Will Inflation Turn into Deflation?

Will Inflation Turn into Deflation?

Posted On June 23, 2021 2:01 pm

After last week’s FOMC and Fed Chair Jerome Powell’s Congressional testimony, the raging debate over inflation continues. 

At this point, Powell seems correct on his insistence that most of the past few months’ price increases will prove transitory — or, at least accepted by the stock market. We’ve seen the reflation trade focusing on the cyclical sectors such as metals, building materials, and industrials fade, as Mosaic (MOS), Caterpillar (CAT), and Gold (GLD) are down some 15%-30% from their May highs.  

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Meanwhile, big-cap tech has regained its leadership as the Nasdaq 100 (QQQ) has hit new all-time highs.  And the bond market concurs as the rate on the 10-Year Note hovers around 1.50%, down from the 1.79%  peak that spooked the market, the catalyst behind a steep sell-off in the high valuation tech sector.  

As mentioned last week in How I’m preparing for the Upcoming Fed Meeting, “My view is that inflation focus is somewhat misplaced because both of them can be correct. The recent commodity prices and input cost increases are temporary as the basic supply/demand coupled with replacement costs result in a price reversion.  For example, the price of lumber, which soared over 300% from February to May, has dropped some 35% in just the past two weeks. Supply chain issues, especially for semi-chips, will work themselves out within the next few months.”

My caveat and reference to “both can be right” concerned wage inflation. As I wrote last month, “if companies continue increasing wages to lure workers, profit margins will be heavily impacted, suggesting inflation is anything but “transitory,” as the Fed claims. Unlike commodity or other input, costs and wage pressure can rarely be passed on to the customer.” 

Although I agree with Powell’s commitment to keeping interest rates at historical lows — as it benefits businesses — I strongly disagree with the Fed’s continued asset purchases (quantitative easing) especially in mortgage-backed securities, and some corporate debt. The housing market’s strong, most corporate balance sheets are healthy and financing costs are minimal. The market doesn’t need the QE intervention which inflates assets that mostly benefit the wealthy.   

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On the one hand, most commodity and input costs will be self-correcting — more soybeans and corn will get planted and semi-chip production is nearly fully back online. 

The irony? Many companies, or even countries, especially China, have been hoarding materials such as copper, agricultural products, and computer chips. Hence, as supply starts meeting demand, they’ll be forced to dump inventory onto the market — causing a further price decline, leading to a deflationary environment. 

Just as the pandemic pulled forward and accelerated the digitalization shift, the re-opening caused a demand surge that’s likely unsustainable. 

Two key areas that surged in volume and prices were homes and autos. 

The images below indicate that demand for both is now subsiding with intentions to make a new purchase within the next year at the lowest levels since the financial crisis. 

buying cars market 2021

While I don’t think housing’s in a bubble, the 15% of all new purchases being for second homes stat was eye-opening. That’s where it peaked in 2005-2007 prior to the bubble burst.  I still think most of the housing activity is reshuffling and is certainly something to keep an eye on. 

second home investment property mortgages

The bottom line: Although we have some conflicting data points on inflation, it does seem transitory, leaving us with a consumer with a plethora of firepower to fuel the pent-up demand — creating a strong economic rebound and a Fed committed to pumping money into the system.   While gains may be harder to come by in the coming months, one must retain a bullish bias. 

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About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.