Inflation or Deflation – What’s on the Horizon?

By Dima Kulakov

Recently, two experts (Wharton Professor Jeremy Siegel and Innovation investor and fund manager Cathie Wood) expressed their differing opinions about future price actions and what may follow for the markets and particular industries/stocks.

Roaring Inflation

Professor Siegel has been consistent in his view that higher than expected (by many strategists and by the Federal Reserve) future inflation could pressure the Fed to pull back its easy monetary policy earlier than planned, which would cause the stock market to sell off.

“For next year we’re going to have much more inflation,” Jeremy Siegel told CNBC. “When you see worse inflation, the Fed is going to be pressured and that’s going to disturb the market and that’s down the line.”

The Fed revealed plans of tapering off its its asset purchasing program on September 22 — the stimulus put in place to boost the economy during the Covid-19 pandemic — may “soon be warranted.” This tapering will start in November and end by the middle of next year. They signaled that actual rate hikes are still far in the future, but nearly half of the central bank’s members foresee at least one rate hike in 2022.

Siegel thinks that the Fed may need to act more aggressively, normalizing its monetary policy and even starting to raise rates, in order to control inflation. He believes that inflation is less transitory (temporary), and more structural (longer-term).

“Powell (the Federal Reserve Chair) opened the door saying, if things get worse, we will have to taper faster. If that happens toward the end of the year, that would rattle the market,” Siegel said. “If they (the Federal Reserve) panic and say ‘oh my god, we’re way behind the curve, let’s jack up rates’. That’s bad. That will really trouble the market and the economy.”

While Jeremy Siegel sees inflation-related market turbulence coming in early 2022, he thinks markets have room to run in the near-term.

“I think the road looks clear ahead for a month or two,” Professor Siegel said. “We could have a market up 10% before another 10% drop.”

Deflation not Inflation

While most of the Wall Street strategists predict inflation ahead (temporary or more permanent), Innovation investor, and founder and CEO of Ark Invest, Cathie Wood thinks the world is entering a deflationary period (when prices for goods and services will fall). The Ark Invest family of funds managed by Cathie Wood contains companies she calls “disruptive innovators”, which Wood and her team expect to “change the world.” Some of her top holdings include Tesla, Teladoc, Zoom Video, and Square.

Wood made a name for herself in 2020, when her fund returned nearly 150%, as many companies they held belonged to the “stay at home” category. However, her flagship fund is down about 5% this year due to a rotation from growth stocks to value names. The US big-cap market index S&P 500 is up 17% in 2021.

“We think there’s going to be a huge deflationary pull out there. We think the higher risk is deflation not inflation,” Cathie Wood said this week.

She believes that consumers have been increasingly spending on goods since the start of the pandemic, as many services such as dining, travel, spa, etc. were unavailable during the lockdowns. As people become vaccinated, Wood said consumer spending will shift to the services sector, which represents two-thirds of all consumer goods and services.

She stated that “businesses are doubling and tripling their ordering of goods right now to meet demand”, but at the same time the market will shift towards services. Companies will be stuck with too much inventory and will be forced to lower prices, leading to broader deflation.

Wood also expects innovation to cause deflation. Costs of production and doing business in general will come down as new technologies (created by companies her funds invest in) change the world.

“This deflationary force is going to develop more momentum and we have deflation associated with each of the five major platforms (she invests in), DNA sequencing, robotics, energy storage, artificial intelligence and blockchain technology,” Wood said. Her investment approach is based on this philosophy. She predicts interest rates will go down – an unconventional view on Wall Street. If she is right, the type of businesses she typically invests in will benefit the most as they all have future earnings well outpacing their current earnings, and therefore should thrive in a low-rate environment.

Only time will tell who is correct. For now, most asset managers suggest that their clients diversify their investments over asset classes such as equities, bonds, and alternative investments; also they suggest to diversify within equities, using a “barbell approach”, owing both value and growth names, as each of the groups should outperform in opposite inflationary scenarios. One thing that is clear is that with the Federal Reserve entering a new phase in their policy and starting to remove excessive monetary support of the economy, markets will become more volatile. With this in mind, risk management becomes even more important for investors of all kinds.