However, Ahya argues that the risk is “inflation could overshoot the overshoot level the Fed is comfortable with”. That might force the Fed to act more quickly than it currently expects, which could hit markets hard.
Great Rotation, then Great Inflation?
We’ve already seen bond yields rising and tech stocks falling this year, but so far it all falls into the category of a “rotation”. Investors are selling the assets that were popular during the long slide in interest rates and the low-growth era that followed the financial crisis. They’re now shifting that money into stocks that should benefit from stronger growth and rising inflation. In other words, as an investor, you shouldn’t panic. The tech-heavy US Nasdaq index has had a tough year, because it’s the home of all the most expensive and popular stocks over the past year. But the broader-based S&P 500 has gained over the year, while the more value-focused FTSE 100 in the UK has outperformed both (if only a little).
What of the longer run? So far, markets only seem to be pricing in a return to something approaching “normal”, rather than a long-term rise in inflation. However, with central banks likely to be highly reluctant to tighten monetary policy and risk crashing the economy, we suspect that longer-term inflation might well be what we get. If that’s the case, bonds will struggle (though they may be propped up by various “financial repression” strategies – such as regulations forcing pension funds to own them, for example) first. Stocks will probably be fine up until inflation hits about 4% (and the UK markets is likely to do better due to the high weightings towards financials and commodity stocks). But if inflation really does take off, it would be wise to be holding some commodities and specifically, some gold.
