The Road to Inflation

Market Perspective, July 2021

The financial markets again demonstrated resiliency in May despite global economies undergoing major structural changes. The pandemic may have forever altered economic activity and consumer behavior. Although investors have enjoyed unexpectedly spectacular returns since April 2020, the aftereffects of the pandemic are still unfolding. Unprecedented fiscal and monetary stimulus has clearly shortened the recovery time, creating a post pandemic boom. However, this new paradigm has rekindled concerns about an overheated economy and an inflation breakout. While policymakers have played down inflation risks as “transitory,” a new era of inflation may have been spawned. The green shoots of inflation have started to sprout with labor shortages, supply chain bottlenecks, product scarcities, and transportation woes combining with soaring commodity prices. Many prognosticators believe the current inflationary pressures are temporary, but the road to inflation may offer investors a bumpy ride in the coming months.

Trending Topics

Inflation currently appears on most investors’ radar screens. The surprise 4.2% gain in March consumer prices represented a warning sign that infla­tion may be gaining traction in the global economic system. The stag­gering borrowing and spending pro­grams passed by Congress and the Fed’s near-zero interest rate policies have created historically elevated as­set prices and investor enthusiasm.

History can present a formative guide of future trends. Many of to­day’s economists and strategists did not live through the Great Inflation era of 1966-1982. With the passage of President Johnson’s Great Society Program and the beginning of the Vietnam War, U.S. inflation hit 3% in 1966. However, it took only three years for inflation to spike to 5% and double-digit inflation struck only five years later. The real concern is that the Great Inflation era could re-emerge. Once inflation becomes imbedded in the economy, it can be extremely dif­ficult to bring under control.

Another impactful trend that may not be priced into the markets is the ex­ploding U.S. debt crisis. What seems quite unsettling is the fact that the cur­rent budget of $4.8 trillion will balloon 25% (to $6 trillion) in 2022 while the White House forecast for GDP growth is only 2.2% in 2023 and below 1.9% for the next eight years. Any government or organization that is adding 25% to spending while their growth rate is a meager 2% will eventually run into fi­nancial trouble.

Exhibit 1 illustrates performance for various indices in May and YTD.

Economic Update

The U.S. economy is increasingly be­coming a victim of its own success. De­spite dire predictions during the onset of the pandemic, economic activity has surged over the last year. The adjust­ments made in anticipation of a pro­longed downturn have since become a hindrance to further growth and a key contributor to inflationary pressures.

The manufacturing sector has been especially vulnerable to the confluence of these circumstances. According to the ISM, activity in the sector rose to 61.2 in May, up from 60.7 in April. Though this is a very positive sign, it masks significant issues affect­ing U.S. producers. While new orders neared a 17-year high, de­livery times have increased to the longest since 1974 as the industry grapples with shipping delays, a labor shortfall, and raw material shortages. Until these issues are resolved, manufacturers will likely continue to lag behind their full potential, despite the strength of the overall economy.

A similar phenomenon seems to be affecting the housing sector as well. New single-family home purchases declined 5.9% in April to an 863,000 annualized rate, according to the U.S. Census Bureau, down from a 917,000 pace in March.

Higher prices have throttled demand while surging lumber prices and the labor squeeze have spurred construc­tion backlogs. The median sales price jumped 20.1% to $372,400 from a year earlier. Homes which have been sold and are awaiting construction (the housing “backlog”) rose 16.5% from March to 325,000, the highest reading since 2006. These factors help quan­tify the 13.2% annual jump in the S&P CoreLogic Case-Shiller index of prop­erty values.

High Yield Market

The high yield market showed its resiliency in May despite robust sup­ply, mutual fund outflows, and eq­uity volatility. The average of the five major high yield indices rose 0.31% in May, bringing the year-to-date return to 2.48%.

Performance by credit rating contin­ued to show a bias toward lower-rat­ed credits in May, though to a lesser magnitude than in previous months.

Exhibit 2 highlights performance by rating for the ICE BofA U.S. High Yield Index (H0A0), showing the outperfor­mance of CCC-rated bonds.

Capital preservation has been para­mount through the first five months of the year. According to the H0A0, price appreciation has contributed -2 bps to the index return while coupon income has generated 233 bps of the 2.31% year-to-date index return.

The high yield bond issuance ma­chine remained in high gear in May as 73 new bonds priced totaling $49.2 billion, the ninth highest monthly volume total on record, according to JPMorgan Research. Year-to-date is­suance now stands at $257.2 billion, a 64% increase versus the same period last year.

The JPMorgan U.S. high yield de­fault rate declined 59 bps in May to a 15-month low of 2.58%. This level is now 359 bps lower year-to-date and is indicative of a trend of improving corporate fundamentals. High yield upgrades now outnumber down­grades by a magnitude of 2.2 to 1.

The leveraged loan market outper­formed high yield bonds in May as strong retail inflows and CLO origi­nations coincided with light new issuance, driving prices higher. The S&P|LSTA Leveraged Loan Index rose 0.58% in May, bringing the year-to-date return to 2.90%.

Leveraged loan issuance declined in May to the lowest level of the year with just $47.4 billion of gross issu­ance coming to market, according to JPMorgan Research. Despite the light primary activity in May, year-to-date issuance of $423.2 billion has eclipsed full-year 2020 volume of $421.6 bil­lion. Year-to-date net issuance of $148.1 billion is 139% higher than the same period in 2020.

Market Outlook

Over the last 14 months, the pandemic recovery trade has proven to be a win­ning strategy. Currently, the markets seem to be counting on the Federal Reserve successfully navigating an un­charted monetary course. The Fed’s traditional tools to manage financial cri­ses include reserve requirements, open market operations, and the discount rate, and have now been revamped into different mechanisms.

Today, the Fed is relying much more on its interest on reserves rate (IOR) and bal­ance sheet bond purchases for imple­menting policy, rather than its histori­cal use of open market operations. The central question is whether the Fed will keep current monetary policies in place too long. Once a spike in inflation occurs, it may be more difficult to contain.

The next key question that needs to be addressed is: how will the markets react to a change in Fed policy? If the Federal Reserve is forced to taper its $80 billion per month buying program while simultaneously raising interest rates by even a small degree in order to combat inflation, the market may suffer a bout of volatility as it readjusts to the new economic reality.

The transformation of the global econo­my may suffer from continued labor and product shortages. However, we expect a renaissance in U.S. manufacturing as more companies build new production facilities in the United States in order to reconfigure their supply chains.

The markets may be underestimating the threat of an inflation breakout. While the global economy will likely show sig­nificant growth over the next few quar­ters as normalcy is restored, the lever­aged finance markets should serve as a ballast compared to the over-inflated public and private equity markets.

Legal Notices & Disclosures

All charts and data are for illustrative purposes only.

Views expressed herein are drawn from commentary provided to Harbor by the subadviser, Shenkman Capital Management, Inc., and may not be reflective of their current opinions or future actions, are subject to change without prior notice, and should not be considered investment advice. The information provided in this presentation is for informational purposes only.

The information provided in this article should not be considered as a recommendation to purchase or sell a particular security. The weightings, holdings, industries, sectors, and countries mentioned may change at any time and may not represent current or future investments. Performance data shown represents past performance and is no guarantee of future results.

Shenkman is an independent subadviser to a Harbor Fund.

*Redistributed with Shenkman permission.

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