Wall Street is looking for inflation in all the wrong places

Investors struggling with the shape of the recovery of Covid-19 have the same blind spot as they did after the financial crisis: They do not know how inflation works.

The S&P 500 hit new highs this month, despite the devastating effects of the pandemic. However, market expectations of inflation returned to their levels in February, just months after reaching an 11-year low.

Below the surface, however, investors can not decide how Covid-19 will affect consumer prices. Some fear deflation in an environment of weak demand, while others protect themselves against the opposite: The risk that a fiscal bonanza from Congress and aggressive monetary stimulus by the Federal Reserve – as from other major governments and central banks – could bring back the dangerous combination of inflation and unemployment that plagued the seventies. The Federal Reserve’s decision to halt advance rates to prevent inflation, approved as part of a new strategy Thursday, heightens recent concerns.

“The inflationary forces are joining them,” Morgan Stanley chief economist Chetan Ahya told clients in a recent note on the subject.

How this debate plays out is important to your portfolio. Signs of higher prices can have a particularly dramatic impact, as inflation has historically been associated with the outperformance of low-value companies at the expense of “growth”, as have the technological stocks that have lifted the stock market over the past decade. Bonds would be hammered, even if the Fed is equally cautious about raising rates.