Highlights:
· It seems clear that widespread vaccination is the key to ending the COVID-19 pandemic. What is less clear is if the spike in inflation created by a surge in consumer demand, coupled with supply chain bottlenecks, will turn out to be transitory or sustained.
· The Fed currently believes we are experiencing transitory inflation due to the reopening of the economy and remains committed to loose monetary policy until there is a more complete recovery in the job market.
· We recommend investors refrain from trying to predict inflationary, or any other economic trends, and adhere to the approach of an investment policy based on time, and not timing.
Commentary:
We have dedicated considerable space in the last few reports to the ongoing COVID-19 pandemic. We are going to pause with this report. Not because we believe we are out of the woods and the pandemic is over. Look no further than the spread of the Delta variant and recent news that the Olympics will be held without spectators as Tokyo enters another state of emergency as evidence of this. Rather, the situation seems to have become significantly clearer over the last couple of months – geographic locations with high vaccination rates appear to be successfully reopening their economies, while many areas with low vaccination rates continue to struggle with outbreaks, including the recent Delta variant, that make reopening their economies more challenging.
The other notable trend is that after falling behind due to longer approval processes, procurement delays and infrastructure issues, vaccination rates in Europe, and even some emerging market countries, are now higher than in the U.S. This appears to be due in large part to vaccine hesitancy in more rural areas of the U.S. It will be worth watching to see if Europe experiences the same vaccine hesitancy that the U.S. has experienced as the percentage of its population that is vaccinated rises. With the world’s biggest sporting event being held in a bubble, in a country where just 15% of residents are fully vaccinated, it is pretty clear that vaccination remains the key to officially ending this pandemic.
Having established a strong correlation with vaccination rates and economic activity, investors have shifted their concern toward inflationary pressures. There is a good chance that the word of 2021 in the investor and economist communities will be ‘transitory.’ Often expected, but not really seen since coming out of the Great Recession, the inflation debate largely centers on whether or not the jump in year-over-year economic data due to massive government spending, a rapid release of household savings built up during the COVID-19 pandemic and supply chain bottlenecks, will stick around for years to come (sustained inflation) like 1970s-style inflation, or pass quickly (transitory inflation) and fall back toward the central bank’s long-term 2% target.
Nobody wants to relive the turbulence of the 1970s, when the CPI climbed annually and peaked at a rate of more than 13%, but it is important to remember that the reopening of the economy is hopefully a one-time phenomenon and the spike in prices caused by pent-up consumer demand and supply chain delays is not inflation. Inflation is not really inflation unless it persists over months and years. Higher prices can often times be the elixir for high prices, meaning that consumer and businesses often recoil when goods and services cost too much. How long it takes this process to unfold is the trillion dollar question.
The Fed’s current belief is that we are in the midst of seeing transitory inflation caused by year-over-year comparisons that are distorted due to the pandemic. This does not just apply to inflation statistics. Earnings per share for companies that make up the S&P 500 index were up 225% in the first quarter of 2021 compared to the first quarter of 2020. This is largely because earnings took such a large hit during March of 2020 as the pandemic began to unfold, not because profits are soaring. Likewise, inflation comparisons from last year are exaggerated because they are being compared to a deflated base in 2020.
Furthermore, a large portion of these gains is currently being driven by a few small categories, such as cars, rental cars, airfares and hotels, despite these categories actually comprising a very small portion of the core CPI basket. The contribution from these categories is so large now because the comparative increases are enormous but are unlikely to be sustained over the long term as prices recover back to pre-pandemic trends. What matters most to the Fed’s longer-term inflation outlook is the trend in larger, more durable inflation categories such as rents and healthcare services. Inflation trends in these categories are currently more muted. Comparing inflation today from two years ago, which subdues the impact due to the pandemic, shows that inflation is trending a bit higher than usual, but not outlandishly as headline year-over-year statistics indicate.
Investors will be watching to see if monthly inflation readings drop back below annualized rates of 2% towards the end of this year and beginning of next year. If this plays out, it would lend support to the transitory inflation theory, which is largely based on the premise that a decline in government spending will act as a drag on economic growth and keep inflation in check. The $1.9 trillion bill that President Biden signed in March will largely expire this summer, and enhanced unemployment benefits will expire shortly thereafter in many states.
The other side of the argument is that if inflation remains elevated throughout this year and into next year, it could start to feed on itself. Companies would likely have to increase prices to cover the higher cost of raw materials, workers might start to ask for compensation increases to maintain their purchasing power, and the Federal Reserve might need to raise interest rates prematurely to prevent runaway inflation.
Wage inflation is typically considered the key ingredient for a sustainable inflationary trend because higher wages are typically more permanent in nature and are passed on to consumers in the form of higher prices of goods and services. There is no doubt that employers are currently finding it challenging to hire a sufficient amount of employees to meet consumer demand. If you have been to a restaurant or hotel recently, you might have even witnessed this first hand. In an environment where the supply-demand dynamic favors employees, employers have to increase wages. The question is whether this labor shortage is temporary due to a mismatch between skills and openings created by the pandemic, or the initial stage of a new economic cycle in which employees hold significant bargaining power over their employers.
At this time, the Fed, Biden administration, and many economists, seem to believe that a normal labor environment is likely to emerge later this year in conjunction with vaccine rates continuing to rise, the expiration of enhanced unemployment benefits, public transportation schedules largely returning to normal, and easier child-care as many schools are likely to be back in session in-person this fall. This has the potential to create a Goldilocks scenario with high levels of employment and robust wage growth for even the lowest paid workers. On the other hand, if workers are slow to return and outsized demand for labor meets stubbornly reduced supply, the result is likely to be even larger and faster wage gains for those who do work, which could provide a tailwind for sustained inflation.
The Fed’s goals are full employment and price stability, and there are times, like now, when these two goals conflict. For his part, Federal Reserve Chair Jerome Powell has made it clear that the U.S. central bank wants to see a “broad and inclusive” recovery of the job market and “will not raise interest rates preemptively because we fear the possible onset of inflation. We will wait for evidence of actual inflation or other imbalances.” Thus, the Fed is currently focusing on putting as many people back to work as possible, but it is fair to wonder how long they will allow inflation to run over its desired threshold of 2% before taking action to control it. To this point the Fed has repeatedly referred to current inflation as transitory, so it is likely 2022 inflation readings, at the earliest, that will dictate any shift in monetary policy.
In the past the Fed has erred on the side of raising interest rates sooner rather than later, but even when it was trying to raise the inflation rate during and after the Great Recession, it remained stubbornly low. The central bank’s monetary expansion after the Great Recession was intended to bring about higher inflation, but it did not. Many economists believe that this suggests that something has changed about the connection between the money supply and consumer prices. One theory is that disinflationary forces, such as cheap technology and globalization, present a headwind for the pricing power of both workers and businesses.
It is clear that officials at both the Fed and the Biden Administration are trying to create a stronger economy without also causing a different set of problems, of which runaway inflation is at or near the top of the list. The ideal outcome that would lead to broadly rising living standards would be a growing economy in which incomes are increasing faster than prices, and stable inflation. This would be an upgrade for the U.S. economy that was characterized by low inflation and weak income growth for most of the past few decades.
We refrain from making predictions on inflation and interest rates in the same way we do not time equity markets. While our opinion might be that supply chain bottlenecks are going to take longer to resolve than many people might appreciate, we are also mindful that it was only 12 short years ago that conservative critics were forecasting an outbreak of inflation due to easy money and excessive federal spending, and this has not yet come to fruition. It is too soon to know whether the recent rise in prices due to temporary supply shortages is the beginning of a sustained inflationary cycle, or if the secular disinflationary headwinds of the past few decades will prove more lasting.
If you are confused at this point of the commentary, that means you are likely following along quite nicely. Warren Buffett and Charlie Munger, Vice Chairman of Berkshire Hathaway and Warren Buffet’s right-hand man, were recently asked to reflect on the lessons they had learned during the past year. Mr. Munger responded by saying, “If you’re not a little confused by what’s going on you don’t understand it. We’re in sort of unchartered territory.” Mr. Buffett agreed, and looked ahead with his response. “We’ve seen some strange things happen in the world in the last year, in 15 months,” he said. “We always recognize the fact that stranger things are going to happen in the future.”
The investment policy we suggest concedes that there is always a proverbial piano waiting to fall from the sky. However, trying to stance your investment policy to time these falling pianos, or “stranger things,” will most likely be a value-losing proposition. Whether it be today’s concerns over inflation or tomorrow’s worries about something else, an investment policy based on time, and not timing, works so long as you are committed to staying invested through all market cycles, most of which will not be fully understood without the benefit of hindsight.
There is a level of intelligence required in investing, certainly as it pertains to an integrated approach that includes cash flow, tax, and estate planning. However, we make sure to check our egos outside the door every morning. As Warren Buffett once said, “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble investing.”
Urban Financial Advisory Corporation – July 2021