Inflation remained in check following the global financial crisis for over a decade despite a massive expansion of the Fed’s balance sheet. That expansion was much less accommodative than it appeared. The bond purchases recapitalized banks and supported rising asset prices but did not result in a huge expansion of the US money supply. At that time, most observers (including me) failed to fully appreciate the magnitude of disinflationary effect of banking restrictions, large scale immigration, and growing world trade. That all changed a few years ago. Since then I have argued relentlessly that four factors were setting the stage for a new era of higher inflation. I also pointed out that those rising consumer prices would ultimately be an ongoing drag on long term economic growth.
• Tariffs and other protectionist measures reduced trade as a percentage of both global and US GDP (even as the US trade deficit has set record after record for the last four years).
• The US workforce is shrinking as population growth stagnates.
• Huge federal budget deficits following the 2017 tax cuts were compounded by unprecedented spending increases in 2020 and set the stage for much slower growth in the next few years.
• The Federal reserve financed those trade and budget deficits with money created out of thin air.
The pandemic interrupted but did not end the pace of the emerging trends of slower growth and rising consumer prices. Those same factors continue to drive inflation even as growth slows from the brief surge in pent up demand as the economy reopened. Most economists as well as the official Fed forecasts continue to deny these shifts. Consumer price increases in 2021 have been more than double their forecasts while growth has been 40% slower (despite record job openings). Personal incomes and retail sales have risen sharply but failed to keep pace with the rise in consumer prices. Since April retail sales are down almost 2% (around 4% adjusted for inflation). The chart I presented in the Spring edition has been updated but continues to demonstrate a multiyear trend of inflation outpacing growth.
Chairman Powell reassures us that the recent rise in consumer prices is transitory, unlike the soaring inflation of the late 1970s. A closer examination of the data tells a different story. The gap between 1970s inflation and today has more to do with how inflation is measured than how fast prices are rising. In 1981 the Bureau of Labor Statistics changed the way CPI is calculated. Prior to 1981 home prices were the biggest single factor in the Consumer Price Index. After that date, a calculation of the rental value of housing replaced home prices in the index. Rising home prices just set a new record in the past year. If we still used the pre 1981 formula both the CPI and the core CPI (excluding food and energy) would be up about 10% in the past year. Average rents remain only a modest contributor to recent inflation numbers (held down by eviction moratoriums and urban vacancies). Rents are poised to soar now that continued moratoriums have been ruled unconstitutional and people are returning to cities. Recent leases have on average been priced 17% above what the previous tenant paid. This will however be ameliorated by a bunch of vacancies as tenants are evicted.
In the 1970s the Fed tried to sustain growth by financing big deficits in the face of a major supply chain disruption. Oil is important but represents a much smaller component of growth in the new millennium. In the age of growing computerization and electrification expanded semiconductor production is the critical growth component. Like the 1970s, rising labor costs are pushing up prices. The artificial transitory restraints imposed by OPEC and labor unions have diminished importance. In their place we have declining birthrates, aging populations, and a shortage of semiconductor plants that will take years to build. With only 25% of the global population vaccinated, the spread of the Delta variant compounds these challenges even if US infections quickly peak.
40 odd years ago investor concern about soaring inflation triggered higher rates and ultimately a recession. Those rates were graphically illustrated by 14% mortgages. Today’s investors seem oblivious to the incompatibility of low interest rate and rising consumer prices. They remain confident that any increase in consumer prices is transitory as promised by the Fed. The latest Fed minutes tell a different story. The big question is whether the Fed will be able to follow through on their decision to reduce liquidity with the Delta variant aggravating the recent economic slowdown.
A whole lot of money has been printed since the days when my opinions were solicited (or at least courteously listened to) by various members of the Federal Reserve Board and the Bank for International Settlements. Reading the minutes of the July Fed meeting one might conclude the Fed was again listening when earlier this year I suggested that it was time to declare victory in their war on unemployment.
Since the Great Recession the Fed has continuously depressed interest rates with massive purchases for Treasury and other debt. In the early years bond purchases were targeted at recapitalizing the banking system. The Fed loaned the banks money at zero interest, then paid interest to those banks for redepositing that same money back at the Fed. This restored bank balance sheets and boosted asset prices, but did not cause money supply and inflation to soar. Any inflationary impact was neutralized by large scale immigration and competition from imports.
Since 2018 the Feds monetization of massive deficits poured directly into the US money supply and the economy. The Fed purchased bonds equivalent to 75% of the additional debt. Those purchases went on steroids during the 2020 pandemic. M2 money supply exploded by 25% last year. The upward trend in consumer prices since 2018 fueled by monetization is accelerating this year. The recent official line was “inflation is transitory” and Fed purchases of $120 billion dollars in debt every month indefinitely seems to have lost all credibility with the publication of the July minutes. Chairman Powell’s speech at Jackson Hole confirms that they now expect to begin tapering the bond purchases later this year.
The remaining commitment not to raise interest rates until 2024 is living on borrowed time. Statements by a number of the governors preceding the release of the minutes as well as recent actions to drain liquidity indicated increasing inflation concerns. As we told you months ago, the Fed began “steriziling ” their bond purchases with short term “reverse repurchase” agreements in Q2. This was the first clear indicator that a tapering of bond purchases was imminent. Those ongoing “reverses” have now drained over a trillion dollars from the bank reserves. M2 growth slowed from 25% in 2020 to 16% in Q1 before dropping below 10% in the latest quarter. It is not coincidental that this corresponds with a trillion dollar reduction in the deficit. It remains to be seen whether they will continue to reduce the pace of monetization. If they act aggressively the risks of recession next year increase. If they falter, any hope of a respite from 4% plus inflation in 2024 will fade quickly. Trying to walk the tightrope between those extremes promises stagflation. Growth will slow one to three years before reduced liquidity will meaningfully reduce inflation.
The tapering of bond purchases will push up long term rates, but you shouldn’t expect a “taper tantrum” of suddenly soaring rates. Traders who bet heavily on rising rates earlier this year were crushed. They will be reluctant to front run the inevitable rate increases so soon. Furthermore, while the record pool of household savings has failed to fuel faster growth, it will buffer the pace of rate increases. Yield starved savers will be quick to lock in returns a percent of two higher than they have seen in the last few years.
THE FEDERAL DEFICIT IS SHRINKING RAPIDLY
You may haThe deficit is now on track to be a trillion dollars LOWER than last year. Rising tax receipts combined with the failure of the Biden Administration to get congressional approval of big spending initiatives have closed the gap. Tax receipts rose by 35% from October through June. Since March (when the last stimulus checks went out) federal spending has slowed sharply. June 2021 deficit was 80% smaller than June 2020 deficit. The child care credits and rental assistance will only add back about $100 million of the trillion dollar reduction.
Even if both the proposed trillion dollar infrastructure legislation and Pelosi’s three trillion in additional handouts are enacted, this year’s deficits will fall far short of Trump’s final deficit. That four trillion dollars will be spent over ten years, not one. 2021 spending was front loaded. Spending in the last half will be much smaller. Of course, all this was true before the disastrous withdrawal from Afghanistan. The tenuous coalition of progressive and moderate Democrats that Biden assembled will be difficult to maintain. Only the infrastructure proposal which is in the interest of both Democrats and Republicans running in 2022 has big probability being enacted.
Deficit lovers need not fear that a surplus will magically appear. This year’s deficit is shrinking, but will still be more than double the 2019 level. Rising consumer prices since last October make it very likely that others like me on the Social Security dole will get a raise in excess of 4.5% next year. Lots of government workers and contractors will get similar hikes. Biden’s child care and food stamp handouts will add to that toll. The big increase in 2021 tax receipts will diminish in 2022 and beyond. This all adds up to higher consumer prices and slower growth.
INFLATION WILL PERSIST
Early this year we pointed to several factors that set the stage for a durable rise in consumer prices. Since then prices rose twice as fast as forecast by the Fed and other observers. The “transitory” inflation elements tied to the economic reopening will soon fade. Year over year statistical price comparisons will diminish. Slower growth has already reduced demand to commodities like oil and lumber. Inflation is also weighing on auto, home, and retail sales, limiting price hikes. Those price pressures are being replaced by other price hikes as companies attempt to pass through rising material, component, and labor costs.
- FEDERAL DEFICITS FUNDED WITH EXCESS LIQUIDITY DRIVES UP CONSUMER PRICES with a long lag. The liquidity expansion over the past four years is reflected in the big increase in price indices this year.
- LABOR SHORTAGES ARE DRIVING WAGES SHARPLY HIGHER. Companies will pass those costs on. Ongoing labor shortages abroad are aggravating the global shortages of materials and components. Virtually every employer is offering big wage hikes. Help Wanted signs are everywhere (some with signing bonuses). Hardly a week goes by without some major employer announcing a double digit pay hike. Reopening schools and the end of supplemental benefits will help but shortages will persist unless growth slows sharply.
- BIG COST OF LIVING ADJUSTMENTS ARE SLATED FOR 2022. In addition to Social Security, lots of government workers and contractors have cost of living clauses in their contracts. Almost half of US workers are employed by some form of government or companies that contract to do government work. 20% of that number are on Social Security and those numbers are rising rapidly. Those rising personal incomes will support higher prices and raise inflation expectations.
- RESIDENTIAL RENTS ARE ALREADY ACCELERATING. Average rents have been held down by urban vacancies and eviction moratoriums. Governments like CA are set to make huge payouts for back rent soon. This is particularly true when vacancies are scarce (like now). Overall vacancies are at a 25 year low while the annual rise in home prices just broke all records. Even without those factors, residential rents tend to follow home price trends with a 12-18 month lag. Various sources indicate the new leases average a 15-20% increase over existing rents. When the eviction moratoriums expire existing tenants face similar hikes. Shelter represents 30% of CPI and almost 40% of core CPI. FNMA models predict the shelter component of CPI will triple in the next 18 months. The effect on the PCE Deflator that gives a lower weight to shelter costs will be similar but smaller.
- Rising medical costs (as Delta spreads and providers play catch up with Covid postponed procedures) put additional upward pressure on the PCE deflator which is already running at over 6%.
- Food shortages persist. If you’ve ventured to the grocery store lately you will still find empty shelves for some items. The global labor shortage is holding back both production and distribution. Those issues are likely to be aggravated by the spread of the Delta variant.
- GLOBAL SUPPLY CHAIN DISTRUPTIONS CONTINUE both as a result of ongoing tariffs and labor shortages. Import prices are soaring while consumer price increases even hit a multi decade high in inflation phobic Germany.
GROWTH HAS PEAKED
Like inflation, growth forecasts made by the Fed and major economists are falling far short of the mark and in line with our expectations. Retail sales and home sales fell in the second quarter when adjusted for inflation and have declined since then. The latest U of Michigan Survey of Consumer Sentiment showed a record drop in response to rising consumer prices and renewed Covid fears. Retail sales may be slowing but rising imports are setting new records for the US trade deficit. This week I had lunch on a bluff overlooking the Long Beach/ Los Angeles Harbor. Fully loaded ships are lined up at anchor for many miles waiting to be unloaded. When those imports come ashore the trade deficit will be even larger as our exports to China continue to shrink. A larger trade deficit reduces GDP. Strong growth as the economy reopened allowed output to recover to its previous peak. Since then the prime determinants of GDP, hiring and productivity have both slowed. The near 6.5% growth (that fell far short of most forecasts) in the 1st half of 2021 will not be replicated in the remaining quarters. Ongoing supply chain issues, a tight labor market, weak business investment, soaring consumer prices, and Covid fears all weigh in.
THE LABOR FORCE IS SHRINKING
JOB OPENINGS ARE AT RECORD LEVELS. Newscasters and the public generally blame this on enhanced unemployment benefits. Those benefits are probably the biggest single factor but fail to explain even half the remaining worker shortfall. Americans are choosing to work less for a variety of reasons as we have been pointing out all year. Enhanced unemployment benefits probably account for only 30-35% of the shortage. A University of Massachusetts study indicates although unemployment rates are lower in the 26 states that have eliminated those benefits, hiring rates are only slightly greater than those that have ended them. This seeming contradiction is easily explained by record baby boomer retirements. Those retirements account for 25% of employment shortfall. When boomers drop out of the workforce and replace their unemployment check with Social Security, the unemployment rate drops but no one gets hired. The next largest factor is the shortage of immigrant workers which account for 20% of the reduced workforce. That only leaves about 20 to 25% unaccounted for. The remaining factors are not as large, but here a few that are having an impact.
- Covid fears and illness have probably accounted for at least 5% -10% of those refusing jobs. Those numbers are poised to rise with school children and others at greater Delta risk.
- “Give me remote work or I QUIT” probably accounts for 10% to 15%. Scores of millennial parents were able to relocate to suburban and remote areas as a combined result of remote work and low mortgage rates. At the same time government handouts enabled them to pay off credit cards and/or build record savings levels. Faced with high commute and child care costs they have no interest in returning to the office or factory any time soon.
- US Population growth is barely above zero (the lowest on record).
- A recent survey indicates the average pay it will take to get people back to work has risen to a record $71,000. The biggest pay hikes are being demanded by workers less than 45 years old.
Employment will however continue to grow but not as fast as the official decline in unemployment. As schools reopen and unemployment benefits shrink, some stay-at-home parents will return to the workforce. Similarly, many part time workers whose current benefits exceed what they earned working are also likely to return to the workforce. Covid fears may someday prove transitory but we are not there yet. For the foreseeable future the combination of a shrinking workforce and meager productivity bode a return to sub 2% growth by early next year.
RETAIL SALES AND THE DELTA VARIANT
We have long argued that Covid fears and ongoing infections would be an ongoing drag on both hiring and growth. Those who disagreed and were surprised by the July drop in retail sales are now blaming that decline on the rise of Delta Covid infections. They were wrong before and they are wrong now. There is little doubt that rising infections negatively impacted retail sales, but the data suggests it was a minor factor in July. First, if infection fears were the primary cause of the slow down, we would expect restaurants and bars to bear the brunt of the decline. Instead, sales at restaurants and bars INCREASED in July despite the overall drop in retail sales. Second, we would expect rising fears to cause purchases to shift back from physical stores to online sales. Instead, physical stores continued to gain market share while online sales plunged. The recent rise in infections will however slow growth in future months until it peaks.
If Delta didn’t cause the drop in July sales, what did? I would suggest that the sharp rise in consumer prices over the last few months has caused consumers to become more cautious in in the last few months. In addition, 25 states ended the enhanced unemployment benefit between June 1 and July 10. As mentioned earlier, hiring has not increased at a significantly faster pace than states that have continued the benefits. Instead, workers appear to have adapted to lower incomes and higher prices by cutting spending. Demand still exceeds supply despite recent slowing of sales. Shortages of labor and other factors persist in putting upward pressure on prices.
THE BOTTOM LINE
The US workforce is shrinking and there is scant evidence of any meaningful improvement in long term productivity. Economic growth will retreat to the sub 2% average rate of the last decade and a half by early next year. There is no recession on the near term horizon unless the Delta variant proves to be a lot bigger problem than it currently appears to be. High household savings have failed to produce the promised spending boom, but savings provide a backstop for spending as growth slows. At the same time US consumer prices continue to weigh on consumer spending and are poised to rise at a rate greater than 4% through at least next year. Recognition of this reality by both the Fed and investors will push up interest rates sufficiently to disrupt the artificially inflated bull markets in various assets. Home sales will continue to falter, squeezed between rising building costs and mortgage rates juxtaposed against personal income increases that are not keeping pace. The surge in corporate profits like the economic rebound has probably peaked as rising wages and other costs become more difficult to fully pass through to customers.
Bonds and interest rates: Interest rates remain below their springtime highs but both are trending higher since last year. Chairman Powell’s assurance notwithstanding, rising rates mean that bond prices are declining. US interest rates are at their lowest level in history relative to inflation. Unless inflation plummets interest rates are poised to resume their rise. The Fed has dramatically slowed monetary expansion that kept rates low with their recent trillion dollar reverse repo program. They will almost certainly allow those reverses to roll off when they begin tapering purchase of long term bonds later in the year. The yield curve will steepen as bond prices fall and long term rates rise. Although rates will rise, the Fed will resist any increase above inflation. That policy of low “real” rates should postpone any potential debt crisis but will reinforce the longer term trend pushing consumer prices higher. Although municipal and high yield bonds have generated positive total returns, the only bond prices that have risen this year are Treasury Inflation Protected Securities (TIPS). TIPS pay interest based on the CPI. Although inflation got ahead of the rising trend in Q2 that trend will remain intact at least through 2020. Our biggest fixed income holdings are short maturity TIPS that are less vulnerable to rising rates. The current environment provides two spectacular risk free opportunities for individuals: Record low rates to refinance your mortgage and risk free Series I US Savings Bonds that pay you the rate of inflation but unlike TIPS they don’t lose value if consumer prices suddenly plunge. You either get paid the inflation rate or you get your principal back to spend when consumer prices are lower.
Gold and Precious Metals: These and related investments performed well over the last few years correctly anticipating rising inflation, but suffered some losses since recently. I believe the bottom is now in. Any purchase when Gold prices near $1800 per oz or lower should be rewarded as inflation continues to exceed expectation.
US Stock Market: An ocean of excess liquidity has continuously rewarded speculators “buy the dip” strategy. Although risk levels are extraordinary, I am agnostic regarding the very short-term outlook for US stocks. At least for the moment our short term liquidity indicators remain positive while investor sentiment indicators are giving mixed signals. Liquidity from last years unprecedented monetary expansion remains abundant and credit spreads remain narrow. At year end, money growth had outpaced inflation by 22%. That differential has dropped to zero in the last three months. Individual investors continue to favor risk assets like stocks, but divergences are starting to appear. Internal divergences have been the most reliable indicator of the end of bull markets. Recent divergences are consistent with our view that economic growth is slowing. The Dow Jones Transports peaked in May failing to confirm the recent highs in the Industrials. Similarly, small cap value stocks that benefit from rapid economic growth have underperformed big cap tech stocks that benefited interest rates that fell since spring. In addition to big cap tech, investors have shifted in to utility and healthcare stocks. These divergences indicate that although speculators remain bullish, they are becoming more defensive. Rising “risk aversion” is typical of bull markets on their last legs.
If these trends continue, the upward momentum of stock indices will fail. The most likely triggers are inflation continuing to exceed expectations or earnings disappointments resulting from the combination of slowing growth and rising costs. A clear indicator of failing momentum will be the so called “death cross” on stock charts when the 50 day moving average falls below the 200 day moving average. My associate, Charles Rother of Sector Logic, has done a study indicating that the “death cross” isn’t always deadly, but can be highly predictive. When inflation is rising and stocks are trading at a high multiple of record earnings (as they are now) the “death cross” not only predicts market direction but also the size of the decline with substantial accuracy.
In the current environment Charles studies show indicate a market decline in excess of 35%. My own analysis suggests a much bigger decline is likely. Even without this imminent decline the longterm outlook from current levels is treacherous. Positive returns over the next 5 or 10 years are unlikely. Some spectacular low risk investment opportunities lie ahead, but not for stocks purchased at current prices..
FINANCIAL SOLUTIONS GROUP LLC FSG provides portfolio management investment advisory services to individuals, trusts, retirement plans, companies and institutions. FSG manages client funds according to proprietary strategies developed by Clyde Kendzierski, Chief Investment Officer to manage his own retirement funds. Please call (562) 430-2223 to learn more about how FSG can serve you. Many Stock Brokers, Financial Planners, and Accountants are also registered as Investment Advisors. Our programs are often misperceived as competitors to their business. FSG maintains relationships with other advisors and are pleased to include additional qualified advisors in our programs to expand their business and enhance their clients’ long-term returns. Unless otherwise indicated, investment opinions expressed in this newsletter are based on the analysis of Clyde Kendzierski, Managing Director and Chief Investment Officer of Financial Solutions Group LLC, an investment adviser registered with the California Department of Business Oversight. The opinions expressed in this newsletter may change without notice due to volatile market conditions. This commentary may contain forward-looking statements and FSG offers no guarantees as to the accuracy of these statements. The information and statistical data contained herein have been obtained from sources believed to be reliable but in no way are guaranteed by FSG as to accuracy or completeness. FSG does not offer any guarantee or warranty of any kind with regard to the information contained herein. FSG and the author believe the information in this commentary to be accurate and reliable, however, inaccuracies may occur. Investors should consider the charges, risks, expenses, and their personal investment objectives before investing. Please see FSG’s ADV Part 2A containing this and other information. Read it carefully before you invest. Past performance is a poor indicator of specific future returns. Such comparisons may be useful in your evaluation of how FSG performs in different market environments. Investors have the ability to achieve results similar to benchmark indices by investing in an index fund or Index-tracking ETF, typically with lower fees. Past performance of any security is not a guarantee of future performance. There is no guarantee that any investment strategy will work under all market conditions. There is no guarantee that the investments mentioned in this commentary will be in each client's portfolio. This material is intended only for clients and prospective clients of FSG. It has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument, or to participate in any trading strategy. This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material may not be suitable for all investors. No mention of any security or strategy should be taken as personalized investment advice or a specific buy or sell recommendation. Please contact FSG to discuss your specific financial situation and suitability. S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market. 8 • Taxable Status of Account: Whether funds are held in a taxable or non-taxable account will affect performance. The Diversified Sector Program was created originally for tax-exempt or tax-deferred accounts. However, a version of the same strategy is employed for taxable accounts. The model account for this strategy is an IRA account. Historically, few distinctions with regard to positions were made between taxable and non-taxable accounts. Currently, some investment decisions are made with regard to the taxable status of the account. • Waiver and timing of all or some advisory fees - The actual timing of the deduction of advisory fees in a client account may differ from the timing in the model account. This may create a disparity between the asset allocation and position allocation of the client account versus the model account. • Different fee schedules based on asset size - FSG model returns are calculated according to the highest fees charged. Some actual fee schedules may be lower. • Technical trading errors - Trade errors are corrected according to the guiding principle that the client always be made whole. • Different commission rates - This fee is primarily generated in FSG accounts when trading in ETFs and is charged directly to the client by the brokerage firm. FSG does not participate in these commissions. • Performance of securities transferred into accounts by clients and brokerage commissions incurred from the sale of these securities - Some "legacy assets" may remain in the account indefinitely if the fees associated with their sale do not justify their sale or client instruction prohibits their sale. • Restrictions on holdings in accounts - Restrictions on holdings will prohibit the matching of performance. Whether the restrictions are imposed by the client directly or via the nature of the account, FSG’s inability to align the client’s account with the model account will result in a performance dispersion. Additionally, holdings requested by clients to be maintained in their account(s) will cause the performance of the account(s) to vary from the model account used. • Some restrictions on mutual fund transactions may be imposed by the mutual fund companies. These restrictions are the result of prohibitions regarding short term sales (usually a buy and sell in the same fund within 30 days and typically triggered by the addition or withdrawal of funds in the client account). FSG attempts to avoid these restrictions when possible. • Account size - The proportional effect on performance of fees and expenses accounts of varying size will be lesser or greater than the effect in the model account. In most cases, clients should achieve returns similar to the model portfolio (after adjustment for fees) in accounts over $250,000 that have been established for over 90 days with no additions or withdrawals of funds during the period being measured. This material is intended only for clients and prospective clients of the FSG. It has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument, or to participate in any trading strategy. This particular material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material may not be suitable for all investors. No mention of any security or strategy should be taken as personalized investment advice or a specific buy or sell recommendation. Please contact FSG to discuss your specific financial situation and suitability. It is always the intention of FSG to minimize any negative effect on clients. Our success in that effort, however, is subject to unanticipated market conditions. Consequently, past performance does not guarantee future returns THE 70% SOLUTION REPRODUCTIONS: Email forwarding and/or complete reproductions are authorized (must include complete attributions and disclosures). All partial quotes from The 70% Solution must include the source of your quote and reference to Financial Solutions Group LLC (FSG), the author’s name, With the exception of complete reproductions and email forwards, please write to [email protected] to inform FSG of the time and location of the reproduction. Copyright © 2013, Financial Solutions Group LLC. ALL RIGHTS RESERVED. FSG is not liable for any actions taken in reliance on information contained herein.