Inflation! What Inflation?
The Fed is expected to raise interest rates this week for the first time in nine years. This could be a turning point in the overall economic landscape. The Fed in its latest meeting has sighted a healthy employment picture and an expectation that inflation will normalize in the near term as the reasons for a rate hike this week. We typically think of low inflation and low unemployment as keys to a healthy economy and this is for the most part true. However, our economy is faced with low wage growth and high debt as a nation. In my opinion we are very near the end of the long term credit cycle. We typically see a long-term credit cycle last around 70-80 years. The next leg of this credit cycle would call for deleveraging. When we have high levels of debt we would want moderate inflation, so that our debt burden would not be as hard to pay off. For this to happen, we need inflation that will cause an increase in wage growth. So far, we are just not there.
Thus far the Fed has pumped $2.5 Trillion of reserves into the banking system in an attempt to force savers to spend and borrow and invest in risky assets. This is not something that is happening only in the U.S. it is happening all over the world. The bank of Japan has launched the biggest monetary easing program of all and is buying not just Government bonds but also equity ETFs. The Bank of Japan has increased its balance sheet from 25% to 75% of the country’s annual output. The told the world they would bring Japan’s inflation rate to 2% within two years. So far their annual inflation rate is running around 0.3% with an economy that is only growing GDP by 1.1%.
I have had many clients ask what has happened to all this money that has been printed. It is very difficult to trace the money, but we can easily see what corporations have been up to. Corporations have been leveraging up at unprecedented levels. We have seen Apple issue bonds in the billions when they have billions of dollars just sitting on the balance sheet. We as consumers have been taught that debt is bad, and it is if we use debt to buy a liability, which is typical. We buy cars and houses and technology all on credit. Not a wise use of credit for sure. However, companies use credit/debt to buy assets, well most of the time. If a company can borrow money at 4% to build a new factory (an asset) that can produce a product they sell for a profit of say 8%. This company is able to buy an asset that in reality they do not have to pay for. They are able to take the profits from the asset and pay off the debt while still pocketing 4%. This is why companies borrow money in the first place. This creates leverage and leverage in a growing economy is GREAT! However, if the Fed decided the economy is getting a little too hot, they will raise interest rates. This makes leverage and debt less attractive. Now let us suppose the company that borrowed money for 4% and was able to get a return on investment of 8% is now faced with shrinking margins (just look at the energy market). They are no longer able to sell their product for a profit of 8% but now only 4%, and let’s assume at this same time the Fed decided to raise interest rates. How will this impact the company that is highly leveraged. Leverage is great in a growing economy and amplifies a company’s profit, however it does the same thing on the downside. It shrinks profits exponentially. We can easily see this in the oil industry. Highly leveraged companies will not likely survive a rate hike when their return on assets has shrunk and can no longer cover the cost of debt. If you are going to invest in a company, now is the time to invest in companies with strong balance sheets.
Did all this Fed printing go to buying assets? The sad fact is that we have seen very little in the way of company capex. We have seen, on the other hand, corporate buybacks at record levels. When a company buys back a portion of its shares in the open market it gives the illusion of increased profits. If a company has $100 dollars of earnings and has 100 shares outstanding its earnings per share (EPS) will be $1. If the company buys back 50 of its shares in the open market, there are now only 50 shares outstanding. The company’s new EPS is now $2, double what it was. However, it did not increase EPS by increasing profits, it manipulated its earning to appear more profitable. This is something I have been warning clients about for some time.
So, if inflation is below normal and debt levels are above normal, it seems crazy that the Fed would raise rates now. However, that is exactly what the market is pricing in.
DISCLOSURE:
This commentary reflects the personal opinions, viewpoints and analyses of Brandon VanLandingham and should not be regarded as a description of services. The opinions expressed are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. It is only intended to provide education about the financial industry. The views reflected in the commentary are subject to change at any time without notice. Nothing in this commentary constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Any indices referenced for comparison are unmanaged and cannot be invested into directly. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.
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