US Growth Has Peaked Inflation Will Persist
Long before supply chain issues and soaring consumer prices made the headlines, I warned readers that massive monetary expansion made persistent inflation inevitable. Last winter we headlined “THE GENIE IS OUT OF THE BOTTLE” in reference to rising inflation. I followed up in spring explaining how massive federal deficits had shortened the normal lag.
“A few years back I suggested that the Feds effort to boost inflation would succeed beyond their wildest dreams. In normal cycles there is a long lag of 12-36 months between the time the Fed expands money growth and consumer prices rise more than they otherwise would. The lags are relatively shorter when the monetary expansion is financing government deficits than when it is fueled by loan growth at banks. The immediate economic boost from big deficits in early 2018 fueled rising inflation late in 2019. It takes ever larger deficits to overcome the drag on growth exerted by rising prices. Last year’s shutdown slowed the price hikes, but prices still rose. This year inflation is once again accelerating faster than the growth in output as it has for the last few years.
You may have seen the headline that economic growth rose to 6.4% in the first quarter. You probably haven't heard that consumer prices rose 7.4% in the same time period. The press reported that consumer prices were up 2.6% at the end of March. That 2.6% number represented price changes over an entire year, whereas the 6.4% number was arrived at by multiplying the 1.6% quarterly gain times four. When you calculate CPI the same way prices rose 7.4%. Since then, growth is slower even as consumer prices are rising faster.
Between March and May "transitory" shortages of almost everything pushed consumer prices up at a 9% annual rate. This a mirror image of the "transitory" price reductions during the shutdown in spring 2020. The shortages will diminish as export-oriented economies reopen, companies slowly ramp up production, and price hikes slow spending. The pace of price hikes will slow, but inflation will remain elevated. The 3.1% rate of price increases since the end of 2019 provides clear evidence of the accelerating price trend net of both "transitory" distortions. That rate is about 65% percent faster than the sub 2% inflation of the prior decade. The seeds of that inflationary trend were planted in 2017 with tariffs, reduced immigration and massive structural deficits financed by the FED monetary expansion. Last year's 25% expansion of M2 is only starting to impact the numbers.
Reported CPI will jump in the next few months as annual change gets measured from the spring 2020 shutdown. This summer that statistical anomaly will pass as Chairman Powell has indicated, but prices will continue to rise. We can take a little solace in the fact that unlike ongoing revenue shortfalls from the 2017 tax cuts, this year’s Recovery Act deficits have expired. Businesses attempting to satisfy rising demand will face ever higher costs in 2022, beginning with payrolls. Last years’ letter introduced a chart displaying how consumer prices were accelerating even as economic growth slowed. Those trends continued, as shown on the next page.
At the time, I forecast that consumer prices would continue to rise at least double the 2% pace expected by the Fed and other forecasters. My relatively pessimistic forecast was instead wildly optimistic. Consumer prices rose about 7% in 2021. Everyone has raised their near-term inflation outlook, but most forecasters still regard recent price hikes as an anomaly that will soon pass. The most vocal proponent of this ‘transitory” view of inflation had been Fed Chairman Powell. Those assurances were bought hook, line and sinker by the vast majority of market participants.
Chairman Powell recently stated “we should drop the word “transitory” but the Fed still expects inflation to retreat to 2.6% in 2022. If you were watching closely last spring, the Fed sensed the rising inflation risk. They began draining bank reserves with an unprecedented reverse repurchase program (reverses**). That program grew to almost two trillion dollars. This more than offset the monetary expansion from $120 billion in monthly bond purchases. (Banks reserves determine how much banks can loan. When the Fed buys bonds, reserves increase. Eventually lending rises. The pace of bank lending normally determines money growth).
Last year household savings rose. Individuals and businesses used government handouts to pay off credit card and other debt. Despite a decline in bank lending, money supply grew 25% in 2020 as the Fed “printed” the money for massive deficit spending. Since spring that has reversed. The economy recovered, bank lending soared and money continued to grow at a highly inflationary pace (despite the “reverses”). When money growth is excessive stock and bond prices rise, followed by real estate prices and economic growth. Only 12 to 36 months later does it show up in consumer prices. Time is up. Although the “reverses” slowed money growth, it is still expanding at an inflationary pace. Reducing inflation will require a slowdown in money growth severe enough to trigger a recession. This is not to say that supply chain issues haven’t added to the price increases. In the absence of excess money growth, those supply chain issues would have pushed interest rates up causing a recession this year. The Feds simultaneously attempts to expand (bond purchases) and contract (“reverses”) the money supply have limited the rise in long term rates even as rates on shorter term debt increased in 2021. Low mortgage rates kept the housing bubble inflated while corporations with questionable credit were been able to lock in long term low rates. Credit conditions eased, despite a slower pace of monetary expansion fueling both consumption and stock repurchases. This “flattening of the yield curve” that kept the party going is about to end.
** Reverse Repurchase agreements (“reverses”) - are used by the Fed to temporarily reduce bank cash reserves by selling bonds to the banks, while agreeing to buy the bonds back at some future date on (pre agreed terms). “Reverses” are typically as short as one day.
BOND PRICES AND THE ECONOMY
Chairman Powell’s statement combined with a reduction in the Feds balance sheet signal tighter credit is coming. That expectation was reflected in the flattening of the yield curve (short term rates rising while long term rates have fallen) in December. That temporary flattening puzzled most observers. There was no mystery, just demand and supply:
- Demand for bonds has been sustained by the Feds massive monthly purchases of TBonds and mortgage-backed securities even as China has cut back purchases. Strong demand has kept long maturity bond prices high and yields low.
- Borrowing demand for credit cards, autos and business loans is soaring, pushing shorter term rates higher.
- Supply of long maturity bonds is slowly shrinking.
- o A significant reduction in the Federal Deficit as a percent of GDP from 2020 reduced bond issuance by the US Treasury.
- o The record mortgage issuance in 2021 slowed in December and will continue to do so rates rise. A less accommodative Fed rather than soaring mortgage demand will be the driver behind rate increases in 2022.
- Few homeowners still have mortgages that can benefit from refinancing.
- The rise in home prices has outpaced income gains. Higher rates will reduce home affordability and sales in 2022.
2021 mortgage underwriting standards were not as loose as they were during the housing bubble, but small premium paid by marginal corporate borrowers remains unprecedented. In both cases real (inflation adjusted) rates are far below any other time in history. In the absence of increased deficit spending (FYI -President Joe Manchin sent BBB down in flames) lending to individual and corporate borrowers with marginal credit is what drives economic growth and inflation. Rising rates on both mortgages and bonds issued by companies with marginal credit (aka junk bonds) will slow corporate borrowing and economic growth by mid-year. The yield curve steepened in the first week of 2022 as corporations issue record amounts of long-term bonds to lock in the current rates. Homebuyers will follow suit racing to lock in low rates and providing a last hurrah for rising home sales and prices.
When the economy is awash in underutilized resources during recessions deficit spending financed with easy credit provides a big economic boost. When the system is awash in easy credit or workers and components are in short supply, deficits raise consumer prices, but there is a lag. Two years of excessive money expansion has baked persistent inflation into the cake for the next 18-24 months. Inflation will oscillate month to month but trend higher until rising prices slow growth to the point of recession. The idea that the Fed will be able to slow inflation without seriously disrupting the economy is just silly. Credit remains extraordinarily loose. The Fed will have to tighten a lot more than markets expect.
To put the current excess liquidity in perspective, the average overnight interest rate (currently 0%) has roughly equaled the CPI (currently 6.8%) for the last 100+ years. Similarly, the average yield on the ten year TBOND (currently 1.5%) has equaled the average growth in nominal GDP (currently 4.9%). Based on those metrics, the yield curve should be inverted with overnight rates above 6% and ten year bonds closer to 5%. The aging of the US population (older folks save more and spend less) may keep rates below normal but we still have a long way to go.
WHERE IS INFLATION GOING?
You are not crazy! Consumer prices are rising a lot faster than even the headlines citing the “fastest pace of price increases in 40 years” indicate. In 1981 the Bureau of Labor Statistics (BLS) changed the way inflation is calculated. Using the “old” (pre-1981) math, 2021 consumer prices would have been 3-5% higher. Using that calculation 2021 saw consumer prices rise faster than all but four years since WWII. In three of those years 1974,1979 and 1980 consumer prices rose less than 1% more than last year. The only year in which inflation was significantly higher was 1948. In 1981 the BLS replaced home prices with an estimate of residential rents (OER). OER represents 24% of the consumer price index (CPI) and 30% of core CPI (excluding food and energy). Home price increases were at record highs in 2020 and 2021 while according to BLS math, residential rents only rose less than 3%. Recent reliable surveys indicate that rents on new leases are up 20% from a year ago. This discrepancy is the result of several conditions:
- Rent moratoriums are still in place or just ending in many localities.
- Landlords can only collect federal rent relief payments for a fraction of pre-pandemic rents.
- The OER calculation relies primarily on a telephone survey that asks homeowners what they think the home they live in would rent for. Owners are notoriously slow in adjusting their estimates to actual changes in prevailing rents.
- The BLS only adjusts CPI for one sixth of changes in the rent estimates each month. It takes six months for rent increases to be fully reflected in the consumer price index.
- Actual rent increases lag home prices by about 12-18 months.
If you substitute the 20% increase on new leases for the 3% BLS rent hike estimate, CPI would have increased about 11%. Although this calculation reduces reported inflation in 2021 it will put a floor under reported inflation for the next two years. Even if every actual price paid by consumers were magically frozen tomorrow, BLS math would cause CPI to rise for at least another year. In other words, a great deal of last years inflation will be reported next year. That lag is further compounded by medical costs that are calculated by insurance reimbursement rates (primarily Medicare). They are largely determined by price changes that occurred in the prior year. The shutdown of most elective medical procedures as well as the government takeover of Covid costs essentially froze most of those prices. Higher 2022 inflation is baked into the cake (even if supply chain challenges are resolved) when you add in the sharp rise in wages.
Ending the Covid handouts has done little to alleviate the continuing labor shortage. Those handouts kept workers off the job in 2020, but other factors have since overwhelmed them. The pace of baby boomer retirements has doubled since the pandemic began. More millennials are choosing to keep a full-time parent at home. This is in addition to hundreds of thousands of Covid related worker deaths (as well as a similar number of patients debilitated by long covid symptoms). The US workforce is about 4 million people below pre-Covid levels. The greatest shortage is for unskilled workers in the hospitality and construction industries. Those sectors have long depended on immigrants coming across our southern border. The immigrant surge due to lax enforcement (before “Remain in Mexico” was reinstated) fell far short of filling the worker shortage.
Inflation was kept in check for the pre-pandemic decade (when money growth was only slightly elevated) by a combination of rising world trade, growing immigration and an aging population. US trade is not keeping pace with growth and inflation (despite record deficits). Immigration has again slowed to a trickle. Younger unskilled workers will take years to become as productive as the experienced retirees they replace. The hot job market gives them little incentive to work harder.
Only one disinflationary factor continues unimpeded. Throughout history, technology has continuously increased worker productivity. New technology only helps when companies invest in it. In the current cycle, companies are buying back stock with record profits rather than investing in productivity enhancing new plant and equipment. Productivity rose when the shut downs ended a year ago (as it always does early in a recovery). However, productivity plunged 5% in the 3rd quarter of last year. Year over year productivity gains fell back down to a meager 2%. The lack of investment and loss of skilled workers has been aggravated by pandemic related supply chain disruptions. There should be some productivity rebound in Q4 as companies are forced to invest in equipment and adjust to workers shortages. Q4 growth will almost certainly be better than Q3. Most forecasters expect the inflation to retreat to between 2.5 and 3.5% in 2022, while growth exceeds 4%. That combination is highly unlikely. The more likely scenario is that inflation remains over 4% (and potentially much higher) while real growth retreats to below the 2% seen in Q3 after an upward blip in Q4. Any serious tightening of credit conditions will trigger a recession. The Feds recent guidance of a few small rate hikes is more likely to result in stagflation.
THE MOTHER OF ALL BEAR MARKETS
Capitalization weighted indices like the S&P 500 or the Dow gave the impression over the last few years that all stock prices are rising relentlessly. A banking system awash in liquidity facilitated record share buybacks while a new generation of market participants bought every market dip. These new speculators never experienced the devastating losses that followed the dot com and mortgage bubbles. They have no concept of persistent inflation in the 1970s that ravaged corporate profits and share prices from 1966 to 1982. Despite the current availability of essentially “free” capital and record profit margins, companies seem unable to find many profitable opportunities to expand capacity. Instead, they have ploughed back profits and borrowed money for share repurchases. Those record 2021 profit margins will get squeezed in 2022. Labor costs are soaring and liquidity is diminishing.
Few people realize a serious bear market in most US stocks was underway before the setbacks this week as the new year began. In December, a JP Morgan analyst calculated the return on the average public traded US stock. In early December, the AVERAGE STOCK WAS ALREADY DOWN 28% from its record highs. How can you reconcile that loss with a plethora of indices showing 2021 year to date gains of 20% and up? Divergences like this have been the most reliable indicators that a bull market is topping out. Other reliable topping indicators have appeared. Record margin debt levels, a downtrend in inflation adjusted consumer spending, record level of IPOs and speculation in securities without earnings or yield like Cryptocurrency, SPACs and Meme stocks all tell the same tale. One of our own three key indicators of short-term liquidity recently turned bearish. At long last, this confirmed the universal bearishness of our long-term valuation indicators.
For the last six months I have been agnostic regarding the short-term outlook for stock indexes. Bullish investor sentiment, low rates and solid profit growth for some mega cap companies were juxtaposed against most bearish overvaluations in history. During this period the divergent price action between stocks and sectors accumulated. Similar divergences are now appearing in underlying corporate profits. The most successful corporations continue to increase profits, while smaller firms have been hard hit by rising costs. Throughout 2021 inflation has been ignored and the small rise in rates had a negligible effect on stock prices. Market participants remained bullish, buying every dip. Now divergences indicate that inflation is taking its toll. Stocks of larger, more liquid companies with shorter durations are beginning to outperform in both up and down moves (duration measures how long it takes income from the investment to return the initial principal). Rising rates primarily hurt the value of long duration assets**.
**Stocks and long term bonds are long duration assets, while TBills, money market funds and bank accounts are extremely short duration assets. The higher the dividend from the stock or interest rate on the bond the shorter the duration.
Companies able to sustain earnings as growth slows (along with those that benefit from higher inflation or interest rates) will fare relatively better in this environment. These will likely include consumer staples (earnings), commodities (inflation) and banks (interest rates) that still trade at reasonable prices. Banks stocks will initially benefit from the rise in long term rates. That will change when inflation forces the Fed to hike short term rates more than expected.
Only a tiny portion of the market will escape losses of over 50% in the next 18 months (similar to the bursting of the dot-com bubble). Unlike the dot-com crash when rates were higher, long maturity bonds will offer no safe haven. As rates rise, duration will separate the winners and losers. The extreme overvaluation of long duration equities will be decimated. Losses will come in waves. Those waves will be interrupted by periodic rebounds as the Fed attempts to stop the carnage by prematurely assuring markets that rates and inflation have peaked. Losses will ultimately exceed the 50% decline the major indices suffered following the dot-com and mortgage bubbles. Adjusted for inflation, this is the setup for the mother of all bear markets.
Bitcoin and other cryto assets have been promoted as “digital gold”. What a scam. They have durations approaching infinity, making them more sensitive to rate changes than almost any other asset class. Rather than behave like gold, or other relatively safe havens, they are simply liquidity and rate driven. They have amplified the trends in the most speculative tech stocks, soaring when speculative stocks rise and plunging when speculative stocks fall out of favor. During the two months between early November and early January yields on ten year TBonds increased about ¼ of 1%. During the same period Bitcoin is down about 40% from its high. That’s the good news for crypto fans. Bitcoin may still exist eighteen months from now at a fraction of its current price, while most so called cryto-currencies will be worthless.
Precious metals are also long duration assets negatively affected by rate hikes. However, metals prices react to “real” (inflation adjusted) rates. Metals prices will generally benefit whenever inflation is keeping pace with or exceeding prevailing interest rates. It could be a wild ride. We expect inflation to win the battle when the Fed cries uncle on rate hikes as stock prices fall. We continue add to metals positions whenever gold falls below $1800 an oz. but will happily take profits on rallies.
Home prices are also positively correlated with inflation, particularly in relation to rents. However rising home prices precede rent hikes, and have already soared. Unlike a decade ago rising rents have reduced the “duration” of housing as a real estate investment making them less vulnerable. The immediate issue is affordability. Over the past few years lower mortgage rates have combined with rising incomes to keep housing affordable, despite soaring home prices. Wage hikes are accelerating, but mortgage rates are now rising rather than falling. This will put downward pressure on home sales and prices later in 2022. Don’t be surprised if home prices rise further first. Buyers racing to beat the next rate hike could easily push prices higher given the general lack of inventory. After that, prices are likely to stalemate as unrealistic sellers hold firm and buyers are unable to qualify for mortgages. Home prices will eventually fall as the economy enters recession sometime in 2023, but the carnage of a decade ago will not be repeated.
Throughout 2021 investors ignored the reality that inflation exceeded expectations while growth and hiring consistently fell short. Recent data on the November trade deficit indicates only a partial recovery in Q4 from the dramatic slowdown in Q3. Nominal GDP declined severely in Q3 (from almost 17% to below 10%). The workforce is fully employed. Only a massive improvement in Q4 worker productivity (which fell 5% in the third quarter) can turn that around.
Despite slower growth, recession is unlikely in 2022. Even if hiring slows, a year of acute worker shortages will make companies reluctant to lay-off workers. Mirroring the mortgage bubble a decade ago, “anyone who can steam a mirror can find a job” today. The combination of low unemployment and high accumulated savings will sustain consumer spending for some time even as growth diminishes. The biggest drag on growth will be rising consumer prices. Rising long term rates will punish interest sensitive industries like homebuilding and auto sales. The Fed will resist a comparable rise in short term rates in front of the elections continuing to feed the inflation monster. By November the Fed will be way “behind the steepening yield curve”. The markets will finally recognize this in 2022 as stocks sink into bear market territory. The Feds attempt to catch up as the election approaches will trigger the 2023 recession and extend the market decline. That mother of all bear markets will provide a final great stock buying opportunity for those baby boomers who managed to preserve their capital.
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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 This circumstances material and does not objectives provide of persons individually who receive tailored it. The investment strategies advice. 7 and/ or It has investments been prepared discussed in without this regard material to may the not be individual suitable for financialall 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.
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