Long Term Transitory Inflation

As the Covid coma of 2020 has morphed into the economic boom of 2021, inflation has become a top concern among forecasters with Google searches for “inflation” spiking above peaks from 10 and 13 years ago. The last inflation anxiety peak was in 2010-11, when the post financial crisis fiscal stimulus amounted to 10% of gross domestic product (GDP). The current US stimulus response to Covid-19 has been a whopping 27% of GDP. It should be no surprise that higher than normal inflation has arrived, but the debate is centered upon it being transitory or sticky. If drinking games were created around the number of times Fed Chair Powell or media pundits have spoken “transitory” regarding inflation, then AA meetings would be beyond capacity. Transitory inflation connotes an inconsequential short term uptrend and sticky relates to a more alarming long term cycle. These are meaningless adjectives without context of time and amplitude. Transitory can be days or even years depending upon one’s perspective of duration, while the amplitude or degree of inflation could be as perilous as the 1970’s or a more placid rise in prices as witnessed in recent decades. 

 In 1917 when the US joined the so called “Great War” (WWI), the Consumer Price Index (CPI) was created when retail price inflation resurfaced as a major economic concern. The CPI allowed us to uniformly measure the level of anxiety amongst consumers and provide fodder for politicians to blame the party in power. While the CPI or inflation index is different for every individual depending upon their spending habits, extreme change in such a general price index was a useful tool for economic policy making. Inflation as measured by the Fed’s preferred core personal consumption expenditures (PCE) ex-food and energy, has risen to 29 year highs of 3.1%. However, we suspect it will peak in the Fall and plateau into the Spring of 2022 modestly above 3%, until exogenous supply chain shocks highlighted by labor shortages catch up to peak demand. As we look at the current wave of rising price indices, some worry over a return to the tortuous CPI stagflation levels of the 1970’s with significant Dollar devaluation and double digit interest rates. As we have noted many times in the past, the 1970’s were a unique period due to the US overturning the Gold standard for an unbacked free floating currency system that ended the convertibility of Dollars for gold. Once the global exchange rates found an equilibrium in the 1980’s, the inflation rate decelerated to manageable levels that accommodated long term economic growth. The massive monetary and fiscal stimulus to counter Covid’s economic lockdown in 2020 plus pent up demand manifesting in 2021 are also unique factors this cycle that spurred inflation above its 2% trend. We do not believe this cycle will generate another alarming price shock similar to the 1970’s when inflation stayed in the 6 to 10% range. 

The other standout bout of inflation over the past century, that a smaller minority worry about, occurred exactly 100 years ago in the German Weimar Republic (1921 – 1923). While it’s easy to feel a degree of shadenfreude over Germany’s post war pain after the atrocities they caused, the hyperinflation and economic disaster in Germany during the 1920’s was essentially forced upon them by their conquerors. The occupation of Germany and crushing financial reparations imposed by foreign powers did extract the pound of flesh being sought to assuage an angry Europe, but the unrelenting suppression unwittingly led to a hyper currency devaluation, mass unemployment and the eventual rise of Hitler and WWII. During the current era of Quantitative Easing (QE)  from 2008 to 2021, where Governments created trillions in artificial currency to utilize for real consumption, some worry of a return to the Weimar Germany era where wheelbarrows of money were needed to buy basic daily necessities. Like the exogenous event of a new currency system in the 1970’s, the 192o’s German experience was a unique historical occurrence of an isolated economic system, in their case, being repressed from the outside, with no realistic solution for the scarcity of production that resulted. Perhaps a similar fate could arise today if the US were the only country printing trillions out of thin air or if cryptocurrencies replaced the US Dollar as the primary medium of exchange, but there are no signs of either at this juncture.

While we don’t expect alarming inflation at levels mirroring the 1970’s, we certainly acknowledge that rising rates of inflation above those of the past 20 years has arrived and will remain above trend into 2022 before working back down towards the desired long term 2% PCE. China is trying hard to depress commodity prices in telling its purchasing managers to avoid stockpiling during the expansion. However, China is no longer the world consumer dictating price, despite being the largest buyer of many commodities. China has had some success, with local iron ore and coal prices down more than 20% in the past few weeks. But the Bloomberg Commodity Spot Index is only down around 1% over the same period. Freeport-McMoRan, the world’s biggest producer of copper, said scarcity of the metal will trump any cooling efforts by China due to huge demand, while supplies would take years to increase significantly. Manufacturing is witnessing its most robust expansion in 4 decades with record labor shortages that will extend the supply expansion and keep pricing pressure high. Finding workers is a secular issue as Western economies age, but this is unlikely to trigger out of control prices such as the 1970’s or Germany in the early 1920’s. Once the stimulus money is spent and individual savings pools are drained this year with a fully open economy, the Fed will allow interest rates to rise until its core PCE inflation measure is back into the low to mid 2% range. 

A major sign of complacency over rising prices comes from reading the tea leaves of the inflation sensitive Bond market. Interest rates have been falling for 40 years as the disinflation trend continues from the 1970’s peak, despite ever greater artificial Government stimulus needed to sustain consumption growth. The subdued rebound in yields and loan rate over the past year in anticipation of an economic recovery, indicates almost no hint of pending inflation concern.

In a March interview on Financial Sense (https://www.financialsense.com/podcast/19888/stimulus-may-juice-economy-record-double-digit-growth-says-kurt-kallaus) we mentioned that GDP could peak above 10% during 2021. Given the explosive rate of economic growth that has become consensus along with record high copper, lumber and iron ore prices, we would have expected over 2% yields in the 10 year Treasury. However, Bond investors appear to be betting that exogenous temporary factors of pent up demand and stimulus are pushing GDP and inflation levels above recent expansion cycles on a temporary basis. Current wage inflation of 3.5% today remains in its 5 year range. With record labor shortages, wages could rise at a 4 to 5% rate later this year, which will indirectly keep overall PCE inflation moving modestly above 3%. Our outlook is for 10 year yields to rise from the very moderate 1.59% yield this week to 2% before year end. Modestly higher inflation over 3% is likely through the end of the 3rd quarter, which should keep the general stock market at risk of a 10 to 15% correction. These moves in bond yields, inflation and stocks should be viewed as rational growing pains after the excessive efforts to “inflate” the economy triggered a demand shock that will require another year for supply to catch up. For now the the Dollar and Bond markets are showing no worry of systemic long term inflation risk. It’s likely the Federal Reserve will continue to temporize the decision to officially taper its stimulus until unemployment tests 5% later this year and employment approaches pre-pandemic levels of over 152 million next year.

Some tapering may have already begun? Money Supply and Federal Reserve asset growth has flattened lately and should continue to moderate through Q3 when inflation momentum may reach a temporary peak. Should monthly job growth approach one million, the bond market may force the Fed to openly “talk about talking about” rate hikes and tapering its bond purchases.

For stock market investors, they will need to watch their Bond investor cousins for momentum spikes or drops in yields that signal anxiety of either overheating inflation or Fed credit tightening. The broad based SP 500 Index forward price earnings ratio (PE) is well above its 5 and 10 years averages at 21 today, thus vulnerable to peak economic reopening expectations. In this ransomware, rising interest rate and labor hiring environment, we would continue to favor financial, cyber security, leisure and employment sensitive stocks. Our report due next week will list sectors and individual stocks that have room to run despite the current overbought stock market valuation.

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