How to Prepare for an Inflation Spike in 2021

Inflation is one of the most important macroeconomic indicators for investors. It is also one of the primary inputs used by policymakers – both fiscal and monetary. Yet, surprisingly, it is one of the least covered topics by the financial media because of its low appeal as a hot topic. This could also be due to the fact that inflation is a primary source of data, meaning these numbers cannot be used as a standalone tool to gauge a measure of where stock prices will be headed in a given time period.

A general increase in the price level of goods and services in a country is not negative, nor is it positive. Given the unprecedented decline in business activities in the first half of 2020, however, an increase in inflation is what policymakers are trying to achieve. If inflation spikes beyond sustainable levels, it could spell trouble for both the economy and stock prices. As part of a portfolio strategy, investors should prepare for the base-case scenario and tactically allocate assets in a way that would tilt the odds in their favor to beat the market this year.

Characteristics of good inflation

Core PCE Inflation, which is used to measure personal consumption expenditure excluding food and energy, fell sharply in the first quarter of 2020 as state governments issued stay-at-home orders to curb the health risks. After bottoming around 0.8%, inflation climbed steadily to over 1.5% on a year-over-year basis in October. As illustrated below, this is still well below the Federal Reserve’s target of 2% to 2.5%.

Source: Calamos Investments

The mobility restrictions were eased off in the second quarter of 2020, which paved the way for an economic recovery that saw job creation once again and the hike in inflation has been driven by fundamentally acceptable factors. More often than not, increasing but below 2% inflation is a very good sign for the economy and stock prices, as such a development is likely characterized by one or many of the below macroeconomic factors.

1. Faster-than-expected economic growth.
2. Job growth.
3. Strong manufacturing growth.

A combination of these developments, in fact, led to the spike in inflation in the second half of 2020, which was welcome news for the market.

The outlook for 2021 is positive, but investors should remain cautious

There are multiple factors driving inflation higher in 2021 as well, including the dovish stance of the Federal Reserve, the trillion-dollar stimulus package and the expected growth in consumer spending resulting from the reopening of the economy. According to Reuters, U.S. household wealth hit a record high of over $123.5 trillion last September, supported by booming stock markets and the cash buffer built by Americans in preparation for the economic crisis. Policymakers have injected a lot of liquidity into the economy as well. In the first half of this year, consumers are very likely to extravagantly spend on discretionary goods because of this strong liquidity position, which suggests inflation will continue to move higher in the short run.

Even though this pent-up demand will help the economy accelerate, not all sectors will be positively impacted to the same degree. For instance, the tourism sector is likely to remain under pressure for quite some time. Oliver Wyman conducted two surveys last year, in May and October, to identify the major reasons that are keeping Americans from traveling. The findings are summarized below.

Source: Oliver Wyman

Results of the second edition of the survey confirm the absolute majority of Americans who are willing to travel will likely delay their planned trips until local infections fall sharply or the availability of a vaccine for them. A massive vaccination program is underway, but experts predict it will take at least until the third quarter for a vaccine to reach the majority of U.S. households. This paints a bleak outlook for the tourism industry even though many companies representing this sector are trading at seemingly attractive valuation multiples.

A guru opens up about inflation expectations

Underestimating the negative outcomes of high inflation is a costly mistake, and Bill Miller believes investors are already committing this mistake. In his fourth-quarter 2020 market letter to Miller Value Partners shareholders, the guru wrote:

“I think the market is likely underestimating the risks of inflation. So far, the Fed’s liquidity provisioning via bond purchases and increasing the money supply have resulted in higher stock prices but not significantly higher inflation expectations. Money velocity remains quite depressed by historic standards. But savings rates are unusually high and, as the economy becomes more “normal” in the second half of the year, it is likely that consumption will accelerate and, with it, money velocity. Lots of liquidity and increasing money velocity could quickly put upward pressure on inflation. Commodities markets have been unusually strong since bottoming in late April and are now considerably higher than they were pre-pandemic. Gold and silver have done well this year and that looks to continue in 2021.”

Miller believes inflation will shoot significantly higher in 2021, but chances are that it will still be within the scope of the guidance provided by the Fed.

Interest rates are likely to remain low despite rising inflation

When inflation increases to unsustainable levels, the Fed moves in quickly to reduce the money supply by adjusting policy interest rates upwards. However, this is only done when there is a risk of hyperinflation. At a time when both fiscal and monetary policymakers are doing their best to revive business activities in the country, it would be very unusual for the Fed to hike rates even if inflation surpasses the statutory target of 2%. The key here is that this target is long-term oriented, so a temporary bump above 2% does not necessarily trigger a decision from the Fed to curb consumer spending.

Asset allocation will be the key to success

Despite the uncertainties regarding the health of the American economy, inflation is poised to tick higher in 2021. Investors need to embrace this reality and tactically allocate assets to design a winning portfolio. Cyclical business sectors will benefit the most from the expected growth in consumer spending. Therefore, investing in the likes of Apple Inc. (NASDAQ:AAPL), Facebook Inc. (NASDAQ:FB), and Amazon.com Inc. (NASDAQ:AMZN) might be a good decision even though some of these cyclical names might appear to be overvalued. The expected growth in earnings warrants a premium for these companies, but a value-oriented investor might want to look for less popular consumer discretionary stocks to invest in.

The energy sector is another industry that could make a strong comeback in 2021 if analysts prove to be too bearish on the prospects of big oil names such as Exxon Mobil Corp. (NYSE:XOM). Wall Street analysts have been very cautious in revising their earnings estimates for most of these companies despite crude oil prices fully recovering to the pre-recession price levels. This has created a strong platform for oil companies to easily beat consensus revenue and earnings estimates, which is a recipe for success. Investing in oil companies that are unlikely to come under pressure from a liquidity perspective is important.

Diversification will also play an important role in 2021. Even though cyclical and energy stocks might outperform the broad market, things could change dramatically if the government decides to impose another lockdown. In preparation for this risk, it would make sense to allocate assets to defensive sectors. As always, the key is to strike a balance that represents an investor’s individual circumstances such as the risk appetite, investment time horizon and return objectives.

Takeaway

Macroeconomic developments often shape the stock market performance and inflation is one of the most important measures of the health of an economy. In addition to internal developments, geopolitical factors such as the escalating trade war between the U.S. and China will determine how fast inflation will climb this year. The positive impact resulting from quantitative easing and fiscal stimulus will likely be partially offset by unfavorable external developments, leading to a meaningful yet sustainable rise of inflation this year. In light of these expectations, investors should tactically allocate assets in business sectors that are likely to benefit from an increase in the general price level in goods and services.

Disclosure: The author is long Facebook.

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