As if waking up to an economic nightmare, investors see
headlines like these and many others flashing across their Bloomberg terminals:
Facebook says Oculus headphone production will be delayed due to virus
Apple extends country wide store closing for another week
Foxconn delays iPhone production
Qualcomm cuts production forecast due to virus uncertainty
Starbucks announces China store closures through Lunar New Year, uncertain when they may reopen
US Steel flashes a warning of a cut in demand
Nike shoe production halted
Under Armour missed on sales, and their outlook is weak. They partially blamed the Corona Virus outbreak.
IEA forecasts drop in oil demand this quarter- first time in a decade
never ending list of delays, disruptions, and cuts rolls on from retail to high
technology. Even services are impacted as flights and train trips are canceled
within and to and from China. While some
technology-based services are provided over the Internet service, restaurants,
training, and consulting, as examples, must be performed in person. Manufacturing operations require workers to be
at the factory to produce products. Thus, manufacturing is much more acutely
affected by quarantines, shutdowns, transportation disruption, and other government
It is as if an economic tsunami is rolling over the global economy. China’s economy was 18 % of world GDP in 2019. For most S & P 100 corporations, the Asian giant is their fastest growing market at 20 – 30 % per year. Even more critical, China has become the hub of world manufacturing after entering the World Trade Organization in 2000. Over the past two decades, U.S. corporations have relocated manufacturing to China to leverage an inexpensive labor force and modern business infrastructure.
Source: The Wall
Street Journal – 2/7/20
Prior to the epidemic,
world trade had begun to slow as a result of the China – U.S. trade war and
other tariffs. World trade for the first
time since the last recession has turned negative.
Analytics, The Wall Street Journal, The Daily Shot – 1/19/20
Based on severity
estimates, analysts have forecasted the impact on first-quarter China GDP
growth. In the chart below from Fitch Ratings, growth for first quarter drops
almost in half and for year growth drops to 5.2 % if containment is delayed:
Sources: The Wall
Street Journal, The Daily Shot – 2/6/20
When news of the
virus first was announced, the market sustained a quick modest decline. The
next day, investors were reassured by official news from China and the World
Health Organization that the virus could be contained. Market valuations
bounced on optimism that the world economy would see little to no damage in the
first quarter of 2020. Yet, there is growing
skepticism that the official tolls of the virus are short of reality. Doctors
report that at the epicenter of Wuhan that officials are grossly underestimating
the number of people infected and dead. The London School of Hygiene and
Tropical Medicine has an epidemic model indicating there will be at least
500,000 infections at the peak in a few weeks far greater than the present 45,000
The reaction, and not statements, of major governments to the epidemic hint that the insider information they have received is far worse and uncertain. U.S. global airlines have canceled flights to China until mid-March and 30 other carriers have suspended flights indefinitely – severely reducing business and tourist activities. The U.S. government has urged U.S. citizens to leave the country, flown embassy staff and families back to the U.S., and elevated the alert status of China to ‘Do Not Travel’ on par with Syria and North Korea. All of these actions have angered the Chinese government. While protecting U.S. citizens from the illness it adds stress to an already tense trade relationship. To reduce trade tension, China announced a relaxation of import tariffs on $75 billion of U.S. goods, reducing tariffs by 5 to 10 %. President Xi on a telephone call with President Trump committed to complete all purchases of U.S. goods on target by the end of the year while delaying shipments temporarily. It remains to be seen if uncontrolled events will drive a deeper trade wage between the U.S. and China.
chaos in the supply chain operations is creating great uncertainty. Workers are
being told to work from home and stay away from factories for at least for another
week beyond the Lunar New Year and now well into late-February. Foxconn and Tesla announced plant openings on
February 10th, yet ramping up output is still an issue. It will be a
challenge to staff factories as many workers are in quarantined cities and train
schedules have been curtailed or canceled.
Many factories are dependent on parts from other cities around the
country that may have more severe restrictions on transportation and/or workers
reporting to work. Thus, even when a plant is open, it is likely to be operating
at limited capacity.
On February 7th,
the Federal Reserve announced that while the trade war pause has improved the global
economy, it cautioned that the coronavirus posed a ‘new threat to the world
economy.’ The Fed is monitoring the
situation. The central bank of China infused CNY 2 trillion in the last four
weeks to provide fresh liquidity. The
liquidity will help financially stretched Chinese companies survive for a
while, but they are unlikely to be able to continue operations unless
production and sales return to pre epidemic levels quickly.
Will the Federal
Reserve really be able to buffer the supply chain disruption and sales declines
in the first quarter of 2020? The Fed already
seems overwhelmed, keeping a $1+ trillion yearly federal deficit under control
and providing billions in repo financing to banks and hedge funds causing soaring
prices in risk assets. While the Fed may
be able to assist U.S. corporations with liquidity through a tough stretch of
declining sales and supply chain disruptions, it cannot create sales or build
Prior to the
virus crisis, CEO Confidence was at a ten year low. Then, CEO confidence levels improved a little
with the Phase One trade deal driving brighter business prospects for the
coming year. Now, a possible black swan epidemic has entered the world economic
stage creating extreme levels of sales and operational uncertainty. Marc Benioff, CEO of Salesforce, expresses
the anxiety many CEOs feel about trade:
“Because that issue (trade) is on the table, then everybody has a question mark around in some part of their business,” he said. “I mean, we’re in this strange economic time, we all know that.”
Adding to the uncertainty
is a deteriorating political environment in China. During the first few weeks of December, local
Wuhan officials denounced a doctor that was calling for recognition of the new
virus. He later died of the disease, triggering a social media uproar over the
circumstances of his treatment. Many Chinese people have posted on social media
strident criticisms of the delayed government response. Academics have posted petitions for freedom
of speech, laying the blame on government censors for making the virus outbreak
worse. The wave of freedom calls is
rising as Hong Kong protester’s messages seem to be spreading to the mainland. The
calls for freedom of speech and democracy are posing a major challenge to
President Xi. Food prices skyrocketed by
20 % in January with pork prices rising 116 % adding to consumer concerns. Political
observers see this challenge to government policies on par with the Tiananmen
Square protests in 1989. The ensuing massacre of protestors is still in the
minds of many mainland people. As seems to be true of many of these events that
it is not the crisis itself, but the
reaction and ensuing waves of social disorder which drive a major economic
has forecast a slowdown in US GDP growth in the first quarter of 2020 to just
Economics, The Wall Street Journal, The Daily Shot – 2/6/20
Will U.S. GDP
growth really be shaved by just .4 %? If
we consider the compounding effect of the epidemic to disrupt both demand and
supply, the social chaos in China challenging government authority (i.e., Hong
Kong), and a lingering trade war – these factors all make a decline into a
recession a real and growing possibility.
We hope the epidemic can be contained quickly and lives saved with a
return to a more certain world economy.
Yet, 1930s historical records show rising world nationalism, trade wars,
and the fracturing of the world order does not bode well for a positive
outcome. Mohammed A. El-Arian. Chief Economic Advisor at Allianz in a recent Bloomberg
opinion warns of a U shaped recession or worse an L :
“I worry that many analysts do not fully appreciate the notable differences between financial and economic sudden stops. Rather than confidently declare a V, economic modelers need more time and evidence to assess the impact on the Chinese economy and the related spillovers – a consideration that is made even more important by two observations. First, the Chinese economy was already in an unusually fragile situation because of the impact of trade tensions with the U.S. Second, it has been navigating a tricky economic development transition that has snared many countries before China in the “middle income trap. All this suggests it is too early to treat the economic effects of the coronavirus on China and the global economy as easily containable, temporary and quickly reversible. Instead, analysts and modelers should respect the degree of uncertainty in play, including the inconvenient realization that the possibility of a U or, worse, an L for 2020 is still too high for comfort.”
Patrick Hill is the Editor of The Progressive
Ensign, https://theprogressiveensign.com/ writes
from the heart of Silicon Valley, leveraging 20 years of experience as an
executive at firms like HP, Genentech, Verigy, Informatica, and Okta to provide
investment and economic insights. Twitter: @PatrickHill1677.
Can Six Myths Keep The Market Going?
Piper Jaffray forecasts by year end 2020, the S&P 500 (SPX) will hit 3600, a 12.8 % increase. Of eighteen analysts interviewed by Marketwatch only three forecasters expect a decline for the SPX. Will the SPX reach 3600? The SPX has soared over 400 % from a low of 666 in 2009 to over 3200 at the close of 2019. Mapping the SPX ten year history onto a psychology market cycle map of growth and decline phases poses interesting questions. As the market has zoomed over 400% upwards over ten years, it is clearly in the Mania Phase. Yet, the US economy is growing at the slowest rate of any economic recovery since WWII at 2.2 % GDP per year, why the disconnect?
Patrick Hill – 12-31-19
reason for the disconnect is investment analysts and the media lead investors
to believe there is no downside risk. On New Year’s Eve, Goldman Sachs released
a prediction for 2020 claiming that the ‘tools of the Great Moderation’ (Fed
policy shift) begun 30 years ago low-interest rates, low volatility,
sustainable growth and muted inflation are still in place and were only
interrupted by the 2008 financial crisis. Plus we would add the Dotcom crash.
GS concluded that the economy ‘was nearly recession-proof.’
mainstream financial media also feed the Mania Phase with stories like Goldman
Sachs declaring the Great Moderation is working with our economy in a ‘new
paradigm’. We are to believe there will not be a recession because our
policymakers have the economy under control.
Really? With over $17 trillion of
negative debt worldwide to keep the world economy going, central banks have
succeeded in sustaining worldwide GDP at 1 – 2 % and falling as of late! For
the SPX market to not descend into the Blow Off phase, investors will need to continue to believe in six economic myths:
Phase of the Economic Cycle is Continuing
Will Bailout the Economy
The Fed Will
Keep the Economy Humming
If the Fed
Fails Then the Federal Government Will Provide Stimulus
The Trade War
Won’t Hurt Global Growth
and Markets Are Insulated from World Politics
Let’s look at each myth that is likely to affect portfolio and market performance in the next year. This analysis is based on research data of economic, social, government, business trends and observation of markets and the economy. If markets are to continue to climb, either policymakers must solve difficult issues or investors must continue to believe these myths are true. The first myth establishes a critical framework for viewing all economic activity. We are actually at the end of the growth phase of the economic cycle; here is why.
Myth 1. The Growth Phase of the Economic Cycle is Continuing
The Fed has reported that the economy is still in ‘mid-cycle’ phase. We differ with this position as several indicators show the economy is reaching the end of its growth cycle and ready to revert to the mean. As GDP is driven 70 % by consumers, let’s look at what is really happening to consumers. The ratio of current consumer conditions minus consumer expectations is at levels seen just before prior recessions not mid-stage growth economies.
Sources: The Conference Board, The
Wall Street Journal, The Daily Shot – 6/14/19
In the chart below, consumers are stretched as
loan default rates are rising despite a 50-year low unemployment rate. Rising
delinquencies tend to signal rising unemployment and economic decline is likely
in the near future.
Sources: Deutsche Bank, Bureau of
Labor Statistics, The Wall Street Journal, The Daily Shot – 6/4/19
Of major concern is that the manufacturing
sector is now in a recession based on five months of ISM reports below the 50 %
economic expansion benchmark. The overall contraction is validated as 70 % of
manufacturing sub-sectors are contracting as noted in the report below. While the US economy is primarily driven by
services, the manufacturing sector has a multiplier effect on productivity,
support services, and employment with high paying jobs. Note the contraction in
sub-sectors is reaching levels last seen before recessions.
Oxford Economics, The Wall Street Journal, The Daily Shot – 12-20-19
There are other indicators pointing to the end of the growth phase. For example, the inversion of the 2 – 10 yield curve last summer is now steepening – often seen before an economic slowdown. Another indicator is the number of firms with negative earnings launching IPOs in 2019 was at levels not seen since 2000. Finally, productivity and capital investments are at ten year lows.
Myth 2. Consumers Will Bailout the Economy
Market pundits have been quick to rely on the consumer to continue spending at growth sustaining rates. Yet, budgets for the middle class are squeezed as consumers cope with student loan debt payments, new car payments, health care bills, and credit card debt. The Bloomberg Personal Finance Index dropped significantly in October:
Source: Bloomberg, The Wall Street
Journal, The Daily Shot – 11/10/19
Car loans now span seven years on average
versus five years a few years ago. Further, the new loans ‘roll in’ debt from
previous car purchases due to negative equity in the owner’s trade-in vehicle. Vehicle price increases up to 10 % over the
last year for both cars and trucks add to the debt burden. Car debt is beginning to weigh on consumers
as delinquencies are climbing:
Sources: NY Federal Reserve, The
Wall Street Journal, The Daily Shot – 10/29/19
Today, credit card rates are running at a ten-year
peak of 17 – 22 % have seen no relief despite the Fed cutting rates. There is a record spread between the Federal
Funds rate and credit card rates as banks seek new revenue sources beyond
making loans. Many consumers are turning to credit cards to pay bills to
sustain their lifestyle as their wages are not keeping up with rising living
In addition, consumers are increasingly working
at more than one job to be sure they can pay their bills.
Sources: Deutsche Bank, Bureau of
Labor Statistics, The Wall Street Journal, The Daily Shot – 10/21/19
Workers need to take on multiple jobs in the
gig economy. McKinsey & Company estimates that 52
million people are gig workers or a third of the 156 million person workforce.
Contractors have no job security. Gig workers often receive hourly wages
with no health, retirement or other benefits. The lack of benefits
means they have limited or no financial safety net in the event of an economic
There are other key indicators of consumer financial distress, for example, consumer spending on a quarter over quarter basis has continued to decline, Bankrate reports that 50 % of workers received no raise in the last year. Real wages (taking into account inflation) for 80 % of all workers have been stagnant for the past twenty years. Uncertain economic forces are putting consumers in a financial bind, for more details, please see our post: Will the Consumer Bailout the Economy?
Myth 3. The Fed Will Keep the Economy Humming
The Fed has said it will do whatever necessary to keep the economy growing by keeping interest rates low and injecting liquidity into the financial system. However, a survey on Fed actions shows that 70 % of economists interviewed believe the Fed is running out of ammo to turnaround the economy.
Sources: The Wall Street Journal, The Daily
Shot – 12-30-19
We agree with their perspective that the Fed is entering an economic space where
no central bank has gone before. In
the past, the Fed lowered rates when an economic downturn was evident. Just
prior to earlier recession’s interest rates were at a higher starting level of
at least 4 – 5 %. Plus, today the Fed has
returned to pumping liquidity into the economy via its repo operation and QE as
Sources: The Federal Reserve of St. Louis, The
Wall Street Journal, The Daily Shot – 12/30/19
The International Bureau of Settlements (BIS)
disclosed in their analysis of recent Fed repo operations that funding
supported not only banks but hedge funds. A key concern is the nature of the
hedge fund bailout. How steep is the loss being mitigated? Is there a possibility
of contagion? Is more than one hedge fund involved? Should the Fed be bailing out hedge funds
that are overextended due to speculation? The
Fed is already using its tools at the height of the current economic growth
cycle. The Fed financial tools are too stretched to turnaround an economy in a recession
from multiple financial bubbles bursting.
The Fed continues to declare that inflation is
at 2.1 %, missing the reality of what
consumers are actually paying for goods and services. We find from industry research that finds inflation
is likely in the 6 – 10% range. Inflation should be defined as price increases of goods and
services that consumers buy, not inflation defined by a formula to suit
political needs. Using inflation lifestyle ‘cost of living’ data, which is not
transparent or available for audit does not meet the foundational data needs of
investors. Gordon Haskett Research Advisors conducted a study by
purchasing a basket of 76 typical items consumers frequently buy at Walmart and
Target. Their study showed that from June 2018 to June 2019, prices
increased by about 5.5%.
industry research supports inflation running at a much higher level than
government figures. On a city by city basis, Chapwood has developed an index
for 500 items in major metropolitan areas of the US. Chapwood reports the average national
inflation level to be about 10 %. Note
inflation is compounded; for example, in San Jose a five year average price
increase of 13% is for each year. An item costing $1.00 would cost $1.13 the
next year and then $1.28 the third year and so forth. It islikely workers caught
in a squeeze between stagnant wages and 10 % inflation will not be able to
continue to sustain present levels of economic growth.
inflation at 6 – 10 % has major policy, portfolio, and social
implications. For example, with the ten
year Treasury Bond at 1.90% and inflation at 6 %, we are actually living in a ’de facto negative interest’
economy of – 4.10 %. Higher inflation levels fit the financial
reality of what workers, portfolio managers, and retirees are facing in
managing their finances. Many
workers must take multiple jobs and develop a ‘side hustle’ to just keep up
with inflation much less get ahead. For portfolio managers, they must grow
their portfolio at much higher rates than was previously thought just to
maintain portfolio value. Finally, for
retirees on a fixed income portfolio it is imperative they have additional
growth income sources or part-time work to keep up with inflation eating away
at their portfolio. For more details on our analysis of a variety of inflation,
categories see our post: Is
Inflation Really Under Control?
One additional assumption about Fed
intervention repeated by many analysts is the Fed liquidity injections mean
that corporate sales and profits will bounce back. For some financially sensitive industries
this argument may be true. For other firms with excellent credit ratings, they
may be able to obtain low-interest loans to ride out falling sales. But, the reality is that corporations build and
sell products based on demand. If demand falls, low-interest loans will not
increase sales. Only new products, new
channels, reduced pricing, marketing and other initiatives will revive sales.
Myth 4. If the Fed Fails Then the Federal Government Will Provide Stimulus
European Central Bank leaders have called on European governments to provide economic stimulus for their markets. Picking up on this idea, analysts have proposed the US government move on infrastructure and other spending programs. However, tax cuts, low-interest rates, stock buybacks, and record corporate debt offerings have shifted a huge balance of world-wide wealth to the private sector. For 40 years, there has been a significant increase in private capital worldwide while public wealth has declined. In 2015, the value of net public wealth (or public capital) in the US was negative -17% of net national income, while the value of net private wealth (or private capital) was 500% of national income. In comparison to 1970, net public wealth amounted to 36% of national income, while net private wealth was at 326 %.
Source: World Inequality Lab, Thomas Piketty,
Gabriel Zucman et al. – 2018
Essentially, central banks, Wall Street, and governments have built monetary and economic systems that have increased private wealth at the expense of public wealth. The lack of public capital makes the creation of major levels of public goods and services nearly impossible. The US government is now running $1 trillion yearly deficits with public debt at record levels not seen since WWII and total debt to GDP at all-time highs. The development of public goods and services like basic research and development, education, infrastructure, and health services are necessary for an economic rebound. The economy will need a huge stimulus ‘lifting’ program and yet the capital necessary to do the job is in the private sector where private individuals make investment allocation decisions. Congress may pass an ‘infrastructure’ bill in 2020 but given the election, it is likely to be lightly funded to pass both houses of Congress and receive the president’s signature.
Myth 5. The Trade War Won’t Hurt Global Growth
By closing the Phase One trade deal, the market has been sighing with relief with observers declaring that trade will resume a growth track. Yet, the Phase One deal is not a long term fix. If anything, the actions on the part of both governments have been to dig in for the long term. The Chinese government has taken several key actions in parallel to the deal to move their agenda ahead.
China has quietly raised the exchange rate of
their currency to offset some of the impact of still in place tariffs on the
U.S. economy. The government made a
major move to block US and foreign companies from providing key technical
infrastructure. The technology ministry has told government agencies that all IT
hardware and software from foreign firms are to be replaced by Chinese systems within
three years. If the Chinese government decides to establish ‘China only’
network standards it may be difficult for US firms to even work with state-sponsored
companies or private businesses that must meet China’s only standards. Apple
and Microsoft would have to build two versions of their products. One version
for the Chinese economy and one for the world.
A critical change is taking place
in world trade which is the establishment of a two-block trading world. China is a key growth market at a 20 % – 30 %
increase in sales annually for US multinational companies. For these
corporations navigating the trade war will be problematic even with the Phase
One agreement. Our post characterizing
this major change in world trade can be found at: Navigating
a Two Block Trading World.
The U.S. has placed sanctions on Chinese
sponsored network provider Huawei, effectively limiting the network vendor from
US government and private networks. The
Phase One agreement includes the US canceling planned tariffs for December 15th
in 2019 and rolling back tariffs to 7.5 % on $120 billion of goods imposed on
September 1st of last year. Yet, tariffs of 25 % remain in place on
$250 billion of Chinese goods. The
Chinese have canceled retaliatory tariffs planned for December 15th
and plan to increase purchases of US goods and services by $200 billion over
two years. In addition, China will purchase US agriculture products at a $40
billion rate per year from a baseline of $24 billion in 2017. If the
Chinese follow through on their purchase commitments US companies should see
increased sales. However, history on
Chinese purchases shows they forecast large purchases but small purchases are
A major trade issue has been created when the
US decided not to appoint any new judges to the World Trade Organization court
for disputes. The court cannot hear or make decisions on any disputes any
longer; meaning countries will resort to free-for-all negotiations on trade
disputes. We expect as economies falter, nationalist policies on trade will gain
more popularity and world trade will continue to decline after a slight
blip up from the U.S.-China Phase One deal.
Sources: BCOT Research, The Wall Street
Journal, The Daily Shot – 12/16/19
Finally, prior to the trade war global trade
has been facing major headwinds. Since 2008, global firms have looked to open
more international markets to sell their goods, but have met sales resistance
causing revenue and profits to be flat or decline. We expect the flattening of global
sales to output to continue and eventually decline as overall world trade falls.
CEOs in a Conference Board survey rate trade as
a major concern as they look at a highly uncertain economic picture. Marc Benioff, CEO of Salesforce, described
his concerns at a company all hands meeting last November:
“Because that issue (trade) is on the table,
then everybody has a question mark around in some part of their business,” he
said. “I mean, we’re in this strange economic time, we all know that.”
Myth 6. The Economy and Markets Are Insulated from World Politics
Protests have broken out in Hong Kong, Iraq, Iran, Chile, and other world cities while stock markets continue their climb. Yet, when the U.S. killed a key Iranian general the overnight S &P futures market fell 41 pts before recovering and closing 23 pts lower. The VIX soared 22 % overnight before settling back to close for a 12 % increase at 14.02. The U.S. – Iran conflict does not seem to be under control with most Middle East analysts predicting a major retaliation by the Iranian government. The price of oil spiked 4 % before settling to a 3.57 % increase on fears the Iranians may attack oil tankers in the Gulf. An escalating conflict will drive oil prices higher, disturb supply chains and likely tip the world economy into a recession.
saw during the negotiations for the Phase One trade deal how rumors both in
China and the U.S. would send the S & P futures market up or down by 10 –
15 points depending upon whether the news was positive or negative. Algo
traders would drop 30k contracts in a matter of seconds to make huge moves in
SPX price, while the VIX was at 12.50, supposedly a calm market. The chart
below shows how positive and negative news whipsawed the market.
Liz Ann Sonders – Schwab – 12-7-19
news not only moves markets but the economy as well. When the president tweets a tariff threat,
consumers and industry move swiftly to buy those goods before their prices go
up. Businesses have to build the product
quickly, sell it and they are left with falling sales as future purchases are
pulled forward. Business to business
deals are caught up in this constant flip flop on trade policies as well. CEOs
must make investment decisions to build a plant in a particular country 1 – 3
years in advance. They must calculate their allocation plans based on
inadequate information and in a highly uncertain policy environment. Often, rather
than make an investment decision, executives will wait for the economic clouds
The current bull market run has set record highs continuously. Yet, as the saying goes: markets go up in stair steps and down in an elevator. As a selling panic sets in the market goes into a free fall. If an economic myth is revealed by market action, corporate results, economic reports or an event the loss of belief causes the market to fall much faster than a slow stair step up.
The prudent investor will recognize the end of
the business cycle is likely underway. It is time to prepare for an economic
slowdown and a resulting equity market reversion to the mean. A reversion to
the mean quite often requires that markets swing beyond the mean.
The wary investor will ask hard questions of
their financial advisor and review corporate reports with an eye on fundamentals.
Financial success is likely to result from good risk management and
implementation combined with agility to make mid-course corrections. Investors should test their assumptions based
on breaking trends that may impact portfolio performance. At the same time, constantly flipping
investments will lead to poor performance. Allocate funds to different
portfolio groups based on long, medium and short term goals to keep from being
emotionally swept up in temporary market swings. The key is to be prepared for
the unknown, or a black swan event. Expect
the unexpected and consider the advice of market legends like Bernard Baruch:
“Some people boast of selling at the top of
the market and buying at the bottom – I don’t believe this can be done. I had
bought when things seemed low enough and sold when they seemed high enough. In
that way, I have managed to avoid being swept along to those wild extremes
of market fluctuations which prove so disastrous.”
Patrick Hill is
the Editor of The Progressive Ensign, https://theprogressiveensign.com/
writes from the heart of Silicon Valley, leveraging 20 years of experience as
an executive at firms like HP, Genentech, Verigy, Informatica and Okta to
provide investment and economic insights. Twitter: @PatrickHill1677.
Is Inflation Really Under Control
analysts have been discussing the pros and cons of using negative interest
rates to keep the U.S. economy growing. Despite
this, Fed Chairman Jerome Powell has said that he does not anticipate the
Federal Reserve will implement a policy of negative interest rates as it may be
detrimental to the economy. One argument
against negative interest rates is that they would squeeze bank margins and
create more financial uncertainty. However, upon examining the actual rate of
inflation we are likely already in a ‘de facto’ negative interest
rate environment. Multiple inflation data sources show that actual inflation maybe
5%. With the ten year Treasury bond at 1.75%, there is an interest rate gap of – 3.25%. Let’s look at multiple inflation data
points to understand why there is such a divergence
between the Fed assumptions that inflation is under control versus the much
higher rate of price hikes consumers experience.
October, the Bureau of Labor Statistics (BLS) reported that the core consumer
price index (CPI) grew by 2.2% year over year.
The core CPI rate is the change in the price of goods and services minus
energy and food. Energy and food are not
included because they are commodities and trade with a high level of
volatility. However, the Median CPI
shows a ten year high at 2.96% and upward trend as we would expect, though it
starts at a lower level than other inflation indicators. The Median CPI
excludes items with small and large price changes.
Source: Gavekal Data/Macrobond, The Wall Street Journal, The Daily Shot – 11-29-19
key items that have small and large price changes is not what a consumer buying
experience is like. Consumers buy based
on immediate needs. When a consumer drives up to a gas pump, they buy at the
price listed on the pump that day. Consumers
buying groceries don’t wait for food commodity prices to go down; they have to pay the price when they need the
food. Recent consumer purchase research shows that prices of many goods and
services continue to increase at a rate much higher than 2.2%.
Haskett Research Advisors conducted a study by purchasing a basket of 76 typical
items consumers buy at Walmart and Target.
The study showed that from June 2018 to June 2019, prices increased
Gordon Haskett Research Advisors, Bloomberg – 8/10/19
and Target are good proxies for consumer buying experiences. Walmart is the
largest retailer in the U.S. with over 3,000 locations marketing to price-conscious
consumers. Target has 1,800 locations in the U.S. and is focused on a similar
consumer buyer profile, though a bit less price sensitive. Importantly, both
Walmart and Target have discount food sections in their stories.
has been rapidly increasing in cost as well.
Rental costs have soared in 2019 as the following chart shows a month
over month shift to .45%, which is an annualized rate of 5.4%.
Bureau of Labor Statistics, Nomura – 5/13/19
of other services like health care and education have increased dramatically as
well. Service sectors, which make up 70% of the U.S. economy, are where wages
are generally higher than in manufacturing sectors. Techniques to increase
service productivity have been slow to implement due to service complexity. Without
productivity gains, prices have continued to rise in most services sectors.
Deutsche Bank – 11/14/19
care costs have increased by 5.2% per year, and education costs have risen 6.8
% per year. Wages of non-supervisory and production workers have fallen behind
at 3.15 % increase per year. Note that the overall CPI rate significantly
underestimates the rate of costs in these basic consumer services, likely due
to underweighting of services in the cost of living calculation.
consumers, housing, utilities, health care, debt payments, clothing, and
transportation comprise their major expenses. Utility and clothing costs have
generally declined. While transportation, housing, and health care costs have
increased. The rate of new car annual inflation
was as low as 1 percent in 2018. Yet, according
to Kelly Blue Book, the market shift to SUVs, full-sized trucks, and increasing
Tesla sales have caused average U.S. yearly vehicle prices to zoom 4.2% in 2019.
The soaring price of vehicles has caused auto loans to be extended out to 7 or
8 years, in some cases beyond the useful life of the car.
are financing 25% of new car purchases with ‘negative equity deals’ where the
debt from a previous vehicle purchase is rolled into the new loan. The October consumer spending report shows
consumer spending up by .3% yet durable goods purchases falling by .7%
primarily due to a decline in vehicle purchases. A 4.2%
increase in vehicle prices year over year is unsustainable for most buyers and
indicates likely buyer price resistance resulting in falling sales.The October durables sales decline could have
been anticipated if inflation reporting was based on actual consumer purchasing
wars with China, Europe, and other countries are contributing to significant price
increases for consumer goods. Tariffs
have driven consumer prices higher for a variety of product groups, including:
appliances, furniture, bedding, floor coverings, auto parts, motorcycles, sports
vehicles, housekeeping supplies, and sewing equipment.
Department of Commerce, Goldman Sachs, The Wall Street Journal, The Daily Shot
chart above, prices increased by about 3.5% over 16 months before mid-May 2019.
As uncertainty in the trade wars grows and earlier cheaper supplies are sold, prices
will likely continue to rise. The President has announced new tariffs of 15% on
$160 billion of Chinese consumer goods for December 15th if a Phase
One deal is not signed. On December 2nd, he announced resuming
tariffs on steel and aluminum imports from Argentina and Brazil and 100 %
tariffs on $2.4 billion of French goods. The implementation of all these
tariffs on top of existing tariffs will only make consumer inflation worse. Tariffs are driving an underlying
inflationary trend that is being under-reported by government agencies.
Evidently, the prices for goods and
services that consumers experience are vastly different from what the federal
government reports and uses to establish cost of living increases for programs
like Social Security. So, why is there a disconnect between the government CPI rate
of 2.2% and consumer reality of inflation at approximately 5%? The raw data that the Bureau of Labor
Statistics (BLS) uses to calculate the CPI rate is not available to the
public. When a Forbes reporter asked the
BLS why the data was not available to the public the BLS response was companies
could ‘compare prices’. This assumption does not make sense as companies can compare
prices on the Internet, in stores, or find out from suppliers. The ‘basket of
consumer items’ approach was discontinued in the 1980s for a ‘cost of living’
index based on consumer buying behaviors. There was political pressure to keep
the inflation rate low. If real inflation figures were reported the government
would have to increase payments to Social Security beneficiaries, food stamp
recipients, military and Federal Civil Service retirees and survivors, and
children on school lunch programs. Over
the past 30 years the BLS has changed the
calculation at least 20 times, but due to data secrecy there is no way to audit
the results. The BLS tracks prices on 80,000 goods and services based on
consumer spending patterns, not price changes on goods and services per
se. For example, if consumers substitute
another item for a higher-priced one it is discontinued in the
Williams has calculated inflation rates based upon the pre-1980s basket
approach versus the cost of living formula used by BLS today. His findings show a dramatically higher rate
of inflation using the 1980s formula.
Government – 10/2019
using the earlier basket formula sets the present inflation rate at nearly
10%. Based on our research on various
price reporting services, we think the real consumer inflation rate is probably
about 5 to 6%.
of this gap between real inflation and reported inflation rates are profound
and far-reaching. Federal Reserve
complacency about a low inflation rate to justify a low Fed Funds rates is
called into question. In fact the
economic reality of today is we are living in a 3.25% ‘de facto’ negative interest rate environment where
the ten year Treasury bond rate is 1.75%, and inflation is 5%. The liquidity
pumping into the economy, based in part on low inflation, is overheating risk
assets while providing support for corporate executives to take on debt at decade
economic framework on erroneous inflation data versus the reality for consumers
and businesses lead to massive financial dislocations. This economic bubble is
unsustainable and will require a brutal recession to rebalance the
economy. As part of a possible soft
‘landing’ policy, the BLS could make price data available to all economists.
Full data access will provide an opportunity for objective comments and
feedback based on other consumer price research.
The Fed actually
focuses on the even lower Personal Consumption Expenditure rate of 1.6%
reported by the Bureau of Economic Analysis for October. The Fed prefers the
PCE rate because a consumer survey technique is used, while economists prefer
the CPI, which is more granular so it is easier to identify goods and services categories
that are driving inflation. Using
unrealistically low inflation assumptions leads to misguided policy decisions
and perpetuation of the myth that inflation is under control. Yet, in fact
inflation it is out of control due to extremely low Fed interest rates,
liquidity injections, and trade war tariffs.
Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.
Trump recently nominated Judy Shelton to fill an open seat on the Federal
Reserve Board. She was recently quoted by the Washington Post as follows: “(I) would lower rates as fast, as efficiently,
and as expeditiously as possible.” From a political perspective there is no
doubting that Shelton is conservative.
Yellen, a Ph.D. economist from Brooklyn, New York, appointed by President
Barack Obama, was the most liberal Fed Chairman in the last thirty years.
appears to be polar opposite political views, Mrs. Shelton and Mrs. Yellen have
nearly identical approaches regarding their philosophy in prescribing monetary
policy. Simply put, they are uber-liberal when it comes to monetary policy,
making them consistent with past chairmen such as Ben Bernanke and Alan
Greenspan and current chairman Jay Powell.
In fact, it
was Fed Chairman Paul Volcker (1979 to 1987), a Democrat appointed by President
Jimmy Carter, who last demonstrated a conservative approach towards monetary
policy. During his term, Volcker defied presidential “advice” on multiple occasions
and raised interest rates aggressively to choke off inflation. In the short-term,
he harmed the markets and cooled economic activity. In the long run, his
actions arrested double-digit inflation that was crippling the nation and laid the
foundation for a 20-year economic expansion.
Today, there are no conservative monetary policy makers at the Fed. Since Volcker, the Fed has been run by self-described liberals and conservatives preaching easy money from the same pulpit. Their extraordinary policies of the last 20 years are based almost entirely on creating more debt to support the debt of yesteryear as well as economic and market activity today. These economic leaders show little to no regard for tomorrow and the consequences that arise from their policies. They are clearly focused on political expediency.
Different Roads but the Same Path
Sanders, Alexandria Ocasio-Cortez, Elizabeth Warren, and a host of others from
the left-wing of the Democrat party are pushing for more social spending. To
support their platform they promote an economic policy called Modern Monetary
Theory (MMT). Read HERE
for our thoughts on MMT.
In general, MMT
would authorize the Fed to print money to support government spending with the
intention of boosting economic activity. The idealized outcome of this scheme
is greater prosperity for all U.S. citizens. The critical part of MMT is that it
would enable the government to spend well beyond tax revenue yet not owe a
Trump blamed the Fed for employing conservative monetary policy and limiting
economic growth when he opined, “Frankly,
if we didn’t have somebody that would raise interest rates and do quantitative
tightening (Powell), we would have been at over 4 instead of a 3.1.”
President Trump took office, U.S government debt has risen by approximately $1
trillion per year. The remainder of the post-financial crisis period saw
increases in U.S. government debt outstanding of less than half that amount. Despite what appears to be polar opposite
views on just about everything, under both Republican and Democratic
leadership, Congress has not done anything to slow spending or even consider
the unsustainable fiscal path we are on. The last time the government ran
such exorbitant deficits while the economy was at full employment and growing
was during the Lyndon B. Johnson administration. The inflationary mess it
created were those that Fed Chairman Volcker was charged with cleaning up.
From the top down, the U.S.
government is and has been stacked with fiscal policymakers who, despite their
political leanings, are far too undisciplined on the fiscal front.
We frequently assume that a candidate of a certain political party has views corresponding with those traditionally associated with their party. However, in the realm of fiscal and monetary policy, any such distinctions have long since been abandoned.
the current stance of Democratic and Republican fiscal and monetary policy within
the TRUST framework. Government leaders are pushing for unprecedented doses of
economic stimulus. Their secondary goal
is to maximize growth via debt-driven spending. Such policies are fully
supported by the Fed who keeps interest rates well below what would be
considered normal. The primary goal of
these policies is to retain power.
To keep interest
rates lower than a healthy market would prescribe, the Fed prints money. When
policy consistently leans toward lower than normal rates, as has been the case,
the money supply rises. In the wake of the described Fed-Government partnership
lies a currency declining in value. As discussed in prior articles, inflation,
which damages the value of a currency, is always the result of monetary policy
If the value
of a currency rests on its limited supply, are we now entering a phase where
the value of the dollar will begin to get questioned? We don’t have a definitive answer but we know with 100% certainty that
the damage is already done and the damage proposed by both political parties
increases the odds that the almighty dollar will lose value, and with that,
TRUST will erode. Recall the graph of the dollar’s declining purchasing
power that we showed in Part 1.
Data Courtesy St. Louis Federal Reserve
If the value
of the dollar and other fiat currencies are under liberal monetary and fiscal
policy assault and at risk of losing the valued TRUST on which they are 100% dependent,
we must consider protective measures for our hard-earned wealth.
underlying appreciation of the TRUST supporting our dollars, the definition of
terms becomes critically important. What, precisely, is the difference between
currency and money?
defined as natural element number 79 on the periodic table, but what interests
us is not its definition but its use. Although gold is and has been used for
many things, its chief purpose throughout the 5,000-year history of
civilization has been as money.
to Congress on December 18, 1912, J.P. Morgan stated: “Money is gold, and nothing else.” Notably, what he intentionally
did not say was money is the
dollar or the pound sterling. What his statement reveals, which has long since
been forgotten, is that people are paid for their labor through a process that
is the backbone of our capitalist society. “Money,” properly defined, is a
store of labor and only gold is money.
In the same
way that cut glass or cubic zirconium may be made to look like diamonds and
offer the appearance of wealth, they are not diamonds and are not valued as
such. What we commonly confuse for money today – dollars, yen, euro, pounds –
are money-substitutes. Under an
evolution of legal tender laws since 1933, global fiat currencies have
displaced the use of gold as currency. Banker-generated
currencies like the dollar and euro are not based on expended labor; they are
based on credit. In other words, they do not rely on labor and time to
produce anything. Unlike the efforts required to mine gold from the ground,
currencies are nearly costless to produce and are purely backed by a promise to deliver value in exchange for
and workers are willing to accept paper currency in exchange for their goods
and services in part because they are required by law to do so. We must TRUST that we are being compensated in a
paper currency that will be equally TRUSTed by others, domestically, and
internationally. But, unlike money, credit includes the uncertainty of “value”
a bank liability which explains why failing banks with large loan losses are not
able to fully redeem the savings of those who have their currency deposited
there. Gold does not have that risk as there is no intermediary between it and
value (i.e., the U.S. government or the Japanese government). Gold is money and
harbors none of these risks, while currency is credit. Said again for emphasis, only gold is money, currency is credit.
There is a
reason gold has been the money of choice for the entirety of civilization. The
last 90 years is the exception and not the rule.
Despite their actions and words, the value of gold, and disTRUST of the dollar is not lost on Central Bankers. Since 2013, global central banks have bought $140 billion of gold and sold $130 billion of U.S. Treasury bonds. Might we say they are trading TRUST for surety?
To repeat, currency, whether
dollars, pounds, or wampum, are based on nothing more than TRUST. Gold and its
5000 year history as money represents a dependable store of labor and real
value; TRUST is not required to hold gold. No currency in the history of humankind,
the almighty U.S. dollar included, can boast of the same track record.
TRUST hinges on decision
makers who are people of character and integrity and willingness to do what is
best for the nation, not the few. Currently, both political parties are taking
actions that destroy TRUST to gain votes. While
political party narratives are worlds apart, their actions are similar.Deficits do matter because as they
accumulate, TRUST withers.
is not a call to action to trade all of your currency for gold, but we TRUST
this article provokes you to think more about what money is.
Federal Reserve Headlines – Fact or Fiction?
“When it becomes serious, you have to lie.” – Jean-Claude Juncker, former President of the Eurogroup of Eurozone finance ministers
On July 16, 2019, Chicago Federal Reserve President Charles Evans made a series of comments that were blasted across the financial news wires. In the headlines taken from his speech on the 16th and other statements over the past few weeks, Mr. Evans argues for the need to cut interest rates at the July 31st meeting and future meetings.
In this article, we look at his rationale and provide you with supporting graphs and comments that question his logic supporting the rate cuts. We pick on Charles Evans in this piece, but quite honestly, he is reiterating similar themes discussed by many other Fed members.
The issues raised here are important because the Fed continues to play an outsized role in influencing asset valuations that are historically high. As such, it is incumbent upon investors to understand when the Fed may be on the precipice of making a policy error. If asset prices rest on confidence in the Fed, what will happen when said confidence erodes?
The Fed’s Mandate
Before comparing reality with his recent headlines, it is important to clarify the Fed’s Congressional mandate as stated in the Federal Reserve Act. The entire Federal Reserve act can be found HERE. For this article, we focus on Section 2A- Monetary Policy Objectives as follows:
The stock market is at all-time highs, bond yields are well below “moderate,” unemployment stands at 50-year lows, and prices are stable. Based on the Fed’s objectives, there is certainly no reason to cut rates.
Evans Thoughts versus Reality
All of the headlines below in red are courtesy of Bloomberg News and the data is sourced from Bloomberg and the St. Louis Federal Reserve
There are a lot of risks out there, citing BREXIT
BREXIT, the UK withdrawal from the European Union (EU), passed in a public referendum over three years ago. Since then, lawmakers on both sides of the Channel have tried unsuccessfully to fulfill voters’ wishes. The exit was supposed to occur by March 29, 2019 but was extended to October 31, 2019. BREXIT is not a new risk. In fact, there was a high likelihood of a hard BREXIT in late March before the extension, and the Fed never mentioned it then as a reason to take action. Further, the Bank of England (BOE) and the European Central Bank (ECB), not the Fed, are the parties that should be first in line to mitigate any financial/monetary risks associated with Europe and any repercussions coming from BREXIT. At some point Fed action may be warranted if a hard BREXIT occurs and rattles global economies. However, acting in advance on what might or might not happen is not the Fed’s job.
There are other risks, such as the ongoing trade war with China, the coming debt cap, and Iran to name a few. We ask you though, has there ever been a period where numerous concerns and risks did not exist?
Fed should not generate excess stimulus
The first graph quantifies the level of Fed Funds and the amount of QE, allowing us to compare monetary stimulus over the last 40 years. Clearly, the last ten years, including the current period, is excessive and if anything means the Fed should be removing “excess stimulus.”
Other evidence also indicates that current monetary policy is excessive. For instance, the graph below, courtesy of Mr. Evans own Chicago Federal Reserve, shows that national financial conditions are near the easiest of any period in the last 50 years. Of the 2,531 weekly data points in the graph, only 60 weekly periods (2.3%) had easier financial conditions than today. Again, conditions are easy because monetary policy is very accommodative. Excess is an appropriate term to describe the state of monetary policy and it may actually be an understatement.
We need to do everything we can to get to 2% inflation
The Federal Reserve Act clearly says the Fed should promote stable prices. Stable prices do not axiomatically mean 2% inflation as they have interpreted it. The Act also makes no mention of persistent inflation that compounds over time.
The following graph shows the level of prices since the Revolutionary War. From 1775 to 1971 prices were relatively stable, except during times of war. Since 1971, when Nixon revoked the gold standard and allowed the Fed carte blanche to manipulate the money supply, higher annual prices have accumulated, resulting in massive price inflation.
The Fed’s 2% inflation target is a far cry from the price stability mandate to which they are supposed to adhere.
Says path of U.S. economy is toward trend growth
Mr. Evans uses language that suggests U.S. GDP has been running below trend but making progress toward trend growth. Based upon data supplied by the St. Louis Fed, real GDP has been running above trend for the last eight quarters as shown below.
Inflation situation alone calls for two 25 basis point cuts by year’s end
The following graphs show various measures of inflation and inflation expectations. It is hard to point to any recent inflation trends in these graphs that have meaningfully changed from the trends of the last few years. Given this broad set of data, why does the current inflation “situation” warrant even more aggressive monetary policy action?
Economic fundamentals are solid / U.S. economy is really quite solid
Mr. Evans is right. GDP was a little soft in the second quarter, but it was running above trend for the prior eight quarters. With Fed Funds still at dangerously low levels, the Fed’s balance sheet swollen beyond any historical precedent, and the economy “really quite solid,” his call for rate cuts does not reconcile with his own assessment of the economy.
Says he forecasts 50 basis points of accommodation to lift inflation
Using data going back to 1990, the graph below shows that there is no statistical relationship between the Fed’s (current) preferred measure of inflation (PCE) and the Fed Funds rate they manage. PCE measured a year forward to the current Fed Funds rate demonstrates even less of a relationship.
Based on data provided by the Fed, the idea that the Fed possess a magical joystick which enables them to control prices is fallacious. Evan’s statement lacks any statistical backing and is a complete guess at best. At worst, it is an intentional effort to influence public sentiment improperly.
The conclusions here suggest that Evans logic is flawed and misleading. Based on his arguments, the Fed has no basis to cut interest rates. Fed speakers that modify their language daily, as they have been doing over the prior month or two, to conjure support for rate cuts put their integrity and investor confidence in the Fed at risk.
The primary objective of Fed policy should be geared toward imperceptible adjustments to foster a well-functioning market-based economy. On the contrary, what we increasingly see is a market-economy increasingly jostled and cajoled by hair-on-fire day-traders posing as a monetary authority. By employing well publicized micro-management tactics, the Fed naturally increases the chances of a policy error. Indeed, the proper characterization of that risk is that the Fed increases the likelihood of further policy errors compounding the legacy issues already in play thanks to Powell’s predecessors.
Given the reliance of equity prices on the so-called “Fed Put” and the excessive valuations in many asset markets, we advise paying close attention as a policy error could quickly cause assets to re-price to properly reflect their inherent risks, and then some. Seldom do those adjustments stop at fair value.
In The Fed We Trust – Part 1
This article is the first part of a two-part article. Due to its length and importance, we split it to help readers’ better digest the information. The purpose of the article is to define money and currency and discuss their differences and risks. It is with this knowledge that we can better appreciate the path that massive deficits and monetary tomfoolery are putting us on and what we can do to protect ourselves.
How often do you think about what the dollar bills in your wallet or the pixel dollar signs in your bank account are? The correct definitions of currency and money are crucial to our understanding of an economy, investing and just as importantly, the social fabric of a nation. It’s time we tackle the differences between currency and money and within that conversation break the news to you that deficits do matter, TRUST me.
At a basic
level, currency can be anything that is broadly accepted
as a medium of exchange that comes in standardized units. In current times,
fiat currency is the currency of choice worldwide. Fiat currency is paper notes,
coins, and digital 0s and 1s that are governed
and regulated by central banks and/or
governments. Note, we did not use the word guaranteed to describe the role of
the central bank or government. The value and worth of a fiat currency rest solely on the TRUST of the receiver of the
currency that it will retain its value and the TRUST that others will accept it
in the future in exchange for goods and services.
Whether its yen,
euros, wampum, bitcoin, dollars or any other currency, as long as society is
accepting of such a unit of exchange, trade
will occur. When TRUST in the value of a currency wanes, commerce becomes
difficult, and the monetary and social
prosperity of a nation falters. The history books overflow with such examples.
Maslow and Currency
diving into the value of a currency, it is worth considering the role it plays
in society and how essential it is to our physical and mental well-being. This point
is rarely appreciated, especially by those that push policies that debase the
his famous pyramid to depict what he deemed the hierarchy of human needs. The
levels of his pyramid, shown below, represent the ordering of physiological and
psychological needs that help describe human motivations. When these needs are met, humans thrive.
up the pyramid by addressing their basic, lowest level needs. The core needs,
representing the base, are physiological needs including food, water, warmth
and rest. Once these basic needs are met,
one then seeks to attain security and safety. Without meeting these basic physiological
and safety needs, our psychological and
self-fulfillment needs, which are higher up the pyramid, are difficult to come
by. Further, as we see in some third-world countries, the social fabric of the
nation is torn to shreds when a large part of the population cannot satisfy their basic needs.
In modern society,
except for a few who live “off-the-grid,” fiat currency is the only means of
attaining these necessities. Possession of currency is a must if we are
to survive and thrive. Take a look back to the opening paragraphs and let’s
rephrase that last sentence: possession and
TRUST of currency is a must if we are to survive and thrive.
It is this
most foundational understanding of currency that keeps our economy humming, our
physical prosperity growing and our society stable. The TRUST backing the
dollar, euro, yen, etc. is essential to our financial, physical and
why we should not assume that TRUST is a permanent condition.
Deficits Don’t Matter…. or Do They?
the imperative connection between currency and TRUST and its linkage to trade
and commerce along with our physical and mental well-being,
we need to explore the current state of the United States government debt
burden, monetary policy, and the growing belief
that deficits don’t matter.
debt never matures, it is rolled over. Yes, a holder of a maturing Treasury bond
is paid in full at maturity, however, to secure the funds to pay that holder,
the government issues new debt by borrowing money from someone else. Over time, this scheme has allowed deficits to expand,
swelling the amount of debt outstanding. Think of this arrangement as taking
out a new credit card every month to pay off the old card.
below shows U.S. government debt as a percentage of GDP. Since 1967 government debt has grown annually 2% more than GDP.
Data Courtesy: St. Louis Federal
debt at a faster rate than economic growth (as shown above) is limited. To
extend the ability to do this requires declining interest rates, inflation and
a little bit of financial wizardry to make debt disappear. Fortunately, the
U.S. government has a partner in crime, the Federal Reserve.
As you read about
the Fed’s methods to help fund deficits, it is important to consider the
actions they routinely take are at the expense of the value of the currency. This warrants repeating since the value of the currency is what supports TRUST
in the currency and allows it to retain its
helps the government consistently run
deficits and increase their debt load in three
The Fed stokes moderate inflation.
The Fed manages interest rates lower
than they should be.
The Fed buys Treasury and mortgage securities
(open market operations/QE) and, as we are now witnessing, monetizes the debt.
Fed’s charter, Congress has mandated the Fed promote stable prices. To you and me, stable prices would likely mean no inflation or deflation. Regardless of what you and I think, the Fed interprets
the mandate as an annual 2% rate of inflation. Since the Fed was founded in 1913, the rate of inflation has
averaged 3.11% annually. That rate may seem
inconsequential, but it adds up. The
chart below illustrates how the low but consistent rate of inflation has
debased the purchasing power of the dollar.
Data Courtesy: St. Louis Federal
in 1913 can essentially be paid off with .03 cents today. Inflation has
certainly benefited debtors.
Interest Rate Management
better part of the last decade, the Fed
has imposed price controls that kept interest
rates below what should be considered normal. Normal, in a free market economy,
is an interest rate that compensates a lender for credit risk and inflation.
Since Treasury debt is considered “risk-free,” the predominant risk to Treasury
investors is earning less than the rate of inflation. As far as “risk-free”, read our article: The
Mind Blowing Concept of Risk-Free’ier.
If the yield
on the bond is less than inflation, as has recently been the case, the
purchasing power and wealth of the investor declines
in the future.
below highlights how U.S. Treasury real rates (yields less CPI) have trended
lower over the past forty years. In fact, over the last decade, negative real rates are the norm, not the exception. When investors are
not properly compensated by the U.S. Treasury, the onus of government
debt is partially being put upon
investors. We have the Fed to thank for their Fed Funds (FF) policy of negative
Data Courtesy: St. Louis Federal
Fed Balance Sheet
The Fed uses
its balance sheet to buy and sell U.S.
Treasury securities to manage the money supply and thus enforce their interest
rate stance. In 2008, their use of the balance sheet changed. From 2008 through
2013, the Fed purchased nearly $4 trillion of Treasury and mortgage-backed
securities in what is called Quantitative Easing (QE). By reducing the supply
of these securities, they freed up
liquidity to move to other assets within the capital markets. The action
propped up asset prices and helped keep interest
rates lower than they otherwise would have been.
Since 2018, they have reversed these actions by
reducing the size of their balance sheet in what is called Quantitative
Tightening (QT). This reversal of prior action essentially makes the benefits
of QE temporary. However, if they fail to reduce it back to levels that existed
before QE was initiated, then the Fed permanently monetized government
debt. In plain English, they printed money to extinguish debt.
As we write
this article, the Fed is in the process of ending QT. Based on the Fed schedule
as announced on March 20, 2019, the balance sheet will permanently end up $2.28
trillion larger than from when QE was initiated.
To put that in context, the balance will have grown 269% since 2008, as compared
to 48% economic growth.
Data Courtesy St. Louis Fed
the Fed employs to manage policy as described
above, all involve using their balance sheet to alter the money supply
and help the Treasury manage its deficits. We can argue the merits of such a policy, but we cannot argue a basic economics
law; when there is more of something, it is worth less. When something of value is created out of thin air, its
point is debt too onerous, deficits too large and the Fed too aggressive such that
TRUST is harmed? No one knows the answer
to that question, but given the
importance of TRUST in a fiat currency regime, it would be wise to avoid
actions that could raise doubt. Contrary to that guidance, current fiscal and
monetary policy throws all TRUST to the wind.
Prelude to Part 2
grow and government debt becomes more onerous, the amount of Fed intervention
must become greater. To combat this growing problem, both political
parties are downplaying deficits and pushing the Fed to do more. In part 2 we
will explore emerging fiscal mindsets and what they might portend. We will then
define money, and with this definition, show why the difference between
currency and money is so important.
Inflation: The Fed’s False Flag
“Don’t piss down my back and tell me it’s raining” –Clint Eastwood/The Outlaw Josey Wales
On April 30,
2019, one day before the Federal Reserve’s FOMC policy-setting meeting, the
Wall Street Journal published an article by Nick Timiraos and Paul Kiernan
Is Likely to Fuel Discussions as Fed Officials Meet. We quickly
recognized this article was not the thoughts of the curious authors but more
than likely indirect Fed messaging.
Similar to a
trial balloon, conveyances like the one linked above allow the Fed to gauge
market response to new ideas and prepare the markets and public for potential
changes in policy.
Based on numerous
articles published over the last two weeks, we are under growing suspicion that
the Fed wants us to believe we need more inflation. For their part, the Fed in
the May 1, 2019, FOMC policy statement changed language from the prior
statement to highlight that inflation is not running at their 2% target but it
is “running below” their goal.
Is declining inflation a legitimate concern or a false flag meant to provide cover to lower rates?
The WSJ article
published the day before the FOMC policy meeting has the Fed’s fingerprints all
over it. The gist of the article is that inflation is running below the two
percent goal and therefore needs to be addressed.
following quotes come from that article:
Lower inflation remains the fly in
Officials worry that the failure to
hit the inflation target could undermine its credibility over time, which could
cause consumers and businesses to expect lower inflation in the future, which
in turn could cause price pressures to weaken further.
If officials grew concerned that the
(inflation) shortfall was persistent, some could push for lowering rates.
Not to be
outdone, Neil Irwin of the New York Times, in discussing how the Fed might
fight the next recession, stated:
“In the near term, any changes are
likely to tilt policy in the direction of having lower interest rates for
longer periods, with the aim of getting inflation to more consistently
average 2 percent (it has been consistently below that level for
These and a
slew of comments from Fed officials, the media and market prognosticators lead
us to believe the Fed is now using a lack of inflation to justify lowering
quarter 2019 GDP was just reported at 3.2% and has grown in each of the last 12
quarters, an unprecedented string of consecutive increases in GDP growth. The
unemployment rate and jobless claims are at or near 50-year lows. Despite the
solid economic growth and strong labor market, the amount of monetary and
fiscal stimulus being employed is immense as we have documented on numerous
occasions. Fed Funds at 2.5%, while off of the zero bound, is still well below
rates of the prior 50 years. The Fed’s balance sheet, despite some run-off, is still
four times larger than where it stood pre-financial crisis.
Since the economy and labor markets are strong and monetary policy very easy, inflation appears to be the only factor that the Fed could use to justify adopting an easier policy stance.
The Smoking Gun
Before considering inflation data, it’s worth reviewing the Fed’s thoughts about inflation as it relates to monetary policy. On October 2, 2018, Chairman Powell stated the following:
From the standpoint of contingency
planning, our course is clear: Resolutely conduct policy consistent with the
FOMC’s symmetric 2 percent inflation objective, and stand ready to act with
authority if expectations drift materially
up or down.
Given the statement above, is
Inflation or inflation expectations materially changing?
Below are six
charts to help you decide if inflation or inflation expectations are moving materially lower. If not, is inflation the
Trojan horse that allows the Fed to lower rates despite any reasonable
rationale? All of the data for the graphs below are sourced from Bloomberg.
Fed’s Own Inflation Measures
two graphs are inflation indicators that the Fed created. They are designed to reduce
temporary blips in the prices of all goods and services within the CPI and GDP
reports. The Federal Reserve believes these measures present a more durable
reading that is not as subject to transitory forces as other inflation measures.
inflation “expectations drift(ed) materially up or down?”
Looking at the ebbs and flows of inflation and inflation expectations of the last three years, we see no consistent change in the trend. As for the dreaded fear of deflation, the United States has not experienced it since the Great Depression in the 1930’s. In our opinion, this recent talk about lower inflation is a sad case of the Fed manufacturing a story to justify easier monetary policy.
with a message for the Federal Reserve- If you want to lower rates then lower
rates, but please do not feign concern about inflation trends that are
non-existent as cover for such moves. You preach transparency, so be
The Real Risk To The Markets In 2019: Stagflation
Derek Chen, CFA, MBA is a sophisticated portfolio manager who digs deep into financial markets. He focuses on analyzing data, patterns and technical structure of different markets to give investors a better timing of entries and exits.
As investors have seen in the recent CPI data, one forgotten risk is arising. For the past eight years, US inflation is low and stable. However, despite with declining oil prices, inflation starts to tick up, and it may make a major impact to portfolio allocation.
The economic environment today is similar to the environment of the Reagan Presidency from 1981 to 1989. In 1986, after implementing a historic tax reform, the U.S economy surprisingly headed into a period of stagflation. Will history repeat itself?
According to Investopedia, the definition of stagflation is: “A condition of slow economic growth and relatively high unemployment and economic stagnation, accompanied by rising prices, or inflation and a decline in GDP.” In summary, four economic phenomena may happen:
High unemployment rate
Stagnant or decline in GDP growth
Slow growth in corporate earnings
During the past decade, we had an extremely easy financial environment as the “Big Three” global banks: ECB, Federal Reserve and Bank of Japan implemented quantitative easing (QE) to help the economy recover, which tripled their total assets.
*Source: Federal Reserve, Bloomberg
Velocity of M2 Money Stock – Another Look At inflation
By definition, M2 includes the amount of currency circulating and all forms of deposits. Velocity of M2 Money Stock, however, is not necessarily the frequency of money exchanging hands via transactions. Instead, an increasing velocity of M2 Stocks is the willingness or incentive to spend at a faster speed. Economist Irving Fisher introduced the equation in 1911:
M: Money supply in financial system; V: Velocity of money stocks P: Price of goods and services; Q: Productions, or the quantity of goods and services.
The Fed started to trim down its balance sheet and gradually increase its Fed Fund Rate. Banks are motivated by higher interest rates and consumers are motivated by the passage of the tax bill. The willingness of lending and spending bounced from historical lows, which fueled the velocity of money stock. Steadily rising money supply (M), higher velocity of money stocks (V) (Shown in Exhibit 1), plus stagnant productivity (Q) (Shown in Exhibit 2) are pushing prices higher (higher inflation).
The natural unemployment rate occurs when the economy is at “full employment” which is the optimal scenario that will sustain stable GDP growth and inflation, according to Federal Reserve. Historically speaking, the unemployment rate tends to act mean reverting around the natural unemployment rate. Especially after a recession, the real unemployment rate is unlikely to stay below the natural unemployment rate for long.
Currently, the real unemployment rate is 3.7%, while the natural unemployment rate is 4.7%. After the 1981 recession, the real unemployment first fell below the natural unemployment rate and quickly reversed above it, causing the 1989 recession. We are now in a similar situation.
Since the 2008 financial crisis, companies have been taking advantage of historically low interest rates. Earnings per share (EPS) were boosted by reducing shares outstanding, which was funded by issuing debt with low cost of debt.
This action not only inflated financial performance, but also increased balance sheet risk. S&P 500 EPS has benefited from share buybacks. When rates rises, this practice will be more expensive.
Companies that have high leverage will have higher cost of debt, which results in lower valuation. For example, if cost of debt reaches 10%, Amazon’s share price in 2019 will be $1,008 while maintaining a median growth rate.
*Source: S&P Dow Jones Indices, U.S Bureau of Labor Statistics, Federal Reserve, author’s calculation
Short-term yields (2 Year) have trended upward over the past five years, while long-term yields (10 Year and 30 Year) are flat. U.S yield curve is near inversion. Reasons:
2-Year Treasury yield reflects the high expectation for a Fed rate hike. The Fed is the first central bank to exit a QE program. Its gradual rate hikes and balance sheet reduction (Treasuries & MBS) directly affect short-term yield.
Long-term Treasury (10 Year and 30 Year) yields reflect the expectation for future economic growth.
Yield spread between long term and short term is declining over time. Indications are:
Short-term monetary supply is tighter than long term’s, which makes business borrowing more expensive. As a result, economic expansion is likely to slow down.
Long term economic condition may be worse off.
Long term GDP growth may be slow, which may signal a recession.
Conclusion: Yield curve will invert as short end rates continue to be lifted by Fed and long end rates continue to adjust to slower growth.
*Source: Federal Reserve
Given the current economic conditions, the four elements that may cause stagflation are met:
Higher Inflation: Stagnant productivity and rising M2 money stock velocity
Higher Unemployment: Real unemployment rate is currently below natural unemployment rate. Unemployment rate normally rises after the recovery of a post-recession period.
Lower Corporate Earnings:
Rising interest rates will
Mitigate the incentives for company to repurchase its shares and issue debt.
Lower companies’ valuation with higher cost of debt and weighted discount rate
Slower GDP Growth:
Narrower yield spread and flattening yield curve indicates an economic slowdown, possibly even a recession in the future.
Higher interest rates, especially fast rising short-term interest rates makes business borrowing more expensive.
Looking back to the period from 1981 to 1989, we believe we are now in a similar situation and that history may repeat itself. While enjoying this nine-year long bull market, investors need to be aware of the potential stagflation risk that is surfacing and be prepared for the unforeseeable headwind in the future.
“Blind Faith” Isn’t A Strategy For “Late-Cycle” Markets
“The journey of a thousand miles begins with one step.” – Lao Tzu
In a tiny first step on December 16, 2015, the Federal Reserve (Fed) did something they had not done in over nine years. From the unprecedented starting point of zero, they raised the Fed Funds rate. Since, they have begun to allow their swollen balance sheet to contract in what can only be characterized as another unprecedented event. Although monetary policy remains extreme and real rates only recently have turned positive, these measures mark the end of an era of maintaining extreme financial crisis monetary policy in the United States.
Reversing these experimental policies initiates a new set of dynamics which will gradually reduce excessive liquidity from the financial system. Just as quantitative easing (QE) and zero interest rates were a grand experiment, the removal of these policy measures is equally experimental. Now, over 325 million domestic lab rats and the rest of the world wait to see how it plays out. Importantly, if the Fed continues down this path, investors should carefully consider potential risks and the appropriate market exposure in this brave new world.
Despite the multitude of unanswerable questions about the implications of these events, what we know is that the economy is in the late stages of an economic expansion. Just as low tides follow high tides, we can use prior cycles as a guide to consider prudent, late-stage portfolio positioning.
As discussed in, Everyone Hears the Fed but Few Listen, the difference between Fed officials’ expected path of Fed rate hikes and market expectations for the Fed Funds rate is important. The implications for the market and investors are especially compelling when considering asset allocation weightings. For example, if the Fed continues on their path of more rate hikes and surpasses market expectations, stocks are likely to struggle as much needed liquidity evaporates. The bond market, on the other hand, will probably continue to do what it has been doing, but to a greater extent. A flatter and possibly an inverted yield curve would be in order unless inflation rises by more than is currently expected. Conversely, if the Fed backs away from their current commitment, it will likely be bullish for risk assets and the yield curve would probably steepen, led by a decline in 2-year Treasury yields.
Through September this year, the U.S. economy has posted an average growth rate of 3.3% (average quarterly annualized) and S&P 500 earnings have grown over 20% so far this year. The news from consumer and business surveys is favorable, and the country is essentially at full employment. That all sounds good, but is it sustainable?
The table below, courtesy of the Committee for a Responsible Fiscal Budget (CRFB), shows that recent tax and budget legislation along with soybean purchases in anticipation of trade tariffs drove recent economic growth at the margin.
While the stimulative impact of fiscal policy remains favorable, it will steadily decline toward neutral for the rest of this year and throughout 2019. Policies regarding tariffs and trade are likely to weigh on economic growth throughout this year and next year. Most importantly, the Fed is clear that their plans are to continuing raising rates and reducing the holdings on their balance sheet that resulted from QE.
Since the end of the recession in June 2009, the economy has clearly moved from recovery to expansion. That means the U.S. economy is nearing the “slowdown” phase of the cycle and heading toward the contraction (recession) phase. The evidence of the U.S. now being in a late-cycle environment is compelling and strongly suggests that investors modify their asset allocation weightings to protect against losses as the cycle progresses.
The Path Forward
The past does not provide investors with perfect information about how we should invest, but it does offer excellent clues. It may be helpful to look at the major asset classes and consider portfolio adjustments for late-cycle positioning.
U.S. Stocks: To evaluate late-cycle performance, we looked at equity performance by sector in the 12-months leading up to each of the prior three recessions (1990, 2001, and 2007).
Data Courtesy Bloomberg
Every environment is different, and what outperformed in the past may not on this occasion as the cycle unfolds. Prior to the last three recessions, investors preferred defensive sectors, such as staples, healthcare, utilities, energy and industrials during late-cycle periods.
U.S. Bonds: Using the same framework, we looked at various bond categories in the period leading up to the three prior recessions (due to limited data, some categories do not have return information for the 1990 period).
Data Courtesy Bloomberg
The important takeaway is that investors prefer lower risk bonds leading into a recession. This is also evident across the rating categories of the high yield bond market. Note how much better BB-rated bonds perform relative to lower-rated B and CCC bonds.
The quality of the securities within both the investment grade and high yield market is so poor in this cycle (highly levered, high percentage of covenant-lite structures, high percentage of BBB-rated securities in the IG sector) that we urge a very conservative position in both cases. Indeed, the “up-in-quality” theme holds for any credit instrument in the late stages of the cycle.
Commodities: Despite the rise in oil and gas prices in 2018, commodities remain the most undervalued of all major asset classes. Some soft and hard commodities have been hurt by the tariffs initiated by the Trump administration, but there is a reason they are characterized as “commodities.” We need them, and they are staples to our standard of living. Supply fluctuations will occur between nations as trade negotiations evolve, but the demand will remain intact.
Additionally, global central bank interventionism remains alive and well as demonstrated by recent actions of the Peoples Bank of China (PBOC). To the extent that central bankers continue to take the easy route of solving problems by printing money to calm markets when disruptions occur, natural resources and agricultural products will likely do well as a store of value – much like gold. They all reside in the same zip code as a means of protecting wealth.
Cash is King: In addition to the ideas illustrated above, it is always a good late-cycle idea to raise cash. As American financier and statesman, Bernard Baruch said, “I made my money selling too soon.” Although the low return on cash is a disincentive, the discipline affords opportunity and peace of mind. Having cash on hand is also a reflection of the discipline of selling into high prices, a skill at which most investors fail. Cash is an undervalued asset class heading into a recession because most investors panic as markets correct. Those with “dry powder” are better able to rationally assess market changes and more clearly see opportunities as certain assets fall out of favor and are cheap to acquire.
Many investors elect to leave the “serious” decision-making to their investment advisors on the assumption that the advisor will make the right decision “on my behalf.” They delegate with full autonomy the task of adjusting risk posture, when the advisor ultimately bears far less risk in the equation. Being inquisitive, asking good questions and challenging the “hired help” is a proper prerogative. One should always operate and engage with humility but never on blind faith.
Given the complexities and the risks of the current environment, investors should not be silent passengers on the journey. One who has wealth and takes that responsibility seriously should have valid questions that are both difficult to answer and enlightening to debate. Iron sharpens iron as the proverb says.
The Fed has now taken eight steps in their path to normalizing interest rates and trying to set the economy on a sustainable growth path. Although he probably did not consider its application in the realm of monetary policy, Sir Isaac Newton’s law of inertia states that a body in motion will remain in motion unless acted upon by an outside force. Rate hikes are in motion and likely to remain so for the foreseeable future unless and until some outside force comes in to play (crisis).
Given the extreme nature of past policy actions and the likely impact of their reversal, forecasting future events and market behavior promises to be more difficult than usual. Reliable guideposts of prior periods may or may not hold the same predictive power. Although unlikely to afford investors with prescriptive solutions this time around, there is value to doing that analytical homework and gaining awareness of those patterns. Finally, as the cycle unfolds, successfully navigating what is to come and preserving wealth will also require investors to apply sound decision-making using clear guidance and input from those who dare to be contrary.
The Fed’s Mandate To Pick Your Pocket – The Real Price Of Inflation
“Inflation is everywhere and always a monetary phenomenon.” – Milton Friedman
This oft-cited quote from the renowned American economist Milton Friedman suggests something important about inflation. What he implies is that inflation is a function of money, but what exactly does that mean?
To better appreciate this thought, let’s use a simple example of three people stranded on a deserted island. One person has two bottles of water, and she is willing to sell one of the bottles to the highest bidder. Of the two desperate bidders, one finds a lonely one-dollar bill in his pocket and is the highest bidder. But just before the transaction is completed, the other person finds a twenty-dollar bill buried in his backpack. Suddenly, the bottle of water that was about to sell for one-dollar now sells for twenty dollars. Nothing about the bottle of water changed. What changed was the money available among the people on the island.
As we discussed in What Turkey Can Teach Us About Gold, most people think inflation is caused by rising prices, but rising prices are only a symptom of inflation. As the deserted island example illustrates, inflation is caused by too much money sloshing around the economy in relation to goods and services. What we experience is goods and services going up in price, but inflation is actually the value of our money going down.
Historical Price Levels
The chart below is a graph of price levels in the United States since 1774. In anticipation of a reader questioning the comparison of the prices and types of goods and services available in 1774 with 2018, the data behind this chart compares the basics of life. People ate food, needed housing, and required transportation in 1774 just as they do today. While not perfect, this chart offers a reasonable comparison of the relative cost of living from one period to the next.
Three characteristics about this chart leap off the page.
Prices were relatively stable from 1774 to 1933
Before 1933, disruptions in the price level coincided with major wars
The parabolic move higher in price levels after 1933
As is evident in the graph, prior to 1933 major wars caused inflation, but these episodes were short lived. After the wars ended, price levels returned to pre-war levels. The reason for the temporary bouts of inflation is the surge in deficit spending required to fund war efforts. This type of spending, while critical and necessary, has no productive value. Money is spent on making highly specialized technical weaponry which are put to use or destroyed. Meanwhile, the money supply expands from the deficit spending.
To the contrary, if deficit spending is incurred for the purposes of productive infrastructure projects like roads, bridges, dams and schools, the beneficial aspects of that spending boosts productivity. Such spending lays the groundwork for the creation of new goods and services that will eventually offset inflationary effects.
After 1933, price levels begin to rise, regardless of peace or war, and at an increasing rate. This happened for two reasons:
First, President Franklin D. Roosevelt (FDR) took the United States off the gold standard in June 1933, setting the stage for the government to increase the money supply and run perpetual deficits. FDR, through executive order 6102, forbade “the hoarding of gold coin, gold bullion and gold certificates within the continental Unites States.” Further, this action ordered confiscation of all gold holdings by the public in exchange for $20.67 per ounce. Remarkably, one year later in a deliberately inflationary act, the government, via the Gold Reserve Act, increased the price of gold to $35 per ounce and effectively devalued the U.S. dollar. This move also had the effect of increasing the value of gold on the Federal Reserve’s balance sheet by 69% and allowed a further increase in the money supply while meeting the required gold backing.
That series of events was followed 38 years later by President Nixon formally closing the “gold window”, which was enabled by the actions of FDR decades earlier. This act prevented foreign countries from exchanging U.S. dollars for gold and essentially eliminated the gold standard. Nixon’s action eradicated any remaining monetary restrictions on U.S. budget discipline. There would no longer be direct consequences for debauching the currency through expanded money supply. For more information on Nixon’s actions, please read our article The Fifteenth of August.
The second reason prices escalated rapidly is that, following World War II, the U.S. government elected not to dismantle or meaningfully reduce the war apparatus as had been done following all prior wars. With the military industrial complex as a permanent feature of the U.S. economy and no discipline on the budget process, the most inflationary form of government spending was set to rapidly expand. Excluding World War I, defense spending during the first 40 years of the 1900’s ran at approximately 1% of GDP. Since World War II it has averaged around 5% of GDP.
Returning to Milton Friedman’s quote, it should be easier to see exactly what he meant. Re-phrasing the quote gives us an effective derivation of it. Inflation is a deliberate act of policy.
The Fed’s dual mandate, which guides their policy actions, is a commitment to foster maximum employment and price stability. Referring back to the price level graph above, the question we ask is which part of that graph best represents a picture of price stability? Pre-1933 or post-1933? If someone earned $1,000 in 1774 and buried it in their back yard, their great, great, great grandchildren could have dug it up 150 years later and purchased an equal number of goods as when it was buried. Money, over this long time period, did not lose any of its purchasing power. On the other hand, $1,000 buried in 1933 has since lost 95% of its purchasing power.
What does it mean to live in the post-1933, Federal Reserve world of so-called “price stability”? It means we are required to work harder to keep our wages and wealth rising quicker than inflation. It means two incomes are required where one used to suffice. Both parents work, leaving children at home alone, and investments must be more risky in an effort to retain our wealth and stay ahead of the rate of inflation. Somehow, the intellectual elite in charge of implementing these policies have convinced us that this is proper and good. The reality is that imposing steadily rising price levels on all Americans has severe consequences and is a highly destructive policy.
The graph below uses the same data as the price level graph above but depicts yearly changes in prices.
What is clear is that, prior to 1933, there were just as many years of falling prices as rising prices and the cumulative price level on the first chart remains relatively stable as a result. After 1933, however, Friedman’s “monetary phenomenon” takes hold. The money supply continually expands and periods of falling prices that offset periods of rising prices disappear altogether. Prices just continue rising.
There is an important distinction to be made here, and it helps explain why sustained inflation is so important to the Fed and the government. It is why inflation has been undertaken as a deliberate act of policy. As mentioned, periods of falling prices are not necessarily periods of deflation. Falling prices may be the result of technological advancements and rising productivity. Alternatively, falling prices may result from an accumulation of unproductive debt and the eventual inability to service that debt. That is the proper definition of deflation. This occurs as a symptom of excessive debt build-ups and speculative booms which lead to a glut of unfinanceable inventories. This is followed by an excess of goods and services in the market and falling prices result.
Furthermore, there are periods of hidden inflation. This occurs when observed price levels rise but only because of policies that intentionally expanded the money supply. In other words, healthy improvements in technology and productivity that should have brought about a healthy and desirable drop in prices or the cost of living are negated by easy monetary policy acting against those natural price moves. By keeping their foot on the monetary gas pedal and myopically using low inflation readings as the justification, the Fed enables a sinister and criminal transfer of wealth.
This transfer of wealth euthanizes the economy like deadly fumes which cannot be smelled, seen or felt. It works via the Cantillon Effect, which describes the point at which different parts of the population are impacted by rising prices. Under our Fed controlled monetary system, new money enters the economy through the banking and financial system. The first of those with access to the new money – the government, large corporations and wealthy households – are able to invest it before the uneven effects of inflation have filtered through the economic system. The transfer of wealth occurs quietly between the late receivers of new money (losers) and the early receivers of it (winners). Although a proponent of inflationary policies as a means of combating the depression, John Maynard Keynes correctly observed that “by continuing a process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
Conclusion – Investment Considerations
In the same way that only a very small percentage of recent MBA grads could, with any coherence, tell you what inflation truly is, the investing public has been effectively brainwashed into thinking that they should benchmark their investment performance against the movements of the stock market. Unfortunately, wealth is only accumulated when it grows faster than inflation. In our modern society of continually comparing ourselves with those around us on social media, we obsess about what the S&P 500 or Dow Jones are doing day by day but fail to understand that wealth should be measured on a real basis – net of inflation. For more on this concept, please read our article: A Shot of Absolute – Fortifying a Traditional Investment Portfolio.
Mainstream economists, either unable to decipher this process of confiscation or intentionally complicit in its rationalization, have convinced an intellectually lazy populace that some degree of rising prices is “optimal” and normal. Individuals that buy this jargon are being duped out of their wealth.
Holding elected and unelected officials accountable for a clear and proper measurement of inflation is the only way to uncover the truth of the effects of inflation. In his small but powerful book, Economics in One Lesson, Henry Hazlitt reminded us that policies should be judged based on their effect over the longer term and for society as a whole. On that simple and clear basis, we should dismiss the empty counterfactuals used as the central argument behind inflation targeting and most other monetary and fiscal policy platitudes. The policy and process of inflation is both toxic and malignant.
Why 80% Of Americans Face A Retirement Crisis
Fox Business recently discussed a new study showing that more Americans doubted they would be able to save enough for retirement than those confident of reaching their goals. There were some interesting stats from the study:
37% are NOT confident they can save enough to retire
32% ARE confident they can save enough.
48%, however, don’t think their retirement savings will reach $1 million.
“Americans feel under-prepared for the financial realities of retirement, according to new data from Northwestern Mutual. Nearly eight in 10 (78%) Americans are “extremely” or “somewhat” concerned about affording a comfortable retirement while two-thirds believe there is some likelihood of outliving retirement savings.”
Those fears are substantiated even further by a new report from the non-profit National Institute on Retirement Security which found that nearly 60% of all working-age Americans do not own assets in a retirement account.
Here are some additional findings from the report:
Account ownership rates are closely correlated with income and wealth. More than 100 million working-age individuals (57 percent) do not own any retirement account assets, whether in an employer-sponsored 401(k)-type plan or an IRA nor are they covered by defined benefit (DB) pensions.
The typical working-age American has no retirement savings. When all working individuals are included—not just individuals with retirement accounts—the median retirement account balance is $0 among all working individuals. Even among workers who have accumulated savings in retirement accounts, the typical worker had a modest account balance of $40,000.
Three-fourths (77 percent) of Americans fall short of conservative retirement savings targets for their age and income based on working until age 67 even after counting an individual’s entire net worth—a generous measure of retirement savings.
So, what’s the problem?
Why do so many Americans face a retirement crisis today after a decade of surging stock market returns?
“13 percent of Americans are saving less for retirement than they were last year and offers insight into why much of the population is lagging behind. The most popular response survey participants gave for why they didn’t put more away in the past year was a drop, or no change, in income.”
“For the third consecutive year, households in the United States experienced an increase in real annual median income. Median household income was $61,372 in 2017, a 1.8 percent increase from the 2016 median of $60,309 in real terms. Since 2014, median household income has increased 10.4 percent in real terms.”
So, if median incomes just hit an all-time high, then why are Americans having such a problem saving for retirement?
The cost of living has risen much more dramatically than incomes. According to Pew Research:
“In fact, despite some ups and downs over the past several decades, today’s real average wage (that is, the wage after accounting for inflation) has about the same purchasing power it did 40 years ago. And what wage gains there have been have mostly flowed to the highest-paid tier of workers.”
But the problem isn’t just the cost of living due to inflation, but the “real” cost of raising a family in the U.S. has grown incredibly more expensive with surging food, energy, health, and housing costs.
Researchers at Purdue University recently studied data culled from across the globe and found that in the U.S., $65,000 was found to be the optimal income for “feeling” happy. In other words, this was a level where bills were met and there was enough “excess” income to enjoy life. (However, that $65,000 was based on a single individual. For a “family of four” in the U.S., that number was $132,000 annually.)
Gallup also surveyed to find out what the “average” family required to support a family of four in the U.S. (Forget about being happy, we are talking about “just getting by.”) That number turned out to be $58.000.
Skewed By The 1%
The issue with the Census Bureau’s analysis is that the income numbers are heavily skewed by those in the top 20% of income earners. For the bottom 80%, they are well short of the incomes needed to obtain “happiness.”
The chart below shows the “disposable income” of Americans from the Census Bureau data. (Disposable income is income after taxes.)
So, while the “median” income has broken out to all-time highs, the reality is that for the vast majority of Americans there has been little improvement. Here are some stats from the survey data which was NOT reported:
$306,139 – the difference between the annual income for the Top 5% versus the Bottom 80%.
$148,504 – the difference between the annual income for the Top 5% and the Top 20%.
$157,635 – the difference between the annual income for the Top 20% and the Bottom 80%.
So, if you are in the Top 20% of income earners, congratulations. If not, it is a bit of a different story.
No Money, But I Got Credit
As noted above, sluggish wage growth has failed to keep up with the cost of living which has forced an entire generation into debt just to make ends meet.
While savings spiked during the financial crisis, the rising cost of living for the bottom 80% has outpaced the median level of “disposable income” for that same group. As a consequence, the inability to “save” has continued.
So, if we assume a “family of four” needs an income of $58,000 a year to be “make it,”such becomes problematic for the bottom 80% of the population whose wage growth falls far short of what is required to support the standard of living, much less to obtain “happiness.”
The “gap” between the “standard of living” and real disposable incomes is more clearly shown below. Beginning in 1990, incomes alone were no longer able to meet the standard of living so consumers turned to debt to fill the “gap.” However, following the “financial crisis,” even the combined levels of income and debt no longer fill the gap. Currently, there is almost a $3300 annual deficit that cannot be filled.
This is why we continue to see consumer credit hitting all-time records despite an economic boom, rising wage growth, historically low unemployment rates.
The mirage of consumer wealth has not been a function of a broad increase in the net worth of Americans, but rather a division in the country between the Top 20% who have the wealth and the Bottom 80% dependent on increasing debt levels to sustain their current standard of living.
Of course, by just looking at household net worth, once again you would not really suspect a problem existed. Currently, U.S. households are the richest ever on record. The majority of the increase over the last several years has come from increasing real estate values and the rise in various stock-market linked financial assets like corporate equities, mutual and pension funds.
However, once again, the headlines are deceiving even if we just slightly scratch the surface. Given the breakdown of wealth across America we once again find that virtually all of the net worth, and the associated increase thereof, has only benefited a handful of the wealthiest Americans.
Despite the mainstream media’s belief that surging asset prices, driven by the Federal Reserve’s monetary interventions, has provided a boost to the overall economy, it has really been anything but. Given the bulk of the population either does not, or only marginally, participates in the financial markets, the “boost” has remained concentrated in the upper 10%. The Federal Reserve study breaks the data down in several ways, but the story remains the same – “if you are wealthy – life is good.”
The illusion by many of ratios of “economic prosperity,” such as debt-to-income ratios, wages, assets, etc., is they are heavily skewed to the upside by the top 20%. Such masks the majority of Americans who have an inability to increase their standard of living.The chart below is the debt-to-disposable income ratios of the Bottom 80% versus the Top 20%. The solvency of the vast majority of Americans is highly questionable and only missing a paycheck, or two, can be disastrous.
While the ongoing interventions by the Federal Reserve have certainly boosted asset prices higher, the only real accomplishment has been a widening of the wealth gap between the top 10% of individuals that have dollars invested in the financial markets and everyone else. What monetary interventions have failed to accomplish is an increase in production to foster higher levels of economic activity.
It is hard to make the claim the economy is on the verge of acceleration with the underlying dynamics of savings and debt suggesting a more dire backdrop. It also goes a long way in explaining why, as stated above, the majority of Americans are NOT saving for their retirement.
“In addition, many workers whose employers do offer these plans face obstacles to participation, such as more immediate financial needs, other savings priorities such as children’s education or a down payment for a house, or ineligibility. Thus, less than half of non-government workers in the United States participated in an employer-sponsored retirement plan in 2012, the most recent year for which detailed data were available.”
But more importantly, they are not saving on their own either for the same reasons.
“Among filers who make less than $25,000 a year, only about 8% own stocks. Meanwhile, 88% of those making more than $1 million are in the market, which explains why the rising stock market tracks with increasing levels of inequality. On average across the United States, only 18.7% of taxpayers directly own stocks.”
With the vast amount of individuals already vastly under-saved, the next major correction will reveal the full extent of the “retirement crisis” silently lurking in the shadows of this bull market cycle.
This isn’t just about the “baby boomers,” either.
Millennials are haunted by the same problems, with 40%-ish unemployed, or underemployed, and living back home with parents.
In turn, parents are now part of the “sandwich generation” who are caught between taking care of kids and elderly parents.
But the real crisis will come when the next downturn rips a hole in the already massively underfunded pension funds on which many American’s are now solely dependent.
For the 75.4 million “boomers,” about 26% of the population, heading into retirement by 2030, the reality is that only about 20% will be able to actually retire.
The rest will be faced with tough decisions in the years ahead.
Would You Give Up Your Smart Phone for $100,000?
Median household income is $1.5 million; you just didn’t know it. That’s what the Wall Street Journal’s Andy Kessler thinks. I’m not making that up. He dedicated his most recent column to constructing a proof for that thesis.
Granted, Kessler doesn’t say it exactly like that. Instead, he works backwards from nominal median household income of $51,640 in 2016 to the equivalent, in his estimate, of a mere $347 in 1973. But to go from $51,000 to $347 in 44 years, you have to discount the $51,000 by around 12% annually. If that sounds like a big discount rate, it is. But that’s what Kessler thinks all the technological advances that have occurred since 1973 are worth, despite the fact that the clumsy Bureau of Labor Statistics inflation numbers haven’t accounted for them accurately.
However, if we move in the opposite direction, beginning with the nominal median income in 1973 — $10,500 — and compounding it for 44 years at 12%, we arrive at around $1.5 million. This is what a more accurate “hedonic adjustment” for technological advances would reflect as the median household’s purchasing power, according to Kessler. For example, smart phones, as Kessler describes them, act as:
“Our newspaper deliveryman, librarian, stenographer, secretary, personal shopper, DJ, newscaster, broker, weatherman, fortuneteller—shall I go on? The mythical man of 1973 certainly couldn’t afford $100,000 or more for dozens of workers at his beckoning.”
And, Kessler asks, how much would we pay for someone to sit in our cars and perform the task of automatic breaking systems? Of course, the answer could well be nothing. We’d simply live with the extra risk as we did from the invention of the automobile until the invention of automatic breaking. And most of us would give up our smart phones for an extra $100,000 or roughly twice the median household income. If smart phones are really worth what Kessler says they are, this is the test they must pass. I doubt a smart phone would stack up to $100,000 for most people.
Here’s another way to think of hedonic adjustment and whether the middle class is living “high on the hog,” as Kessler says. In 1973, the average rent was $175 per month or $2100 per year. In other words, rent was around 20% of household income. Today, however, rent is around $1200 per month or $14,400 per year. That’s 28% of $51,000. So we have smart phones and automatic breaking systems on our cars, but do those things make up for rent taking out a bigger piece of our paycheck every month? Kessler doesn’t say.
He does say that most hedge fund managers he knows think the CPI is obsolete as a measure of inflation, and prefer the CRB Commodity Index. There’s nothing particularly wrong with using a basket of commodities as an inflation gauge, but it’s hard to know how a commodity index accounts for the technology development that Kessler thinks is so sorely missing from CPI.
More importantly, Kessler talks to hedge fund managers and was once one himself, but he doesn’t seem to have ever had a conversation with one of the investors Michael Lewis profiled in his book The Big Short. As Lewis tells it, Steve Eisman was trained as a stock analyst specializing in banks and other lending companies, and he didn’t know much about the bond market. But he arrived at his decision to short subprime mortgage-backed bonds partly from having observed as an equity analyst of “specialty finance” companies that middle class Americans were experiencing income stagnation and could only maintain their standard of living by borrowing through credit cards and against the value of their homes. Of course, Wall Street and the companies Eisman covered were happy to oblige them in this endeavor.
Eisman was a big critic of the banks leading up to the crisis, and shorted many of their stocks in addition to subprime mortgage-backed bonds. But here’s Eisman’s statement in a 2016 NYTimes op-ed column, where he argues against breaking up the banks after their post-crisis reforms, lest that would cause us to avoid the real problem of income stagnation:
“The central economic problem of our time is income inequality, especially the lack of personal income growth for most Americans, which was one of the underlying causes of the financial crisis. In lieu of rising incomes, credit was allowed to be democratized. Living standards were maintained only because increased credit supplemented deteriorating incomes. That helps explain, post-crisis, why United States growth is slow: Without easy credit, consumers cannot increase spending, because their incomes have fallen since 2007.”
I don’t know what prescient bets the hedge fund managers Andy Kessler speaks to have made. But when he contemplates the fortunes of today’s middle class, Kessler might want to expand the circle of investors with whom he exchanges ideas.
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