In the face of the greatest stimulus in the history of mankind, it is a small wonder that it is leading to the US adding as much debt in the last 18 months as was in place up until 2006 for the whole history of this country. There can be many reasons as to "why," but I believe it is far more important to accept that it is what it is and to now think, "what next?"
According to one of my favorite market persons, Andrew Adams, on October 15th, "Market finally follows through. The stock market continues to support my view that a major bottom has probably occurred, and new highs are probably coming. October 14th was the fifth 80% upside session since September 22nd, which indicates heavy buying over the past few weeks despite the volatility." I would like to believe that this could possibly be the case should we see good 3rd quarter earnings and not too hot of a rise in interest rates, but I wanted to focus today's note more on the concept of inflation. True, inflation is often thought to be an evil concept; one to be feared and avoided at all costs. The problem today is that if too much action is taken by the Fed to stifle it, too quickly, it could result in economic devastation and a virtual screeching halt to a rebirth in economic growth. This is clearly NOT what the Fed is wanting to do.
The Fed's Inflation Test:
The more appropriate question is whether inflation is Transitory, Episodic, or Sticky, and as a result, what is the Next Step? It appears clear that we are seeing, what I think, is a huge shift in view both from markets and increasingly from the Fed and other Central banks with regard to inflation. The latest concept bantered about is whether we are embarking on a period of Stagflation or good old-fashioned Inflation and, as a result, what can we expect next for the economy, the equity markets, and the bond markets.
So, what is the path from here?
Transitory: It has been espoused by Fed officials, media prognosticators, and other market pundits that inflation is nothing to be concerned about and that it is only transitory. I think we can confidently dispose of the idea that this current inflation is a temporary supply chain dynamic that would start to move into the rear-view mirror by the summer months. The labor numbers, unemployment rate, and oil prices have been evidence of this.
Episodic: This is the new “post facto” description that is starting to be mentioned. What does it mean? “Containing or consisting of a series of loosely connected parts or events” Really? Seriously? The events of the past year and the outcomes thereof can be described as a lot of things but “loosely connected” seems a complete stretch in terms of a description. Everything that we have seen in terms of events and policy has been closely intertwined and connected. The reality is that this is just another word being thrown out there because “Transitory” has now become cliché. We have become a society that wants to put a really neat little bow on things by putting events in a special little place and therefore not having to deal with loose ends. Treat everything like a TV episode, with a beginning and an end. Inflation is not an episode.
Sticky: This is going to become the next new word and, in my view, is going to have a much stronger shelf life than both transitory (the only thing that has been transitory is the amount of time this description was being used with conviction) and episodic. The Fed and the Central banks of the World have (again, in my view) become too comfortable in the idea over the last 25 years that they would always have no problem in managing inflation and that disinflation/deflation was the only real issue to be worried about. While saying "it is different this time" is a phrase that has ended in tears in financial markets so many times over the years, the inverse can also be true. When we see how different these events and policy responses are to anything we have seen over this period, why would we possibly not expect a much different outcome?
When The Fed talks comfortably at managing inflation they obviously forget what happened in the 1970s. Don’t get me wrong, I am not implying that we are going to the double-digit core inflation levels of that time, but that also did come from a complacency borne over very low inflation in the 1960s. Let us also not forget that yes, the Fed under Volcker was able to get that inflation under control — but at what cost? Paul Volcker took interest rates to 20%, crushed the economy (deliberately), crushed housing, crushed employment, and as a consequence, crushed inflation. He believed that allowing inflation to run away with abandon was the biggest danger to future growth and prosperity. In my view, painful though it was, history proved him right in that respect and set us up for a strong period of growth and prosperity. However, that was a period in monetary and political circles where there was an approach of doing what you believed was right for the economy, even if that meant pain today for gain tomorrow. It was the era in the US of “creative destruction.”
It appears we are increasingly not prepared to take the pain today to provide the gain tomorrow. Instead, we are borrowing from tomorrow to avoid the financial pain of today. Please don’t explain this to your grandchildren at Christmas this year. Is this the right tactic? Only time will tell. As we exit today’s Great Pandemic, the likelihood that we would be prepared to administer the “hard financial medicine” is probably lower than ever. This is an event that is “nobody’s fault” and no central banker or politician wants to risk sending the economy back into recession at this point. I like to consider the liquidity that has been provided to our system has not only been necessary but could almost be compared to a type of addiction — an addiction that has been now so ingrained into the fiber of our economy that we really need to ask ourselves how we are to wean ourselves off of the addictive liquidity.
As a consequence, and as I have said on a number of occasions, I think we are far more likely to see stickier inflation ahead than at any time in the last 25 to 30 years.
Why, we can ask, has inflation managed to stay so subdued for so long? There are probably many reasons, but four particularly stand out: Globalization, Technology, Preemptive Monetary Policy, and Semi-Responsible Fiscal Policy.
Clearly, Globalization (and the “just in time” inventory management system) has been a strong disinflationary force over the last 20+ years. Just as clearly, this model has been completely exposed by the pandemic. Having all of your supply chain so distant and having minimal to no inventory on hand domestically has been disastrous within the supply chain. To touch on this a bit more, think about all those tankers out there off the coast of San Pedro. Were the contents ordered in July, or were they ordered last October? I believe that it was a massive attempt at building back up inventories when the big box retailers, and pretty much everyone else from appliance retailers to athletic shoe companies thought, "Holy cow! How are we going to meet this unquenched demand we are seeing?" In addition, it is also clear that a lot of the supply chain “cogs” have been decimated/disappeared so this will not be an overnight repair process. It could take years to be fully back on track and even then it will be different from what it was before and likely a far less dampening force on inflation. And lastly, when it has become blatantly obvious that we needed to go to 24/7 shifts and increase the pay to the truckers and dock workers, one has to ask themselves if the current administration brought us to the brink so they could take credit for being the knight in shining armor that rescued the US consumption economy. Hmmmmmm...
Technology is alive and well. This is now firmly elevated from a “nice to have” to a “critical factor of production.” Whether it is to address labor shortages, or as we have seen in the last 18 months, possibly even the difference in a business between survival and collapse, we are clearly moving to a new level of technology focused on both a personal and business level. One small caveat, of course, is that technology is not “costless” and the ongoing supply chain issues and chip shortages may, at least for a while, make this a less disinflationary force than normal in the past recoveries. We still must not ignore the continued deflationary aspect of technology and how it instantly recognizes inventory buildups and shortfalls and adapts immediately. Software and AI are at their finest, as far as I can tell.
Preemptive Monetary Policy:
The rumors of its demise are NOT greatly exaggerated. The Fed has clearly articulated a new era in terms of how they manage monetary policy both on the way in (easing) and, more importantly, on the way out. Add to that their newfound social policy objectives and we can feel comfortable that any more talk of rate increases (hawkishness) will probably be much more gradual and much more about what they see than what they anticipate. This is super important as technology and the "just in time" global economy has taken a 'normal' time period of gestation to higher rates and made it almost impossible to prepare for.
It is therefore clear (to me) that The Fed is and will continue to stay deliberately ‘behind the curve." I think the better question is do they have a choice? I mean, find me another time in history where the stars misaligned the way they are now!
Semi-Responsible Fiscal policy
It has always been a “kind of a given” that as we move through the economic cycle we end up having to borrow more money during downturns due to reduced fiscal revenues. Now, if you were Margaret Thatcher, you would argue that that is OK as long as you put money aside during the good times for a rainy day to balance it out. That is also a policy that Alexander Hamilton would likely have supported. In addition, he felt borrowing was acceptable if you had a clear repayment schedule and were borrowing to invest in the economy such that the return over time would outweigh the cost. That world is long since gone. As a function of the change from an accommodative economy, and assisted by the 40-year bull market in fixed income (and now QE), we now borrow a lot of money in the good times and an exponential amount of money in the bad times.
The present debt stands at around $28 trillion ($79k for every person in the US and about $202k per household). In 2005 that number stood at less than $8 trillion. With interest rates now having reached zero the ability to constantly refinance this at lower interest rate levels has essentially passed us by after a 40-year bull market. That is, presuming that we do not go down the disastrous policy route of negative interest rates. Our interest burden is the highest ever (8% of the Federal budget) and when combined with Social Security (23% of the Federal budget), Medicare (25% of the Federal budget), Defense (16% of the Federal budget), safety net programs (8% of the federal budget), and Federal retirees/veterans (8% of the Federal budget), amounts to a total of 88% of the budget and a higher figure than total Federal revenues in 2019 (Source: Center on Budget and Policy Priorities).
We should also touch on Employment here and some of the statistics other than the one-dimensional NFP that are important.
- The Household survey last month was much stronger than expected and the lack of people choosing to continue seeking employment shocked the economic forecasters. People simply chose not to go back to the workforce. Is this due to free money? That is a whole other discussion, but let’s just take it for a fact that fewer people chose to back to the workforce.
- The unemployment rate dropped to 4.8% from a peak of 14.8% in April 2020 (17 months). The peak at 10% during the financial crisis posted in October 2009 did not see a return to 4.8% (from a far lower peak) until January 2016 (7 years and 3 months)
- Even if the labor force were to quickly return to its pre-COVID peak, that would add about 3.3 million workers, leaving us with likely 5.5 million potential workers with over 10 million jobs; an almost 2:1 ratio (providing we had the right skill set matches). Of course, all of this also does not take into account the consideration that as the economy opens up, even more jobs could become available.
- Bottom line the labor market is unequivocally, extremely tight, and in the World of supply and demand that means higher wages (stickier inflation) which has already clearly started to happen.
It is clear, as I noted above, that it is appearing that the narrative on inflation is changing. However, I don’t think it is going to change aggressively. Yes, I believe that further Fed hikes and a sooner move (maybe even ultimately by September of next year with June not impossible) may occur. However, if it does occur, it will be because the economy opening up and transitory/episodic inflation now looks like core sticky inflation (not stagflation). As a consequence, the adjustments will likely not be remotely able to keep up with the changes (i.e. remaining behind the curve). We talk a lot about how tapering is not so much tightening as it is a slowing of accommodation into a point of incrementally being neutral — not tightening and not staying accommodative. With core CPI at 4% and the Fed funds rate at ZERO, it could take a very long time, if ever, in this cycle under the new Fed policy to get to a point where the Fed is actually tightening in real terms especially if inflation stays sticky at levels higher than we have been used to.
In my view, we are setting up for a new inflation era that, without a financial and or economic crash (massively dampening demand and thereby inflation), is not going to see policy measures that are remotely geared to contain/reduce it. In the weekend edition of Wall Street Journal, there was an article titled, "Inflation Isn't Always All Bad." The translation, as I see it, is that inflation, if measured and moving at a manageable rate, is nothing more than a reflection of economic prosperity. If we are able to come out the backside of this pandemic, supply chain lockup and labor shortage with a sustainable growth rate and inflation that does not scare manufacturers, retailers and ultimately consumers, we could be in a happy place where the interest rate market takes care of itself, the Fed coaches rates and growth to where they feel it should be, and equity prices continue to benefit from good growth rates without runaway inflation. A tall order? Maybe, but hey, if the beginning of third quarter earnings and the lack of large moves in precious metals or interest rates are any indication, things appear ready to improve where problems exist, and companies seem to be managing through the minefield pretty well.
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