Three Key Thoughts:

1. Stimulus on Top of Rebound

2. Rates and Oil Jump

3. Inflation Coming: Temporary or Permanent?

Stimulus on Top of Rebound

It was definitely expected that the Biden Administration would kick off its legislative agenda with an enormous stimulus package. Perhaps the only small surprise is that they chose to do it via the budget reconciliation process with no Republican support. With that success, it is now clear that the new administration intends to push through as much of its agenda as possible while the Democrats control both houses of Congress without seriously attempting to get bipartisan support.

The new stimulus bill comes on top of very strong economic and employment reports so we expect that labor and materials shortages will become quite prevalent. You might wonder why labor would be in short supply with the unemployment rate still at 6%. Quite simply, for many lower paid potential workers, they can make as much or more by collecting unemployment as they can by working. The Federal supplement to regular unemployment benefits brings the total benefit to roughly the equivalent of $15 per hour on a 40 hour week. We hear this story repeatedly in discussions with small business owners who are struggling to find workers.

Materials shortages will continue as we work through the supply chain issues caused by COVID interruptions to production and shipping schedules. Pricing for many commodities and building supplies have soared in recent months as demand has bounced back sharply while supply is still constrained. It is going to take some time, along with a more complete vaccine rollout, to alleviate these shortages. If the current “fourth wave” of the virus hampers the effectiveness of the vaccine distribution, then the supply shortages could well continue for some time.

While we don’t know all of the details associated with the tax increases planned as part of the infrastructure bill, we have seen some headlines come out piecemeal. The corporate tax rate will be raised, along with some sort of minimum tax proposal based on earnings reported in financial statements. Tax rates on individuals earning more than $400,000 per year will also be raised, along with an increase in the capital gains tax rate. Surprisingly, the financial markets have not reacted to the prospect of higher corporate taxes yet. Ultimately, the final details will determine the winners and losers and those likely won’t be sorted out until this summer.

In the meantime, stock investors have cheered the liquidity provided by both the Federal Reserve and Congress. And they are also excited about the strong rebound that is happening as the economy reopens. Bond investors, on the other hand, are nervous about whether this liquidity and growth will lead to a sustained rise in inflation.

Rates and Oil Jump

Yields have risen back to where they were in late 2019 which is an enormous percentage increase off of the historic lows reached a year ago. However, in absolute terms, we are still in a broad downward-trending band in interest rate levels that started 35 years ago. With the rate on ten-year Treasury bonds still below 2%, we are certainly at a point where the potential decline in rates is much smaller than the potential increase. However, with rates this low, price swings can be very large with small absolute changes in rates. And the most important input to long term bond prices is inflation expectations. In the short term, those pressures are likely to be upward.

After bottoming just below $20 per barrel about a year ago, oil has tripled to about $60 per barrel today. Some of that increase is just an expected return to a more normal demand environment and the broad range in which oil had traded for several years prior to the pandemic. The oil market has fundamentally changed over the last several years, with costs of extractions declining, providers being more proactive about adjusting output and demand generally plateauing. With the Biden Administration’s green energy initiatives, it seems to us that oil will become a less important economic input, even as supply remains relatively plentiful.

Inflation: Temporary or Permanent?

With all of this talk of supply shortages and oil price increases, are we in for a big rise in inflation over the next few years? We don’t think so because there are several important factors that while likely keep inflation in check. First, the enormous amount of debt incurred by the US and other governments to fight the pandemic will ultimately be deflationary. Second, the pandemic spurred great advances in technology and health care. These advances will be positive for productivity but negative for inflation. Third, just as the current supply chain bottlenecks cause prices to rise, their resolution will spur some price competition and lower prices. Finally, the long-term story of demography – the rapid aging of the population in the developed world – puts a lid on growth and inflation.

Investment Implications

The race between reopening and new COVID strains/cases makes the current environment a bit uncertain. However, we believe that the combination of vaccination success and massive government stimulus will ultimately win out. This is good news for investors, for the most part. However, we are cautious that other government policies – particularly on taxes and regulation – are likely moving against investors. As a result, we are keeping asset allocations close to long term targets, with sufficient cash available to take advantage of short-term setbacks.