Stocks erased most of the prior week's gains after a string of disappointing economic releases and escalating tensions between the U.S. and China. U.S. retail sales and industrial production registered their steepest declines on record for the month of April, reflecting the full and sudden stop of economic activity. The U.S. administration moved to block semiconductor shipments to Huawei, adding to investor caution. The most recent inflation reading showed a sharp decline in core inflation from 2.1% to 1.4%, the largest decline since 19571. In our view, the impact from the pandemic is deflationary, which implies that central banks will maintain very accommodative monetary policies for the foreseeable future.
Whither Go Inflation?
The S&P finished the week down more than 2%, posting the biggest weekly decline since March, in what has been a robust 27% rally from the March 23 low1. In our view, the market recovery to date has been driven in large part by the unprecedented level of monetary and fiscal support for the economy. However, the size of the federal response has prompted concerns that inflation could spike over time in response to higher-than-average federal debt levels and ultra-low interest rates. While it is likely that inflation rises moderately from current levels, we think that the risk of hyperinflation is low for the following key reasons:
Large-scale federal support is needed to help the economy weather the worst downturn since the Great Depression.
Though a necessary reaction to the biological crisis caused by the COVID-19 pandemic, the economic toll of shutting down nearly all nonessential businesses in the U.S. and the corresponding social-containment efforts is likely to be severe, prompting the worst economic downturn of the U.S. economy since the Great Depression. In order to help the economy weather the economic downturn and support an eventual recovery, the federal government has provided $2.9 trillion in economic relief to businesses and consumers affected by the coronavirus-induced shutdown. The Federal Reserve has also acted aggressively to support the economy during this critical time, providing over $2 trillion in low-cost funding to businesses and consumers. In total, the Federal response to the ensuing economic downturn to date is 14% of GDP and could go higher if new relief measures are passed by Congress. This level of spending compares with just 4% of GDP during the 2008-2009 recession. In addition to the magnitude of the spending, it's also the fastest federal response to any downturn in the post-WWII period.
As a result, the federal deficit is projected to grow to $3.7 trillion in 2020, and the total debt is likely to climb to 107% of GDP, representing the highest level of debt to GDP since WWII1. While the deficit will need to be addressed over the long term, the more looming near-term risk is that the recession is longer and more severe without federal support. Fiscal support can help alleviate enduring impairment of the U.S. economy that leads to widespread business and household insolvency, reduced business investment, low productivity, and persistently high levels of unemployment. It can also help speed up the eventual recovery, which will ultimately lead to higher revenues from a growing economy and lower fiscal debt.
COVID-19 is deflationary in the short term, with inflation likely to increase from low levels as the economy recovers.
Inflation is a general rise in the overall price level of goods and services and is a key concern for investors, because steep increases in the inflation rate can reduce the purchasing power of a dollar and lower the value of investment returns. The unprecedented nature of COVID-19 and the global social-containment efforts to limit its spread to date have both been a shock to demand and supply. However, the more dominant short-term effect has been the hit to demand, as households abided by stay-at-home orders and drastically reduced their consumption of goods and services.
The table below compares a key measure of inflation, the Consumer Price Index, across different time periods. The CPI measures yearly increases in the price level for a broad basket of consumer goods and services, from haircuts, cars and clothing to medical care. In the month of April, headline inflation, which includes volatile food and energy prices, dropped to 0.3% from 1.5% in March. Core CPI, which strips out food and energy prices that can fluctuate dramatically from month to month, dropped to 1.4% compared with 2.1% just a month earlier2. This represents the largest month-to-month decline in inflation on record, driven by the 17% decline in energy prices due to the global lockdown.
This recent data is in sharp contrast to the hyperinflation scenario that occurred in the 1970s, when sluggish growth and an oil shock that spiked energy prices led headline inflation to top 7% and core inflation to rise to nearly 4%2. During this time period, despite relatively lower federal debt, recessions were often triggered by spikes in inflation as the Fed raised interest rates to cool an overheated economy. The Fed actions also helped quell asset bubbles, which can occur when the economy grows too quickly. As pointed out by Federal Reserve Chairman Jay Powell in remarks last week, neither hyperinflation nor asset bubbles are a concern in the economy currently.
Over the past few decades, inflation has remained at moderate levels.
In fact, the Federal Reserve exists to fulfill two mandates – full employment and price stability (also known as moderate inflation). If inflation is too hot, the Fed raises rates to cool down the economy, and if inflation is too low, it cuts rates to stimulate growth in the economy.
Over the past 30 years inflation has been both lower and more stable due to the dampening effects of automation, global supply chains, and improvements in monetary tools and polices. Low and stable inflation has led to longer economic expansions and lower interest rates, and, as a result, higher stock returns. During the 2008 recession, the increase in government debt also fueled concerns that inflation would spiral after the economy recovered. In contrast, inflation remained near the Fed's 2% target through most of the 2009 to 2019 expansion, the longest in U.S. history2. Moreover, during the last time debt-to-GDP was close to this high just after WWII, it eventually shrank to just 28%, showing that high debt levels can be diminished over time by a growing and healthy economy, particularly when the interest rates on that debt are low, as they are now and will likely remain for some time to come2.
Inflation is a normal part of the economy, historically averaging about 3% per year over the past three decades. Hyperinflation is not that common and is usually triggered by spiking energy prices that increase the overall costs of goods. We don't think it's likely in the near future. While economic conditions are still quite uncertain, the best defense against inflation is a long-term investment strategy that can help investors achieve their financial goals over time thorough all types of economic environments.