March 11, 2021

Several economists have warned about an impending rise in inflation. Some base their forecast on the Phillips Curve arguing that a strong recovery and a rapid decline in the unemployment rate will fuel the inflationary flames. Others use a straightforward monetarist argument and point to the double-digit growth in the money supply. Their warnings are further reinforced by the rise commodity prices and bond yields. We do not share the inflationary surge hypothesis ; in fact, we believe that instead the data is signaling a strong recovery. In the next few paragraphs, we make our case for a strong recovery while simultaneously arguing against the rising inflation view. Collectively all of the arguments we develop lead us to conclude that the US is likely to outperform the rest of the world. The degree of outperformance will depend on how the rest of the world reacts. Nevertheless, the US recovery and higher rate of return will attract domestic and foreign capital. The foreign capital inflow will result in a dollar appreciation over and above the purchasing power parity. That is the US terms of trade or real exchange rate will appreciate long as the US terms of trade is above the PPP line. Finally, since larger cap tend to be multinational companies and the small cap are more likely to be domestic companies, we expect the dollar appreciation to favor the smaller capitalization stocks over the larger capitalization stocks.

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