The S&P 500 had its worst three-day stretch since October. But it quickly recovered to close just 1.4% below its all-time high.1 The early week sell-off was likely the result of rising anxiety over inflation pressures. There have been anecdotal reports of price increases for months now, and April's inflation reading seemingly confirmed these.2 Though skewed higher by the low base from April of 2020, CPI came in at 4.2%. Economists had only been expecting a 3.6% increase. Furthermore, nearly all major components of the CPI experienced a substantial uptick.
We expect the burst of inflation pressure in April is fueling concerns that the Fed may be forced to pivot from their ultra-accommodative stance. The committee has maintained that such pressures are likely to prove transitory as the economy returns to a more normal state post-Covid. In their view, price increases are most likely the result of temporary supply and demand imbalances and base effects that will even out as the economy stabilizes. However, we believe there are indeed some signs of more sustainable pressure building.
The employment situation is beginning to present a particular challenge for the path forward. Across much of the country, expanded unemployment benefits may be disincentivizing a return to work. As a result, the unemployment rate remains elevated at 6.1% despite a record number of job openings. To draw workers back in, several businesses have started to increase wages. Traditionally lower-wage industries like food service have had no choice but to raise wages to levels well above what they have been. As a result, earnings on the lower end of the wage spectrum could soon be increasing. This is certainly a good thing on its own but could be a meaningful variable in causing a more sustainable rise in inflation.
Inflation, by definition, is too much money chasing too few goods. Therefore, productivity must keep pace with a rise in income. If business owners cannot increase productivity at the same rate as wages, they are often forced to raise prices. We have not yet reached this wage-price spiral, but we will be watching wages closely over the next few months. If there is sustainable inflation on the horizon, wages should begin to rise sharply.
For the market, inflation is the critical variable. If inflation begins rising faster than what the Fed would like consistently, they will likely be forced to tamp it down. This could be trouble for parts of the equity market and stocks with high P/Es in particular. However, we have worked over the last few months to mitigate the impact of rising inflation on our portfolios and believe we are well-positioned to weather such an environment.
We continue to have our ears to the ground and will pivot as necessary. As always, our focus remains on owning the highest quality companies that we believe are built to withstand all kinds of markets. We make changes on the margin to take advantage of or work towards protecting ourselves from macroeconomic developments.
Preston May, CBE®
1 St. Louis Federal Reserve Economic Data
2 Bureau of Economic Analysis
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