The Perspectives Podcast
Inflation:
How high for how long?
With
Candace Browning,
Head of BofA Global Research
Chris Hyzy,
Chief Investment Officer,
Merrill and Bank of America Private Bank
And Ethan Harris,
Head of Global Economics
BofA Global Research
Please see important information at the end of this program.
Candace Browning: Following a very long period of fairly stable prices, Americans are now experiencing the sharpest rise in inflation in decades. Now, while we aren’t seeing the double-digit inflation rates the country faced back in the 1970s and early 80s, Americans are paying higher prices for just about everything -- from groceries and gas to cars and computer chips.
So what’s triggered inflations return after such a long lull? And what might it mean for how we save, spend and invest for the future?
Hello and welcome to this edition of the Perspectives podcast. I’m Candace Browning, head of BofA Global Research. Today’s program is all about inflation and what it could mean for us as consumers and investors, and as workers and retirees. We’ll look at the factors driving it higher and what could it take for inflation to get back to “normal.” We’ll also consider what inflation could mean for our financial lives and offer steps that you could take now to prepare for what could come next.
Joining me for this conversation are Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank.
Chris Hyzy: Hello, Candace.
Candace Browning: And Ethan Harris, head of Global Economics for BofA Global Research.
Ethan Harris: Hey, Candace.
Candace Browning: Ethan, let’s start with you. The U.S. inflation rate soared in 2021, clocking in at the highest pace in about 40 years. What’s your take on what’s going on here and could these higher prices be with us for a while?
Ethan Harris: Well, this is really a perfect storm in the inflation picture. You have a combination of very strong spending running up against limited supply of goods and services. On the demand side, you’ve had very aggressive fiscal policy with repeated waves of new government stimulus coming into the economy. You’ve also had a zero interest rate policy from the Fed, and the combination of those two along with the reopening of the economy is creating very high demand and putting pressure on markets.
On the other side of the equation, the COVID crisis and the very high demand for goods is creating shortage issues, shortages of workers, shortages of components. And so when you put the two together, you’re looking at very high short-term inflation.
Now, we do expect inflation to come down. We don’t think we’re going to be at the kind of 7% level or so that we started the year forever, but it’s going to stick a bit. It’s going to take a while and people should get used to the idea that the very low inflation of the past is not coming back.
Candace Browning: Chris, there are growing concerns over both inflation and rising rates, and that has triggered a huge bout of volatility in the markets recently, both in stocks and bonds. So what do you make of that market reaction and what do you think is most important for investors to stay focused on, especially if this volatility continues?
Chris Hyzy: Yes, Candace. I think it’s quite fascinating to watch the different markets and how they discounted whether inflation was coming or not, initially, what they’re doing about it now and what they’re signaling about it for tomorrow.
This year, there is significant repositioning going on in terms of what you own to protect against inflation or benefit from pricing power and that has increased volatility because a good portion of the growth part of the market, which has been owned for the better part of the last 10 years, tends to be pressured when rates go up and there’s a recycling of money going from the high-growth areas to the higher-quality, more value-oriented areas of the market. That’s number one.
In the bond market, the longer-dated areas of the bond market, the 10-year and up space is basically still signaling that inflation in the long run is still not an issue. But yet the shorter-term measures are signaling it is.
So what should we stay focused on? This is a word that is so often discussed but sometimes not practiced, and that’s diversification. We want to have our highest level of diversification across assets at this stage of the cycle, move towards higher quality investments, whether that means good balance sheets, high cash companies, areas that can have pricing power, areas that are of good value and ultimately are not as harmed by rising rates. And in areas where there’s extreme weakness in the equity markets, use weakness as an opportunity to reposition and rebalance portfolios, not just exit and move to the side lines.
Candace Browning: So Ethan, going back to you, what the Federal Reserve does from here is obviously going to be key and it’s a very delicate job. They need to get inflation under control but in a way that doesn’t derail the economic recovery or put a damper on the job market. Do you think they can actually achieve both of those goals? Or does tighter monetary policy mean some slowdown in economic growth is actually ahead?
Ethan Harris: Well, I think the Fed has some catching up to do here. This has been going on for months now, these very high inflation readings, and they did not move very quickly at all in this cycle. Our guess is that the Fed will end up hiking at each meeting this year and then hike a few more times in 2023. That would mean a gradual containment of some of this pressure in the economy.
We think the economy is going to be fine for 2022 but as the Fed keeps going here, depending on how hard they hit the brakes, 2023 should be a weaker growth period and, indeed, you can’t 100% rule out a recession down the road. So it’s a cycle where the Fed at least initially is only a modest constraint on activity but eventually could become a serious constraint.
Candace Browning: So Ethan, if you think about inflation as being too many dollars chasing too few goods. What about supply chains coming back and the physical side of inflation? What should we be looking at and tracking on that side?
Ethan Harris: Well, it’s extremely important for the inflation outlook that supply chains reengage. We need to get more people back to work as they have less fear of getting COVID on the job. We need to fix these supply chain issues around shortages of components, shortages of transportation capability. Those should improve over time. It’s not going to happen in a few months. It should be over the course of a year or so. That is very important to getting inflation down. The Fed can’t really do it on its own. It needs some help from an improving supply of goods and services.
Candace Browning: Chris, we also have midterm elections coming up later this year, and the outcome of those could potentially change the political make-up in Congress. How important do you think inflation could be at the ballot box?
Chris Hyzy: Yeah, there are a number of recent surveys that suggest it’s either number one or number two as it relates to the importance level. You see that in focus groups. You see it out there in the market already, so certainly we’ll be watching that very closely.
I think also important is as inflation peaks out, at what level does that come down and start to bottom out at? What does that mean for the average voter or the citizen out there? It could mean that wage growth stays below the level of inflation. In other words, negative personal income or negative purchasing power, even though wage growth is picked up. That’s something to watch very aggressively and will likely be a very strong topic as we move towards the midterm elections.
Candace Browning: So Chris, you mentioned the average voter or the average person. Let’s take a closer look at what all this could mean for our financial lives.
Ethan, I’m particularly interested in where food and energy prices could go next, as well as housing and so-called shelter costs. Do you think that those areas are going to take larger bites out of household budgets as we go forward?
Ethan Harris: Well, I think the main shock from higher food and energy has already happened and it has been quite painful for low-income households. Food and energy is an extremely important part of their budget. I do think that things will settle down a bit in those areas. That will help take some of the burden away from low-income households.
On the other hand, if you talk about rent, rents are on a pretty strong upward trend and it’s going to be very hard to cool down the rental market. It takes a long time to build new, construct new apartment buildings, so rents could be quite strong for quite a while. So it’s a mixed picture going forward with continued pressure from the rental market.
Candace Browning: Chris, how do you see corporate profits holding up in this environment? Are there particular sectors or industries that tend to fare better when prices are rising – and maybe others that struggle?
Chris Hyzy: Yes, Candace. This is another very interesting area. There are a lot of different elements at play here as we move through 2022 that are different than last year and even 2020. As we move into ’22, pricing power is evident in some sectors and industries, particularly energy. Some parts of materials, some parts of industrials. But trying to pass it on further is starting to pressure some other areas like restaurants, retail in general, and those industries that have high labor components because of wage growth.
But when you roll it all up, we’re still noticing that margins are hanging in there. Corporate profits are still strong. We are noticing, however, a little bit of estimate revisions just slightly lower than where guidance was just about a month ago. So we’re noticing the fact that potentially later this year, margins could start to contract.
Candace Browning: Ethan, let’s talk a little bit about wages and job growth. What does inflation mean for wages and job growth? Is now an ideal time to ask for a raise?
Ethan Harris: Yes. That was the title, actually, of one of our weekly pieces. Yeah, the labor market is strong. We’ve had a little bit of a hiccup around some of these omicron and other COVID waves. But job growth is fundamentally strong and will continue to be strong through the rest of the year. You have a worker shortage that’s only going to be partly alleviated by workers coming back to the job market, and so workers’ wage negotiating power should remain strong.
So while wages may not be growing quite as fast as they have at the start of the year, they’re still going to remain above normal levels. We’re kind of in that later part of the cycle where with low unemployment, workers get a little bit better negotiating power, and so that means low unemployment rate and solid wage growth.
Candace Browning: Ethan, can you talk a little bit more about the labor market and particularly all the people who are still on the side lines in the labor market and the quit rate? How important is getting those people potentially back into the labor force for bringing down inflation?
Ethan Harris: Well, the labor supply picture is very mixed. You have a good chunk of people who’ve left the labor market on a permanent basis. You had a lot of early retirements for households that had strong wealth holdings and could afford an early retirement. You’ve had some two-earner couples where one member of the family has decided to stay home with the kids.
So there is a permanent component to some of this abandonment in the job market. But there’s also another group that is basically waiting for the go signal. They’re waiting to see that they’re comfortable with the effectiveness of the vaccine, the reduction in the number of cases, and they’re ready to go back and reengage. That effect is very important for these sectors with tight labor market conditions. So we really need to see those workers come back if we’re to avoid even more wage and price pressure.
Candace Browning: Chris, you heard Ethan mention retirements and that there were a number of early retirements. How does what we’re discussing here affect people who are nearing retirement and the value of their earnings over time and their savings? Could rising interest rates potentially be a good thing for people who rely on bonds for some of their income?
Chris Hyzy: It’s a fascinating topic, interesting by itself, but in regard to this cycle, it’s even more important. In terms of retirement and the value of savings over time at this juncture, what we’re noticing is twofold. We’re still on the front side where inflation has yet to peak. The response by the central banks, not just the Federal Reserve but others around the world, is you could call it soon to be, if not now, a synchronized tightening cycle.
And what we’re witnessing is the beneficiaries of that are still the areas that have been traditional beneficiaries: equities because of rising revenues through pricing power and then ultimately, operating leverage is still good. You get better profits, and there are specific areas of equities that are doing better than others.
But to your point, Candace, the benefit to savers and retirement income down the line when ultimately the hiking cycle gets halfway through, the longer dated interest rates start to slow down. The yield curve begins to flatten, and ultimately, you can start to move towards longer duration securities which tend to have more retirement income in them. And that’s where you start to benefit from higher yields, whether it’s your cash allocation because now you’re getting a higher yield than zero, or it’s longer-dated bonds. We’re still on the front side but as we get closer and closer to ’23, retirement and savers in particular should benefit better then than they do today.
Candace Browning: Chris, last question for you. If a higher inflation is with us for a while longer and it sounds like it will be, does it call for a change in how we approach things like asset allocation and diversification? And are there steps that we as investors should take now to help offset some of these long-term effects?
Chris Hyzy: You always start with your plan. There should be no change to that. What are you trying to achieve. If you know your objectives and you know the kind of investor you are, then you could have a much, what I would call it a more robust asset allocation designed for that.
Now, as inflation stays a little higher, it might mean increasing your risk a little bit — coming into more dividend growing equities within the equity space. So I think no change to how you think about investing or your objectives or the diversification elements, but certainly adjusting your risk profile while you’re still on the front side of the inflation dynamic should be considered.
Candace Browning: Well, great. Thank you. I think that’s really good advice to close with, so Chris and Ethan, thank you both for joining me in this conversation.
And thank you all for tuning in to this edition of the Perspectives podcast. My co-hosts have been Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank and Ethan Harris, head of Global Economics for BofA Global Research.
I’m Candace Browning, head of BofA Global Research.
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