Inflation and Growth Fears Take Wall Street on a Wild Ride

Wall Street has been caught between growth fears and inflation fears recently. As a result, traders and investors are placing their bets on growth in one week and inflation in the next, adding to the daily volatility of the major equity and debt averages.

Fears of inflation are fueled by several inflation indicators released by government agencies in the last 12 months, confirming that the old villain of the American economy has returned. That includes a couple of reports released by the U.S. Bureau of Labor Statistics (BLS) early this month. One of them is the Consumer Price Index for All Urban Consumers (CPI) — a gauge of retail inflation— that rose at an annual increase of 6.2% in October, the most significant gain since the early 1990s.

Then there's the Producer Price Index (PPI), a gauge of inflation at the wholesale or producer level. It is running at 8.6% in October of 2021, the same as in September. It’s the highest figure since November of 2010.

Meanwhile, there are reports by several companies that inflation is beginning to creep into the pricing equation, including Federal Express, Tyson Foods and P&G — to mention but a few.

Both supply and demand factors fuel the return of the old villain of the American economy. Supply factors include global supply chain interruptions and labor shortages that prevent companies from producing and moving commodities fast enough to accommodate consumer demand. At least, that's the position held by the U.S. and European central banks and government officials, arguing that inflation is transitory, and it will eventually fade away.

Demand factors include unprecedented monetary economic stimulus, in the form of near-zero, short-term interest rates, and quantitative easing (Q.E.), the buying of U.S. Treasury bonds and mortgage-backed securities by the Fed. These policies have helped keep marginal firms afloat across the economy, improve American households' balance sheets through asset inflation, and keep consumer spending elevated during the pandemic recession.

Meanwhile, there's unprecedented fiscal stimulus in the form of generous government benefits that helped household incomes remain elevated during the pandemic recession. That's something Fed officials have called an "anomaly" in one of the Federal Open Market Committee (FOMC) meetings.

Supply and demand factors aren't independent of each other. Demand-side inflation feeds into supply-side inflation and vice versa, as inflation enters the household and business decisions in the form of cost of living adjustments (COLA). For instance, John Deere and the UAW ratified a labor deal that incorporated a COLA clause. That raises the risk of turning inflation from transitory to permanent, defying the Fed’s position.

Still, there are growing fears fueled by many macroeconomic indicators released by the U.S. government showing the economy is growing at an anemic rate. For instance, two weeks ago, BEA reported that real gross domestic product (GDP), a measure of the value of goods and services produced during a calendar year, rose at an annual rate of 2% in the third quarter of 2021, down from the 6.7% increase in the second quarter.

The primary reason for the slowdown in Q3 GDP growth was a decline in its most significant component, consumer spending. And the situation could get worse from here, according to the University of Michigan consumer sentiment report released last week, showing that consumers are planning to cut down on spending due to rising inflation.

Then there's a decline in the real disposable personal income (DPI) — personal income adjusted for taxes and inflation — which dropped 5.6% in Q3, after a 30.2% drop in Q2, as an anemic recovery in the labor market has yet to make up for the end of pandemic-related government benefits.

Growth fears are also fueled by labor and material shortages in several sectors, like automobiles, construction, transportation, and leisure and entertainment.

Compounding the problems of slowing U.S. consumer spending and labor and material shortages is the resurgence of COVID-19 cases in Europe, which has several countries contemplating the return to lockdowns, which raises the likelihood of another pandemic recession. That's what happened at the end of last week, as Austria returned to lockdowns with Germany ready to follow suit, sending economically sensitive sectors like energy commodities, financials and travel-leisure into a tailspin. The S&P 500 energy sector lost 5.22% for the week, the S&P 500 financials lost 2.82% and the S&P 500 materials lost 2%.

While it's unclear which of the two fears will dominate the market, one thing is clear: volatility will continue on Wall Street, aided by the end-of-the-year investment strategies by hedge fund managers and institutional investors.