Pundits are forecasting high inflation, even hyperinflation in some cases. There are signs everywhere of higher prices. Used cars, lumber, electronic gadgets, food, houses and gasoline are just some of the examples. The Federal Reserve is getting the blame but I believe Congressional spending packages are the real reason. Accepting this, it’s hard to blame anyone because the alternative was economic collapse.
The chart below does a nice job of illustrating how Congress made inflation jump by increasing spending by more than $5 trillion since Covid started. This is the real reason for the jump in inflation.
Yes, it was the Federal Reserve that purchased those extra Treasury bonds so the government could send out checks to keep the economy from imploding but it’s similar to the “chicken/egg metaphor where it’s unclear which came first. If we follow the transactions that caused the increase in prices backwards, we find ourselves in the US Treasury Department where the checks were issued.
By purchasing all of the additional Treasury Bonds issued by the US Treasury, the Fed makes it possible to spend without an attendant increase in interest rates. In this way, the Fed keeps the supply and demand of bonds in balance. The place where we really see the impact of the Federal Reserve’s activities is in the stock market. As you can see from the chart below, the size of the Fed’s balance sheet correlates strongly with the S&P500 stock index.
You can see a five year difference where the Fed’s balance sheet was flat while the stock market rose in price. This was a function of a sharp increase in stock buybacks and the Trump tax plan in 2017 which freed up more corporate cash flow for buybacks. Since Covid struck, the move in stocks has been almost perfectly correlated to the Fed’s balance sheet.
The Global Supply Chain
Another key factor in the higher prices we face is the global supply chain. Initially, the wholesale and retail markets across the globe started slashing orders for manufactured goods when Covid struck. In addition, Covid restrictions made it impossible for workers to get to factories and warehouses across the globe. Once it became clear that some people would be able to work from home, orders for electronic equipment skyrocketed. It caught the world unprepared for both the drop in output and the subsequent avalanche of new orders.
This resulted in transportation assets distributed around the globe, far from the places they needed to be. In effect, a global supply system that was highly predictable suddenly became unpredictable which greatly added to the costs of moving goods around the world.
With Covid still raging in the emerging markets, it’s likely that we’ll suffer through supply chain imbalances for quite some time. People who lump all price increases together in their analyses of inflation will miss this important component which signifies temporary inefficiencies more than anything.
The global supply chain will ultimately sort itself so that leaves us to watch Congress for future signals of inflationary pressures. With the US Senate split 50-50 between Democrats and Republicans and growing ideological differences growing within the Democratic Party, it’s going to take bipartisan efforts to pass future bills and that’s only likely if the economy turns negative. The currency markets appear to agree with this assessment.
The chart below shows the value of the dollar against a basket of other currencies. On two occasions it almost dropped through the 90 level but rallied back. Pundits attributed the declines to the trillions of dollars in government spending and the Fed’s willingness to monetize that spending. Instead, the second chart explains why the dollar fell versus other currencies.
By importing far more than we exported during 2020, world markets were flooded with dollars. It was simple supply and demand. Dollars which would otherwise have been spent in the US for domestic goods and services were sent abroad so we could import the things that made us comfortable while we experienced Covid restrictions.
With the US economy re-opening for the most part, consumer spending is shifting away from imported goods, removing the inflationary impetus on those goods. The strength of the dollar suggests as much.
There are also two market signals that indicate a lessening of inflationary pressures. The first is the price of copper. It’s telling us that inflationary pressures are abating.
The second is the 10 year Treasury Bond where the yield has dropped from 1.75% to 1.30%. Historically, the yield on Treasury Bonds has been an indicator of future inflation expectations with falling yields indicating a decline in inflation expectations. Interestingly, 10 year government bonds around the world have been dropping in yield suggesting global inflation expectations are falling as well. Both charts together indicate both a lessening of inflationary pressures and uncertainty about future economic growth.
The stock market is having another great year with the S&P500 up 16.5% year to date. As mentioned earlier in this piece, it’s the Federal Reserve that is responsible for this strength but it’s not creating strength across the board as there are many stocks that are no longer participating in the rally.
As much as it’s been beneficial to simply ride the Fed’s coattails to market expansion, the Federal Reserve has limitations just like everything else in life. The Fed’s limitations revolve around the US Treasury market. If the Fed takes too many US Treasury bonds out of the market by purchasing them, the US banking system loses the high quality collateral it has historically used as backing for short term loans. In effect, this has the potential to create a liquidity crisis, which would force the liquidation of levered stock positions. We’ve already seen some stress in the overnight funding markets which suggests the Fed is close to its current limits.
While I don’t believe the Fed will allow that to happen, the only way we will get more Treasury bonds in the market for the Fed to buy is if we get the Democrats and Republicans to act together on a future spending package. But what would scare them enough to work together? Historically, it’s taken a drop in the stock market.
And that’s just what might be happening. Yes, the S&P500 Index continues to move up but the majority of industries that make up the index appear to have topped out in May or earlier in the year. The topping in most industries coincided with the topping in the price of copper. This means that the recent positive move in the market is a narrow advance and that often precedes a downward move.
The next chart is my favorite for showing risk/reward in the markets. It’s the S&P500 priced in volatility units, or VIX. History has shown that when this chart gets into the 250 range, the markets tend to experience a correction.
This doesn’t mean that a correction is imminent but it does tell us to prepare for possible volatility in the equity markets.
The US Economy
The impact of Covid on our economy a year ago when everything was shut down is analogous to when a person’s heart stops beating. In such times a doctor will administer a shot of adrenaline to the heart to restore its beating. We can say the same thing for the extra $5 trillion spent by the government and the monetization of that money by the Federal Reserve. The extreme action got our economy going once again and allowed the stock market to reach new highs. But did it fix anything?
Adrenaline will typically induce a strong heart beat for a short time but if there are underlying issues with the heart, problems will resurface. The same can be said for “shock and awe” in fiscal and monetary policy.
We’re still nowhere near pre-Covid employment levels. One important reason is that unemployment benefits have been so generous as to make it unwise to return to work. But another reason is that a lot of small businesses shut down over the past 18 months and small business employs roughly 2/3rds of our workforce.
After spiking thanks to federal government guarantees, business lending is once again falling which suggests that our economy is getting addicted to government guarantees and that we are less willing to accept risk when the guarantees run out. We’ve already witnessed Wells Fargo shut its personal credit line business suggesting a drop in liquidity for the bank’s customer base.
Historically, it was rapid growth in bank lending that created inflation. The Federal Reserve would slash interest rates and banks would rush out to offer loans to credit worthy borrowers. This is how central bank policy worked in the past.
Today it’s much different as banks are in no rush to make loans and credit-worthy borrowers are hesitant to make large scale investments in business capacity. In an odd twist, the popularity of junk bonds makes it easier for corporations to borrow money to return capital to shareholders in the form of stock buybacks and dividends which reduces the availability of capital for making investments. In this way, central bank policy works against economic growth.
This is why I’m not convinced the economy is recovering as opposed to enjoying a flash of adrenaline. There are deep, systematic problems that won’t be solved by extra money and a divided electorate.
It’s also the reason why I’m more sanguine about inflation than other analysts. For me to forecast continued growth in inflation, I would have to see another big spending package pass through Congress. Until that time, I believe deflationary pressures will once again prove dominant.
If the US economy is a question mark, the global economy is a certainty – it’s still weak. Whereas US Covid cases are in decline thanks to highly effective vaccines, the global economy
is still suffering the ravages of the virus. In recent days, we’ve witnessed increasing lockdowns in Japan, China, and Australia that are expected to impact the Olympic Games. We’ve also seen a regrowth of the virus in regions that were supposedly fully vaccinated. This appears to have been a function of using Chinese vaccinations which seem to scale between useless for stopping the virus to roughly half effective.
China continues to experience severe issues resulting in lockdowns in their most critical economic regions. With much of the world’s supply chain flowing through China, we shouldn’t expect much help on the inflation front. Indeed, things are so difficult in China right now that their central bank was forced to slash rates by 0.50%. Does this look like economic recovery?
I’ve previously discussed how China is heading into demographic decline thanks to the negative impact of their former one child policy. When we add the continued difficulties of Covid and the Communist Party’s increasing crackdown on individual liberties, China seems destined to go the way of the former Soviet Union.
This will result in profound changes in the global economy. Where Asia has been the growth engine for the world over the past thirty years, growth is likely to shift to other locales.
We’re approaching an important decision point for our nation. If we continue to pass large government spending packages, inflation will become an enormous problem in the future.
If we don’t continue to pass large spending packages, the Fed will either be forced to stop adding money to the banking system in the form of monetizing Treasury Bonds or they will be forced to buy Corporate Bonds because they’ve run out of Treasury Bonds. The result will either be a crash in the stock markets or a rally that will make all others look tame by comparison.
Getting ahead of the curve and having a plan is more important than ever before because our nation is at a turning point. As a society, we can move in a number of different directions, with each direction providing different outcomes for investment portfolios. Having a plan for each is critical to long term success.
The GeoVest Approach has proven to be the right approach over the long term and we expect this to continue long into the future. Thank you and it is our continued pleasure to serve you.