What a Difference a Year Makes
May 14, 2021
Covid is ending in the USA and Inflation is rising. What a difference a year makes!
We suggested outcomes during the past year that appeared probable to us, and because many were unwilling or unable to accept the possibilities for: a swift economic recovery, a Covid-19 vaccine, money creation and spending on an unprecedented scale, and higher prices for goods and services as we recovered, the opportunities for investment had been abundant. Hopefully, we were fortunate to capture some of them, but we will always strive to do better.
We suggested investing in asset classes and companies that would keep up with currency debasement, and be able to pass on price increases as demand picked up. I suppose we were generally “right” in our thinking that prices would rise because of Fed policy, increased fiscal policy, and increasing consumer demand. Although, I am not sure this prediction was particularly clever. Last year, expectations for demand destruction seemed like consensus, and prices for many goods and services across the economy were soft. If we look back, it seemed companies had a perceived oversupply of lumber, oil and gas, rental cars, hotel space, etc, for an economy that was about to fall off a cliff due to a pandemic.
As it turns out, the economic predictions of demand destruction turned out to be either completely wrong, or much shorter lived than expectations. Last year, personally, I was able to buy a car at a reasonable price, travel across the country, stay in very nice hotels at low prices, and generally enjoy uncrowded roads and space. Those days seem long gone. As Covid comes to an end (at least it pertains to being the only risk we face) in the USA, people seem to all want the same things at the same time. They have been given more money to spend, and they have more time on their hands to do it. Just try to buy a boat on the East Coast or try to book a ferry to the islands! Is it any wonder when everyone is competing for the same goods and services, the supply of many of those goods and services is constrained, that prices will rise?
For economists, this should not be surprising; they are called base effects, and their impact on the latest published CPI number were huge. Used cars and energy prices were big contributors to that much higher than expected inflation number released this week.
Much of the media now is talking about this higher inflation, and much market discussion is now about the Fed being “behind the curve”. Stanley Druckenmiller wrote an opinion piece in the WSJ this week essentially questioning why the USA is running central bank and government policy for an emergency when there is no longer an emergency. I am paraphrasing, but he is suggesting there will be consequences to these actions and that the Fed is “courting bubbles” in asset prices. As most of my readers know, I tend to agree that there is way too much money chasing too few assets, and this will contribute to rising asset prices. Voila, prices have risen for many an asset over the past 12 months.
Where do these actions and subsequent price increases in goods, services, and assets (some real and some virtual) leave us now?
From my perspective the environment is trickier to navigate than it was last year. That is mainly because it is harder for me to understand where consensus opinion sits. However, I do have some thoughts that leave me still very constructive on the economy, equity markets, and probably more relaxed than most on higher inflation (and rising interest rates) derailing economic growth and optimism over the next twelve months. Here’s why:
1) On Fed policy: There will be consequences to the Fed aiming policy at specific groups of people in the economy where there are income and employment disparities (see full quote from Powell below in italics). I am not judging their intentions, nor the policy, but I am generally cynical of powerful institutions (even well intended) achieving their goals without collateral damage. So, I agree with Stanley Druckenmiller to an extent. “Bubbles” (whatever that means) will crop up in various pockets, and I think this means generally that people will continue to lose respect for “cash money”, and will take chances buying many risky “investments” that turn out to be worthless down the road. People will likely also be looser with their spending because they have more money. We have also read in the media plenty of social media groups trying to push the price of some lightly regulated or unregulated product higher for the sake of profit. I would agree this is a sign of excess, and I pay close attention. However, I would say this is a necessary, but not sufficient condition as an indicator of an impending change to the investment climate. Therefore, I am back to the big picture theme: The Fed will view inflation as “transitory” and will keep policy unchanged. I repeat as I have done for a year: there is too much money chasing too few assets, and asset prices are likely to continue higher.
2) On Inflation: Is Fed policy going to lead to much higher rates of inflation and much higher interest rates? It is certainly a possibility that inflation continues to rise, and that will cause interest rates to increase significantly, and that in turn will cause slower growth and lower asset prices. However, I place a probability of only 10-20% on this. Why? Here is what goes into my analysis:
Inflation is notoriously difficult to forecast.
I am not sure the most recent economic data gave us any new information (we knew measured prices had to jump in official data; albeit more than the consensus forecast). There is abundant focus on higher inflation in the media and markets because of the rise in the Consumer Price Index, but much of the rise was due to energy prices and used car prices. More energy and cars will likely be supplied (over the coming year) by producers.
Currently, most economic data is noise from my perspective because: Covid supply and demand changes/disruptions and shipping delays, and clogged ports because of Suez Canal disruption. It’s extraordinarily hard to use a model to help in prediction in such times.
The most important issue (in my opinion) that would have caused widescale changes to the inflation outlook was the effort to unionize employees at Amazon. That effort was soundly defeated. The status quo on low-cost consumption of many goods continues unabated.
The world is far more interrelated than it was during the inflation of the 1980’s. Because of this, production globally is incentivized and able to take advantage of many demand and price increases by increasing supply.
I have considered the following question for many years: perhaps excess availability of capital (too much money), actually allows for increasing production at extremely low rates of return (perhaps negative rates of return)? Because capital is available at negative real rates, more capacity can be provided at low or no rates of return to build market share. Would Elon Musk or Jeff Bezos have been able to create the companies they have without access to endless amounts of cheap capital? Therefore, perhaps when interest rates rise, and constrain production increases, that is when inflation will start to rise? This view is totally unorthodox in the light of economic texts, but I believe this is a possibility.
3) Economics is very good at looking backward and projecting into the future, but I think it is difficult to measure productivity gains in real time. The problem is that the economic situation is constantly changing, but many of our biases remain the same. Daniel Kahneman, author of Thinking Fast and Slow, came out in 2011; it made me realize why I became disillusioned with the field of economics while studying at NYU. To me, he was explaining Behavioral Economics before I understood that was even a field of study. As an aside, years later, I introduced myself to Robert Schiller (famous Behavioral Economist at Yale) on a train from New York to New Haven to thank him for his work in the field, and to tell him I wished I studied under him. Despite being perfectly polite, I don’t believe he cared! The point is that humans will adapt to their environment as it changes; relationships are not static. I would suggest that some government assistance (agree or not with the policy) has created incentives that entice people to collect unemployment income without returning to work. Some of the consequence is obviously unproductive. Many friends from the “old neighborhood” tell me they are going to visit Doctor “Summeroff”, and a summer spent on Cape Cod is just the cure. However, I have also seen many anecdotes of resourceful people collecting unemployment assistance, and then launching their own businesses (because they can now afford to do so). The data from the St Louis Federal reserve on the jump in the number of business formations perhaps supports many of these anecdotes. Although claiming benefits may not be technically legal, if you are afraid of the working conditions and the risks of Covid, who can judge? Unintentionally, the US Government might be subsidizing entrepreneurship and business creation! This perversely could be very additive to an already increasingly productive and dynamic economy. I suspect that the economy has adjusted very well to new challenges created by the pandemic.
4) The attention and focus on President Biden’s tax proposals seem a distraction, but it seems to consume the media and talking heads of finance. The factors that leave me unperturbed: thin majorities in both houses for the Democrats, SALT deduction issue is a major conflict for Democrats, and President Biden will start to move toward the center as the midterm elections approach because he is a pragmatic politician.
In summary, although I think the environment is more challenging if you are trying to “outperform” an index, but I still believe there is an important question to ask if you are sitting in excess cash. The question is: What is your plan? Many people answer with: The market is too expensive, or I am safe in cash because the value is certain, or I am afraid of losing my money.
I’m not sure those qualify as answers, but I do hear those responses a lot. If you are adept at placing a valuation on the market, I applaud you, but that is difficult (I claim to have no edge here). I do know the market will never care how you “feel” about it. And, although the value of your cash is certain, I believe the important follow up questions are:
Will your purchasing power be the same in the coming years as it is today?
Will you be able to buy good quality companies that grow their earnings at lower prices in the future? (I guess this is back to the market is too expensive)
Are you confident that currencies currently being printed by central banks will retain their value in relation to other commodities and assets in more constrained supply?
Truthfully, I cannot answer any of the above with certainty. I place probabilities on outcomes based on what I know and based on the research I conduct. I invest based on what I view as the most likely outcomes, and always within the risk parameters and tolerance to fluctuations in portfolio valuations. These risk tolerances are different for everyone, and that is why we spend time getting to know clients intimately (both personally and financially).
Joe Cardello Principal, August Wealth Advisors LLC.
Fed Powell Comment: “Our upcoming SHED report notes that 22 percent of parents were either not working or working less because of disruptions to childcare or in-person schooling. Black and Hispanic mothers—36 percent and 30 percent, respectively—were disproportionately affected. In a similar vein, labor force participation declined around 4 percentage points for Black and Hispanic women compared to 1.6 percentage points for white women and about 2 percentage points for men overall.4 The Fed is focused on these long-standing disparities because they weigh on the productive capacity of our economy. We will only reach our full potential when everyone can contribute to, and share in, the benefits of prosperity.”
Thanks to T.E. for drawing our attention to this comment from Fed Chairman Powell.
Investment advisory services are offered through Stratos Wealth Advisors, LLC, a Registered Investment Advisorwww.stratoswealthadvisors.com. August Wealth Advisors is a DBA of Stratos Wealth Advisors, LLC. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The information also does not intend to make an offer or solicitation for the sale or purchase of any product or security. Investments involve risk and unless otherwise stated, are not guaranteed. All performance referenced is historical and is no guarantee of future results. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed here.