The stock and bond markets knew inflation was coming. This week’s 6.2% jump in the Consumer Price Index drove home the fact that inflation has become a fact of economic life, at least for the near future.
The jury is still out on whether inflation will prove to be “transitory” as the Federal Reserve Bank argues and as some economists believe. Others fear that we could be on the verge of something a little more serious. The fear is that the Fed might be forced to raise interest rates if that were the case.
The Producer Price Index (PPI) and the Consumer Price Index (CPI) both came in a little warmer than forecasted on a year-over-year basis, but not as high as some expected. And yet the U.S. dollar spiked to new highs, the yield on the U.S. Treasury rose by more than 10 basis points, gold and silver jumped, and stocks dropped.
The culprit behind the ongoing pressure on the inflation rate, as readers know, is the heightened consumer demand caused by the reopening of the economy and the supply chain issues that do not seem to be easing. The pandemic can be blamed for both conditions.
For me, the markets were so over-extended and in need of a pullback that traders were just looking for a reason to take down the averages. As you may recall, I had been expecting a minor bout of profit-taking, no more than 3% or so, in the markets. This week, the S&P 500 Index lost almost 2%, while some other indexes like the small-cap, Russell 2000 Index and some technology areas were down more than 3% before rebounding.
Between the good news on the passage of the $1 trillion infrastructure bi-partisan spending program (which now awaits signing by President Biden) and the climbing rate of inflation, the market winners have been mostly in sectors that benefit from construction and inflation. Mines and metals, gold and silver, basic materials, lithium, uranium and rare earth plays have climbed during the past few days. These sectors have played a back seat to large-cap technology stocks over the last two months. We have seen this kind of rotation many times in the past. Once prices have been bid up to unreasonable levels, short-term traders will switch their focus back to technology, or reopening plays. What is important to understand is that the overall markets tend to rise, or at worse move sideways, as some sectors that are out of favor are simply replaced by those in favor.
Consolidation is healthy for the markets. A period of digesting gains, possibly over the next few days, would do wonders for reducing the overbought conditions that presently plague many stocks and sectors. Investors should keep their eyes on the U.S. dollar, which appears to want to climb even higher. If it does, it could squash the present rise in commodities.
Gold is another asset I am tracking closely. It has been one of the world’s worst performing assets in 2021. If inflation fears continue to worry investors, there is a possibility that gold may reemerge in its traditional role as an inflation hedge.
Last, but not least, is the cannabis space. A bill introduced by Nancy Mace, a Republican House member from South Carolina, to decriminalize and regulate what is now a federally illegal substance sent pot stocks higher. This could be a huge boost for the U.S. cannabis industry. Stock prices in this industry have languished all year, despite improving profitability in many cases.