David S. Lynch, CFA Senior Vice President, Chief Investment Officer
The mainstream bond market also took notice, but only fleetingly, as the 10-year Treasury briefly rose above 0.70%; yet it is now back at 0.66% as of August 24. Thus, though inflation is potentially a threat in the future, there are no indications that it is a primary concern of the market right now. A reliable vaccine, of course, could lead to a sharp economic recovery and robust reflationary pressure. However, absent that vaccine, traditional demand-driven inflation caused by a roaring economy does not appear to be a significant risk in the foreseeable future.
Milton Friedman posited: “Inflation is always and everywhere a monetary phenomenon”. This may well be true, but it is also not only a function of the raw availability of money. There needs to be steady uptake and multiplication of that money across the fractional reserve borrowing and lending system. The Fed is pumping money into the banking system and continues to provide liquidity. However, that money is not (yet) being sufficiently multiplied with the sustained appetite for borrowing, spending, lending, and economic activity that is necessary to generate meaningful inflation. In any case, traditional “roaring economy” inflation is more easily managed with interest rate hikes and the relatively well-known monetary policy tactics. The Fed would be glad to have some inflation to deal with if it meant the economy had returned to health. In any case, they are also likely to allow inflation to overshoot their typical 2% target for a time as they move toward targeting “average inflation” rather than their historical vigilance toward capping inflation at 2%. This regime shift is expected to get additional airtime at the Fed’s upcoming (virtual) Jackson Hole conference.
Weaker demand in the near term does not rule out inflation resulting from currency weakness or general loss of confidence in US dollar assets because of fiscal looseness or poor handling of the virus generally. Also, input costs could rise if certain supply chain bottlenecks develop as de-globalization starts to gain traction alongside expensive COVID safety measures, even without broad economic health being in place. These kinds of inflation would be harder to manage with the usual methods since interest rate hikes would stifle a fragile economy while also raising debt service costs for the US government.
In conclusion, like many portfolio management challenges in which there is no simple answer, the prescription remains to stay diversified across asset classes and risk factors. A more sustained increase in inflation could drive bonds out of favor (although also potentially allowing for reinvestment of maturities at more favorable yield levels). In the meantime, international equities and US multinational companies with sizeable overseas exposure (which could benefit if dollar debasement becomes a deeper issue) as well as non-traditional holdings such as gold can all serve as a general buffer against outlier events and continue to make sense when held alongside liquid, core holdings in US equities and bonds.
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