June Investment Comments
President Biden is negotiating for a $2+ trillion spending bill centered around infrastructure. It is hard to argue with infrastructure, which explains why that word features so prominently in the bill’s marketing push. The positive economic value from infrastructure improvements may be diminished by the potential chilling effects of tax increases to pay for the bill. Investors should keep a close eye on the risk of higher corporate taxes. The market responded robustly to the tax cuts that were implemented four years ago, and from the market’s perspective it is very hard to find a silver lining in the prospect of a rollback.
Wouldn’t it be nice to get the benefits of more spending without the cost of higher taxes? The difference between outlays and tax collections is the deficit, and the government’s ability to run expanding deficits depends on its borrowing rate staying low. Bond owners have not been very demanding in recent years, but their continuing good nature is forever being tested. In early May Treasury Secretary Janet Yellen admitted that the improving economy, boosted further by a large infrastructure bill, could necessitate higher interest rates. This sounds to us like basic common sense, or maybe Macroeconomics 101, but it stirred up quite a controversy. Investors are very sensitive about interest rates, inflation, and asset prices, and the Secretary’s remarks touched off a modest stock market decline that was stemmed by Yellen quickly “clarifying” her comments, saying she was not predicting higher rates. She was only speaking hypothetically.
Meanwhile, the Federal Reserve is entertaining no such hypotheticals. The Fed’s ever-dovish messaging around inflation and interest rates is starting to offend shoppers and business leaders who worry that a recent price surge may not subside in accordance with policy makers’ stated expectations.
Many commodities have posted stunning one-year price increases compared to pandemic-affected 2020 levels. Lumber has nearly quadrupled. Corn has doubled. Copper has doubled. Oil has more than doubled. The S&P 500’s approximately 50% increase over the past twelve months looks comparatively modest. Acute supply shocks for such things as ocean freight, computer chips, lumber, and gasoline can be at least partly laid at the pandemic’s feet.
This is a particularly hard time to parse economic data. As developed economies reopen and consumer demand returns to pre-COVID levels, global supply chains remain disjointed due to the pandemic. After a period of slack demand and slack supply, demand is simply coming back faster.
Interpreting the U.S. labor market presents a unique challenge. The unemployment rate has recently leveled off at about 6%, compared to 4% before the pandemic, while labor force participation is currently about 3% below its pre-pandemic level. Some potential workers are saddled with lingering personal health problems or childcare responsibilities. Meanwhile, unemployment benefits have lessened but remain elevated compared to pre-pandemic levels. One natural consequence is that people’s reservation wage, or “get off the couch price,” is higher. The pandemic has lessened both people’s ability and their desire to work. The extra unemployment benefits will likely recede, but employers also need to adjust wages higher.
And many employers can afford to adjust. Money is anything but tight right now. By any measure, the money supply has expanded more than 20% during the past year, and with central banks around the world firmly against tapering their balance sheets, it appears this huge bolus of emergency money will prove permanent. It stands to reason that the price of real assets must also adjust higher, although the relationship between money creation and consumer prices is not a tight coupling, and inflation is not evenly distributed. Central banks view these higher prices mainly as a temporary imbalance, and there is probably some merit to this argument. A blocked canal and a cyberattack at a refinery are hardly the fault of central bankers. If supply chains remain fragile and struggle to adjust, then some amount of inefficiency is only to be expected.
It is worth noting the pandemic has a deflationary side as well—especially pertaining to the rapid adoption of remote work, which reduces demand for transportation and non-residential real estate. We have not heard anybody at the Federal Reserve talk about temporary deflationary forces.
April’s Consumer Price Index (CPI) reading came in higher than expected at 0.8% month-over-month and 4.2% year-over-year. Deconstructing that statistic, monthly inflation was driven disproportionately by energy and automobile prices. These spikes can plausibly be called temporary, resulting from supply shocks and the influence of muted year-ago comparisons. Yearly inflation numbers are driven by those same forces plus housing contributing 0.7%. Surging home prices should be contributing more to inflation than is reported. The CPI calculates the impact of housing based on the rented value of homes so it is not directly tied to home values. Recent CPI statistics seem to understate housing inflation.
James Mackintosh at The Wall Street Journal warns that even if the recent spurt in measured inflation does indeed prove temporary, its ghost will linger in the official data for at least a year because of the convention of defining “current” inflation as the 12-month trailing history. Even if inflation politely returns to a 2% annual pace throughout the rest of 2021, at this time next year the official statistics would likely still show 5% trailing inflation as early 2021’s big figures only gradually drop out of the data. The non-technical term for this phenomenon is “a pig in a python.”
In summary, easy money and temporary supply shocks are driving inflation. This should relax, at least somewhat, but continued deficits and, arguably, economic necessity inspire central banks to run their money printers at absolute top velocity. Investors would be wise to keep the length of their monetary instruments short—cash is better than CDs, which are better than bonds. It may be too late to play the commodities surge. Remember that equities are real assets as well. Valuations are stretched by historical standards, but it makes sense to pay up when the alternatives look worse.
Miles G. Putnam, CFA