Consumers have an effect on what inflation looks like: Strategist

Craig Fehr, Edward Jones Principal & Investment Strategist joins the Yahoo Finance Live panel to discuss the latest market action.

Video transcript

JARED BLIKRE: What are you going to be on alert for? Is this truly going to be the most important meeting of Powell's career, according to Paul Tudor Jones?

CRAIG FEHR: Well, you just mentioned your upcoming interview around WrestleMania. I think that's an applicable term for what we're seeing in the markets at the moment as well, which is the market continues to wrestle with this "is it or is it not transitory." That's effectively the phrase that the market's going to continue to grapple with and digest for probably the remainder of this year at a minimum.

And so is this meeting important? Yes. Not because of the policy decisions that are going to come from it. The Fed will keep rates at 0 in terms of the policy rate. The Fed is not likely to announce any meaningful change right now in terms of bond purchases.

But the markets are hanging on every word in terms of any signal that the Fed might be digging its heels in on easy policy, despite the fact that inflation readings are running quite high and probably putting a little bit more pressure on the Fed to think about when the transition to a slightly tighter or less accommodative policy starts to get implemented.

AKIKO FUJITA: What do you think that's actually baked into the market right now in terms of expectations? We had a few guests on yesterday who all said that Jackson Hole is what they're looking to to actually get the talking going. Is that already priced in?

CRAIG FEHR: If we look at real rates-- so if you just look at nominal 10-year rates and back out inflation-- they're still deeply negative. And so that would tell me that the market's not particularly pricing in a huge amount of inflation risk at the moment. And I think that that probably puts the bias to the upside in terms of nominal rates-- probably not the same magnitude or trajectory of the spike that we saw earlier this year, but I do think that the market is going to have, particularly the bond market, is going to have to come to grips with the fact that inflation is going to stay higher for a while.

And our base case view is that it's not going to be fully transitory when we go back to an inflation environment that we saw from 2010 to 2020. We're also not going to, in my opinion, head back into the 1970s, early '80s style inflation environment. I think it's somewhere in between. I think we're going to see the hottest readings on inflation that we've gotten more recently come back down as we move through the summer months and the base effects wear off.

But I think we'll settle in at a slightly higher level of inflation. And part of that is because of expectations. Consumers are expecting higher inflation now, and that does have a powerful effect on what actual inflation starts to look like.

So in terms of what the market is expecting, I think the market seems to be displaying a bit of complacency at the moment. And that's not fully misplaced. The fundamentals are still quite positive, in my opinion. The path of least resistance over time is probably still higher for equities.

But I do think that there's a bit of complacency that suggests that as the Fed starts to, as Jared mentioned before, talk about talk about tapering, I think ultimately that probably injects a bit more volatility into this market.

JARED BLIKRE: Oh, Craig, you just had to go there and say that again, right? I want to follow up on inflation here, because I think it's really good that you pointed out, we do tend to get inflation in waves. And there's different types of price inflation. I think the one we just saw and are seeing now is more based on commodities. And there is some spending that's involved in that too.

But what about the wage side? Because when you just mentioned the '70s, we had stagflation. So we had the problem of inflation plus jobs. But when wage growth ramps up and it stays there for a while, we can get sustained inflation. I'm wondering if that's factored in to your thinking there at Edward Jones.

CRAIG FEHR: Yeah. There's a phrase I've used in the past, which is that somebody has to pay for inflation, meaning that supply and demand curves still matter in terms of where prices go. And Jared, I think you're spot-on.

There's two elements to this inflation story. One is kind of the core input component of inflation, which is that we know that the pandemic, the global shutdown created imbalances, disruptions, in supply chains. Commodity prices have come roaring back. It's nice to see lumber prices retrenching a little bit. All of that is feeding its way through the system, the production chain so to speak, and driving higher inflation. That, I think, will start to come back down. We're going to see supply catch back up with roaring demand at the moment. I think that helps rein in inflation on that side.

You're raising a critical element that I think speaks specifically to the Fed's role here and what the Fed's likely to do, which is the old adage around the wage price spiral and the Phillips curve. And I think if we go back to the '70s and look for some keys, back then we had organized labor that was pushing wages sustainably higher in a broadbased, kind of bargaining chip type of element. We had the oil embargo that pushed commodity prices, particularly crude oil prices, much higher. Globalization and the supply chains around the world were not quite as fluid.

So we've got all those factors today that suggest that we're not going to see that runaway level of inflation. We are seeing a bit of a collective bargaining of the labor force at the moment, which is that we're seeing workers reluctant to come back into the labor force because of a whole host of factors, I suspect, which is partly because of the benefits that are being afforded to them at the moment, and some disruption and some friction in terms of the skills mismatch. I think we'll see that work its way out.

But I think wages will settle and grow at a slower pace moving forward, but settle in at a higher level. So that's a large part of why we think we'll see inflation come back in from uncomfortably high levels, but probably stick higher than what we experienced during almost the entirety of the last expansion.

AKIKO FUJITA: Craig, what does all of this mean from an investment standpoint? Are you putting a little more cash to work? Are you sort of staying put, comfortable in your positions?

CRAIG FEHR: We maintain a neutral allocation to equity and fixed income within the relevant asset allocation for each investor. And all that is to say that we think this still remains quite a positive environment for equities. If we think about the fact that every conversation starts and ends with inflation in the market at the moment, equities tend to do well in an inflationary environment. Companies can reprice their sales, which adds to inflation but also adds to overall revenue growth and profit growth. And I think that will continue to be the case.

So we don't have to start to get a little more nervous about equities until the Fed really starts to hit the brakes and ratchet rates up, which is going to be well down the line. We're still a way's away from that. So I still think it's important for investors to maintain an appropriate equity allocation. Our advice to our clients right now is, make sure you're focusing on that next layer down in terms of diversification-- the sectors that can perform well, the value in cyclical sectors that perform well in this belly of the economic cycle, this stage in the inflationary cycle. So we think there's great opportunities that still exist in the market.

Don't forget about bonds, though. As we start to see more volatility in equities, which I think is coming-- as we start to see more volatility, even as the bull market progresses, having that allocation, the fixed income to protect or buffer against that volatility will be critically important as well. So stay fully invested. However, make sure you're looking underneath the hood for the appropriate amount of diversification in those areas that can perform well in an inflationary environment.

JARED BLIKRE: Craig, I kind of like being in the belly of the economic boom. That's Craig Fehr, Edward Jones Principal and Investment Strategist. Thank you for joining us.

Stay tuned to Yahoo Finance for live coverage of the Fed decision at 2:00 PM Eastern, followed by Fed Chair Jerome Powell's press confidence 30 minutes later. You don't want to miss it.