Inflation is here. The Consumer Price Index (CPI) recording for full year 2021, or the change in price over the course of 2021 of a basket of goods and services, is an increase of 7.0%, the largest reading since 1982. Unless you had to manage a portfolio or a household budget 40 years ago, you haven’t had to deal with material inflation in a formal manner until now.

Significant market dialogue has revolved around whether inflation is transitory or longer term in nature. A number of aspects of the inflation we are currently experiencing are arguably and/or by definition transitory in nature, including but not limited to: certain supply chain issues, backlogged shipping ports, and reduced worker days due to COVID.

There are other features (delineated below) that suggest inflation may be more persistent and longer term in nature. These factors are by and large structural in nature, relatively newer phenomena, and don’t seem to be going anywhere anytime soon.

Declining Supply of Low Cost Labor

Economics 101 suggests that everything else being equal, lower supply will lead to higher prices. China leads the globe in population at north of 1.4 billion people, yet for decades has imposed a one child policy with the intention of reducing population, only easing that restriction as of 2015. The working aged (15-64 years old) percent of total population began shrinking in 2011 and the outright population is expected to start declining in the coming years.

China’s Working Aged (15-64 years old) Percent of Population

Source: World Bank, fred.stlouisfed.org

China’s Total Population

Source: United Nations, Department of Economic and Social Affairs, Population Division

While the U.S. is a fraction of China’s population despite being the third most populous country in the world and thus might not be quite as consequential as China, the U.S. has also faced a declining supply of labor due in part to earlier retirements and/or a mass re-evaluation of long-term goals and life priorities in response to the pandemic.

Number of U.S. Workers Resigning Per Month Since 2001

Note: December 2021 data is preliminary.
Source: Bureau of Labor Statistics, Job Openings and Labor Turnover Survey, December 2021.

This decline in the labor force has led to supply constrained worker availability, leading to roughly 1.7 million fewer employed than pre-COVID in the U.S. economy despite a post COVID low 3.9% unemployment rate at year end 2021. In the past 60 years, the average unemployment rate in the U.S. has been 6.0%. Even if the unemployment rate reached the lows of the past 60 years (3.4%), the number of employed in the U.S. would still be 700,000+ fewer workers than prior to COVID. This dynamic could lead to further wage pressure.

U.S. Total Employment

Source: Bloomberg

U.S. Unemployment Rate

Source: Bloomberg

ESG – Environmental, Social, and Governance

Environmental sustainability has increasingly received attention and focus in recent years from all constituencies of economies and financial markets. Many nations have committed to a global temperature rise of less than 2 degrees Celsius with a goal of less than 1.5 degrees through the Paris Accord. Individual countries have put forth commitments and plans beyond the Paris Accord such as China’s pledge to be carbon neutral by 2060. Many corporations have adjusted how they do business, either due to internal constituencies or in response to external constituencies such as investors. End investors have increasingly communicated their desire for environmental sustainability either through investing in ESG funds and/or directly instilling ESG criteria in their investment mandates (by endowments for example).

Long-term sustainability can come in the form of economic and/or environmental sustainability. Economic sustainability may have upfront costs but the expectation is that the upfront investment has a positive net return on investment. Environmental sustainability may have upfront infrastructure costs which may or may not be recouped over the investment horizon. That is to say that individuals and governments, as representatives of individuals, might value environmental sustainability and thus invest upfront capital even if there is the expectation of an ultimately negative economic return on investment. In the most extreme, one could suggest that a positive economic return on investment probably doesn’t matter on an uninhabitable earth. Regardless, both economic and environmental sustainability have upfront costs which can lead to inflation.

One demonstration of the inflationary effect of environmental sustainability is through carbon emissions futures. Carbon emissions have been and will increasingly be monitored and curbed through government mandates. Businesses can buy or sell capacity through the carbon emissions futures market. Businesses with low carbon emissions can sell their excess capacity and businesses with high carbon emissions can buy excess capacity to get in line with government mandates. As carbon emissions have come under greater scrutiny, futures pricing has increased. With a secular movement toward further reduction in carbon emissions, the capacity allowed for each company will likely go down over time, further increasing futures pricing.

Carbon Emission Futures

Source: Bloomberg

Lack of Yield in Global Assets

U.S. 10 Year Real Yields

Source: Bloomberg

U.S. real yields are near all-time lows and are largely negative.

These real yields are calculated using TIPS (Treasury Inflation-Protected Securities) which, along with traditional treasury pricing, suggests the capital markets believe longer term inflation will be materially below where current actual inflation is. To the extent longer term inflation has more of a relationship to current inflation rather than market implied inflation, today’s near all-time lows in real yields, which are largely negative, will prove to be artificially high as inflation further eats into real returns. For example, if 2021’s CPI inflation of 7% goes back down to 2%, and treasury rates remain around 2%, the net effect generates a real return of 0%. If 2021’s inflation of 7% remains secularly persistent, then treasury rates of about 2% would net a real rate of return of -5% annually.

When the economy and market prices (stocks, bonds, etc.) suggest large and positive real rates of growth, everything else equal there is a higher demand for assets that can participate in that real growth as compared to an environment of lower real growth. Everything else being equal, when economic and market implied real rates of return are lower, there is a much lower opportunity cost of not participating in that real growth, thus creating additional demand and price pressure for commodities.

Monetary and Fiscal Policy

The Federal Reserve is in the beginning stages of raising short-term interest rates and reducing the balance sheet.

Capital markets pricing (notwithstanding a softening of expectations since Russia’s attack on Ukraine) recently suggested roughly eight short term interest rate hikes in the coming two years. The Federal Funds rate is just above 0%, and should the Fed raise rates to 2%, it would still be roughly 2.6% lower than the 65+ year average Federal Funds Rate of 4.63%, which would still be accommodative, though less so than the recent past.

Federal Funds Rate

Source: Bloomberg

The Federal Reserve is also looking to reduce its $9 trillion balance sheet. Current Wall Street estimates are that the balance sheet will be reduced to +/- $7 trillion. To put this in context, prior to the Global Financial Crisis roughly 15 years ago, the balance sheet was under $1 trillion. After all of the excesses during that time (for example negatively amortizing loans and mortgage credit underwriting that simply required a pulse from the borrower) the Fed stepped in and increased the size of the balance sheet, thus subsidizing the problems that led to the GFC and not allowing the excesses to fully wash through. The relationship between the size of the Fed’s balance sheet and the size of the economy has gapped higher, and many of the problems remain, namely continued divergence in wealth and income gaps and other excesses in the market such as Special Purpose Acquisition Corporations (SPACs), non-fungible tokens (NFTs), and expensive valuations in the capital markets. On the fiscal policy side, over $10 trillion was utilized in 2020/2021.

Federal Reserve Balance Sheet Versus Annual U.S. GDP

Source: Bloomberg, Federal Reserve, federalreserve.gov

Real Average Household Income By Quintile and Top 5% in 2019 Dollars (Recessions Highlighted)

Source: Census Bureau, 1976-2019

Of course, the expected tightening in the balance sheet and short-term interest rates, in addition to going from extremely accommodative to slightly less accommodative, is contingent on if the Fed can and will pull it off. As the conversation of tightening merely began at the beginning of 2022, the S&P 500 experienced a drawdown of 9.7% within the month of January. The Federal Reserve did not blink at the price action in the markets, but at what point will they? What would Jerome Powell and the Federal Reserve do if stocks went down 20%, 30%, 40%, or more? Even if they do act at some point, at what juncture will capital market participants respond less to their actions? On a fundamental basis, what are the limits of what monetary and fiscal policy can do and at what point might the U.S. dollar’s reserve currency status be called into question irrespective of the efficacy? Regardless of how much the Federal Reserve tightens, it will likely still be accommodative from a broader lens. The Fed might at some point make a change in course, or they might have the resolve to tighten policy as much or more as the market currently expects. Either way, bloated and deeply embedded monetary and fiscal policy suggests there may be an impact on future inflation.

Global Reserve Currencies Since 1450

Source: Monetary Gold, www.stansberryresearch.com

De-Globalization

Back to the Economics 101 classroom, the most efficient/most cost effective approach in a global economy is to specialize. Each country produces the goods and services they do best and cheapest and then trades with other countries who do the same, leading to collective needs being met at the lowest cost. Rising tension among nations however has started to reverse globalization. Rather than buy goods and services at the cheapest price, countries including the U.S. have started to choose to buy the goods and services not at the cheapest price, but rather with the most reliable output, specifically keeping purchases ‘in house’ so as to not rely on other countries. The U.S. even published a 2021 report titled “Building resilient supply chains, revitalizing American manufacturing, and fostering broad-based growth.” This reliance on other countries can be seen historically through the U.S.’s rising reliance on imports, the declining percent of global semiconductor production capacity, and the shrinking share of global rare earth materials production. The U.S. (and others) are looking to reverse these trends, though that will have associated costs, and thus is another inflationary construct.

U.S. Net Import Reliance (2020)

Source: June 2021 White House Report

U.S. Semiconductor Manufacturing Capacity as a Percent of Global Capacity

Source: June 2021 White House Report

Global Rare Earth Production (1960 - 2020)

Source: June 2021 White House Report

In addition to the aforementioned structural constructs for longer term inflation, the psychology and experience of inflation can beget future inflation, and is certainly top of mind in both the investment community as well as everyday consumers of goods and services. If your portfolio construction currently does not account for a potentially material probability of longer-term inflation, it may be worth reconsidering and addressing.