Kelly Bogdanova
Vice President, Portfolio Analyst
Portfolio Advisory Group – U.S.

U.S. equities are grappling with their first real challenge since the bull market began over a year ago—inflation.

The combination of shutting down and then restarting the world’s largest economy amid waves of stimulus from Washington and the Fed has created unusual distortions, which helped push consumer prices up 4.2 percent in April compared to one year ago, the highest year-over-year level since 2008.

Essentially, this is an aftershock from the COVID-19 earthquake. The year-over-year inflation rate plunged to almost zero percent at this time last year when the economy was shut down—prices actually fell for three months running last spring—and has rebounded sharply this year as businesses have reopened. We don’t think it is the start of runaway inflation or a longer-term shift into a high-inflation regime for the U.S. and other developed countries. But it will likely take financial markets and investors some quarters to convincingly sort out.

This process could provoke market volatility and create pullbacks along the way. Uncertainties about how long elevated inflation will last—and, importantly, how the Fed will handle it—have implications for equity markets as a whole, and should be taken into account for portfolio positioning.

Highest inflation reading since 2008
U.S. Consumer Price Indexes (CPI) in year-over-year percentage change


CPI Core (excludes food and energy)

Price increases and supply shortages

Much of the recent U.S. inflation surge occurred in a narrow group of categories: auto sales, auto rentals, lodging, airline fares, recreation, furniture and bedding, and education and communication services. For example, in just one month, airline fares and used car and truck prices jumped 10 percent and lodging rose 7.6 percent. The monthly inflation increases for each of the seven categories were extreme statistical anomalies coming in at 3.5 to 8.5 standard deviations above their long-term averages.

Inflation could rise further over the near term if supply chain disruptions and brisk household spending persist as we anticipate. Production in many industries and the distribution of goods have yet to catch up with new, reopening demand. Shortages in semiconductor supplies, for example, are constraining auto production and pushing auto prices higher worldwide, boosting demand (and increasing prices) for used autos. Disruptions along the supply chains of many industries and bottlenecks in global shipping (shortage of containers) are unlikely to be rectified right away.

Prices of the outlier categories could pop up again, on and off during the year, or other areas of the economy could experience price spikes as businesses struggle to normalize operations and as demand for certain products and services remains outsized due to the effects of the pandemic.

Prices of these items plunged during the worst of the COVID-19 crisis and then surged recently
Select components of U.S. Consumer Price Index (year-over-year % change)

Used cars and trucks

Lodging away from home


Will inflation stick?

For U.S. inflation to rise at a high rate for a number of months and then become sticky and entrenched at an elevated level for years, we think two things would need to happen:

  • Meaningful increases in domestic wages across a wide range of industries, and
  • Sustained, outsized inflation in other major economies, particularly in China, the latter of which has a significant impact on global commodity prices.

RBC Global Asset Management Inc. Chief Economist Eric Lascelles points out, “Historically, inflation problems become chronic when a wage-price spiral occurs. Product prices (or wages) rise, and then the other responds—repeatedly.”

There are signs of wage pressures in specific industries, especially within the service sector. Labor supply is tighter than usual, partly due to COVID-19 nuances and generous federal and state stimulus checks and unemployment compensation. A survey conducted by the nation’s largest small business advocacy group, the National Federation of Independent Businesses, indicates 44 percent of firms are having difficulty filling job openings, the highest level in the survey’s history going back to 1974. Some of these business owners may end up increasing compensation to attract new employees.

Despite these pressures, compensation levels are not rising at an outsized rate. The closely-watched Employment Cost Index is up by 2.6 percent year over year while the Atlanta Fed’s Wage Growth Tracker is pacing at 3.2 percent, both within recent ranges.

Lascelles doubts that wage growth in select industries will lead to sustained high rates of consumer inflation: “The bottom line is that a wage-price spiral is quite unlikely and businesses are ultimately unlikely to jam through significantly above-cost price increases … One would struggle to anticipate more than around 3.0 percent wage growth.”

Relatively lower inflation rates in China and other major economies are also unlikely to add to U.S. price pressures. China is attempting to slowly dial back stimulus and reduce leverage in its economy in order to avoid a harsh boom/bust cycle. This could relieve pressure on commodity prices over time, as China typically consumes the highest levels of most industrial commodities and some agriculture commodities.

Overall U.S. wage inflation remains tame
Broad measures of U.S. wage inflation (year-over-year % change)

Atlanta Fed Wage Growth Tracker

Employment Cost Index
U.S. inflation is loftier than in other key economies
Consumer inflation rates in April (year-over-year % change)

The case for “transitory”

Despite the record-breaking amount of liquidity the Fed has thrown into the financial system, there has not been a corresponding increase in the velocity of money. In other words, money is not turning over within the economy at a rapid clip that would sustain high inflation—its velocity remains depressed. For economists who argue that inflation depends on both money growth and the velocity of money, the second requirement just isn’t there.

The unwinding of the unique COVID-19-related income and savings trends could also ease pricing pressures. We think the surge in household spending caused by multiple factors—pent-up demand due to the COVID-19 shutdowns, high savings rates during the crisis, and generous stimulus checks and unemployment benefits—will moderate as the demand gets worked down over time and government benefits expire.

Fed uncertainty

Even if this inflation burst proves to be transitory, the threat of it potentially lingering above the Fed’s 2.0 percent target into next year raises uncertainties about when and how the Fed will back off of its ultra-loose policies.

The Fed has already signaled that the hot April inflation data will not in and of itself change the course of its highly accommodative stance. But financial markets are beginning to prepare for the Fed to start easing off of the gas pedal. The possibility that elevated inflation might advance the Fed’s timetable for tapering asset purchases and eventually raising rates has generated some equity market volatility recently.

Money has flooded into the financial system (blue line has surged), but it is circulating at very low levels (yellow line has plunged)

M2 money supply % change y/y (LHS)

M2 velocity of money % (RHS)*

* M2 velocity of money is the average number of times a unit of money turns over during a specified period of time. Data calculated by the Federal Reserve Bank of St. Louis. When the number of turns is low (like now), it indicates a preference of saving over spending.

Government payments to individuals skyrocketed during the COVID-19 pandemic
U.S. government transfer payments as a % of personal income

This is likely to drop meaningfully once cash stimulus payments and extra unemployment benefits expire.

RBC Wealth Management Senior U.S. Fixed Income Portfolio Strategist Tom Garretson wrote, “While [tapering] discussions are likely to pick up at the central bank’s June 15–16 meeting, we don’t expect any formal announcement until later in the summer … Even if the Fed does wind down its asset purchases by the end of next year, the central bank will very likely continue to reinvest interest earned and maturing bonds, keeping its balance sheet flat as it did from 2015 through 2017. We don’t anticipate the outright sale of bond holdings.”

The Fed’s balance sheet has ballooned to a record level
Federal Reserve Balance Sheet as a % of U.S. GDP

The actions of other major central banks also will be closely monitored and could influence the debate about Fed tapering and gyrations in risk assets. The Bank of England and Bank of Canada have already announced plans to pare back their asset purchase programs, which were instituted during the onset of the COVID-19 crisis. The European Central Bank’s June 10 meeting will be closely watched for similar signals, particularly since the region’s vaccine rollout and economic indicators have improved.

As Garretson pointed out in this report, “The last time U.S. markets had to contend with fears around the Fed ceasing its asset purchases was at the end of 2014, and while many feared at the time this would put the market rally in jeopardy, the S&P 500 went on to deliver returns greater than 30% from 2015 through 2018. The same was true at the end of 2017, when the Fed’s balance sheet actually began to contract while risk assets continued to perform strongly, broadly speaking.”

The unequal inflation effect

For equity investors, inflation deserves attention not only because it can affect Fed policy and the market as a whole, but due to the fact it can also impact various sectors within the market, which shapes portfolio performance.

S&P 500 profit margins usually rise when inflation and expectations of future inflation push up from a low level—as long as wages aren’t the major factor for the inflation boost. Generally in the post-WWII era, the equity market and other risk assets have been able to cope when inflation has been caused by shortages in supply, known as demand-pull inflation. But the market has struggled when inflation has increased due to higher wage and production costs, known as cost-push inflation.

During periods of demand-pull inflation, similar to what the economy has been experiencing so far during the current COVID-19-induced inflation scare, companies have pricing power. They are typically able to pass some or all of the inflation in input costs to their customers, maintaining or increasing profit margins. We saw this pattern in Q1 earnings reports, and expect to see it again during the Q2 reporting season. Furthermore, when commodity prices rise, this often provides a broad range of industries with added pricing power—even some non-commodity producers.

Inflation expectations—how the population perceives inflation will trend in the future—also have a historical relationship with the stock market. Throughout this expansion period and in others in recent decades, the public’s expectations about the direction of future inflation and the broader stock market have been positively correlated. As households’ inflation expectations have risen, the market has worked its way higher.

But when it comes to sectors within the market, inflation doesn’t necessarily treat them equally. According to an RBC Capital Markets study going back to 2004, some of the most economically-sensitive “value” sectors (those that are highly cyclical), such as Energy, Materials, and Financials, outperformed when inflation expectations rose. In contrast, the Technology, Health Care, and Communication Services sectors were underperformers. This track record supports our ongoing recommendation to tilt U.S. equity holdings toward “value” stocks rather than “growth” stocks, at least for 2021.

Energy, Materials, and Financials tend to outperform the S&P 500 the most when inflation expectations rise
Correlations of relative S&P 500 sector performance with inflation expectations since 2004*

* The S&P 500 sector performances are measured relative to the S&P 500 Index as a whole. Inflation expectations are measured by the University of Michigan Inflation Expectations Surveys of Consumers, which presents the median expected growth of prices of goods and services over the next five years.

We think this sector phenomenon could end up pulling the valuations of “growth” stocks down. And because Tech and tech-related segments now represent a bigger share of the S&P 500, this could be a headwind for the overall market’s price-to-earnings ratio.

The inflation-vulnerable and valuation-stretched Tech sector currently represents 26 percent of the S&P 500 vs. 17 percent in 2010. The broader Technology, Internet, Media, and Telecommunications (TIMT) category represents 41 percent of the S&P 500 today compared to just 25 percent in 2010.

As long as inflation jitters are front and center, institutional investors may be inclined to ratchet down their exposure to the Tech sector and broader TIMT segment, at least temporarily. To us, this means more adjustment time for the market as a whole, which could include additional volatility and rotation between sectors along with constraints on the market’s valuation.

A manageable aftershock

We think inflation trends will remain uncomfortably elevated over the near term, but should gradually subside. Lascelles wrote, “Overall, we would argue that the inflation risk isn’t quite as high as it seems right now, though the annual figure will get worse (with the May data) before it starts to get better into the second half of the year.”

While Lascelles anticipates inflation will be “slightly higher than normal” over the next few years, he believes it will shift back to below-normal in the long run due to disinflationary forces such as demographic headwinds, deflation in key segments of the economy (including technology), declining labor unionization, and maturing emerging market economies.

We think long-term investors should look past the latest inflation disruption and continue to moderately Overweight equities in portfolios. It’s still early in the business cycle, and the tight credit conditions necessary to produce the next recession, an accompanying decline in corporate profits, and an equity bear market appear to be a long way off.

But we think heightened inflation risks underscore the need to tilt U.S. exposure more toward “value” stocks than “growth” stocks.

Source - RBC Wealth Management, Bloomberg; monthly data through 4/30/21

Source - RBC Wealth Management, Bloomberg; monthly data through 4/30/21

Source - RBC Wealth Management, Bloomberg; quarterly data through 3/31/21, ECI data begins in 2001

Source - RBC Wealth Management, Bloomberg

Source - RBC Wealth Management, Bloomberg; quarterly data through 3/31/21

Source - RBC Wealth Management, Bloomberg; monthly data through 4/30/21

Source - RBC Wealth Management, Bloomberg; monthly data through 4/30/21

** TIMT stands for Technology, Internet, Media, and Telecommunications.

Source - RBC Capital Markets U.S. Equity Strategy, Haver Analytics, S&P Capital IQ/ClariFi; data from 2004 through 3/31/21

RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC.

Kelly Bogdanova

Vice President, Portfolio Analyst
Portfolio Advisory Group – U.S.
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