It has become one of the most feared things in not only the American zeitgeist, but throughout the world as well. Earlier in history it was the spark that ignited social unrest, war, and even some high profile beheadings. I am referring to none other than price inflation. More recently, say the last 6 months, the specter of inflation has taken on a completely different personality. As consumers, we surely don’t like inflation eating into the purchase power of our money, but for investors, inflation could stir up some headwinds halting the growth of our portfolios. Those fears began to emerge earlier this year as vaccinations began to ramp up, a third stimulus package was approved, and restrictions began to be eased. The impacts on the market can be clearly seen as the explosively growing Nasdaq suddenly pulled back in February and then chopped sideways ever since. So what does it all really mean to us? Let’s go through a quick description, review some history, and then figure out how to deal with it going forward.
Working hard for less
Inflation is the rate at which the prices of goods and services increase over time. Increases in price cause the value of a currency to decline, meaning a consumer can purchase less with the same amount of money. This is known as a decline in purchasing power. There are three primary causes of inflation.
When consumers have more money to spend, demand increases, thus driving prices higher. This occurs when the supply of money increases or the ability to access credit expands.
This should ring a bell given recent events. Interest rates have been low for some time. The Fed first began to lower key lending rates in 2019 in what they referred to as a “mid-cycle adjustment.” The move caused credit card and mortgage rates to go down for consumers. When the pandemic struck last year the Fed lowered rates effectively to 0%. Simultaneously, the Fed also began to purchase treasury and mortgage backed bonds in the open market (quantitative easing), thus causing longer maturity yields to fall. Ten-year treasury yields started 2020 around 1.5% and fell to around 0.55% by late summer. This massive monetary easing caused mortgage rates to hit an all-time low by the end of the year. Borrowing money for consumers and businesses became cheap. The Federal Government responded to the pandemic with 3 principal fiscal stimulus packages amounting to more than $5 trillion, putting money directly into pockets of consumers and corporate coffers. The end result of 2020/2021 fiscal and monetary stimulus is more money to spend. More money to spend leads to increased demand, which causes prices to go up.
Companies generate profit by producing goods and services and selling them at prices above their costs. If raw material prices increase or labor costs go up, companies faced with diminishing margin are likely to raise prices to maintain profitability.
Last year’s events threw global supply chains into a tailspin. Think of a packed cargo ship running at full steam suddenly having to throw its engines into reverse in order to come to a complete standstill. The global economy essentially did just that last February as the lockdowns began. Factories shut down, workers were furloughed if not laid off, and logistics slowed to a crawl. Cargo ships were literally put on mothballs and empty shipping containers piled high in foreign ports. As quickly as global commerce as we knew it ground to a halt, everything picked back up with ferocity, but what emerged was a shift in demand to different types of goods. Just as less travel by roads, rails, and sea meant lower demand for fuel causing crude oil prices to go down, increased demand for home office computers and home-based durables meant increased demand for the semiconductor chips that are in virtually everything you bought last year. Supply of those raw materials and assemblies came up short causing costs to rise. Remember that steaming cargo ship analogy up above? As you might guess, those ships can’t start and stop on a dime. Likewise, big shifts in global economies take time to work their way through a system. Last years demand shifts, logistics snags, and supply hang-ups have led to decreased inventories, or supply, in the current year causing material costs to rise. Shipping costs have risen as well. In December of 2019, the average cost of transporting a shipping container by sea was around $958. That cost skyrocketed in the second half of last year and has continued through current, where it now stands at $3,432 per container! That is an astonishing +258% increase. Costs are not limited to material, they include labor as well. While you would think that labor costs would be going down with such high unemployment, the opposite has actually occurred. In order to compete with lucrative, temporary unemployment benefits, companies are having to raise salaries to get workers to fill openings. In labor intensive production facilities, such as poultry processors, labor costs are critical input costs. In labor intensive service industries such as restaurants and hotels, labor costs are also critical inputs. There too employers are struggling to fill vacancies, having to raise salaries… and costs. All of these cost increases ultimately cause both goods and services companies to raise prices to consumers. The result is: inflation.
When inflation is on the rise, people expect prices to continue to go up in the future. With those expectations, would-be workers demand higher salaries to cover price increases. Higher salaries mean increased labor costs, which ultimately get passed on to the consumer in cost-driven inflation.
As mentioned above, companies have been struggling to fill job vacancies as the economy emerges from pandemic restrictions. If job-seekers expect prices of goods to go up in the future they will demand higher wages. In this past earnings season many labor intensive companies have reported an increase in labor costs resulting in sign-on bonuses and wage increases. Many expect to pass those increased costs on to the consumer.
Qu’ils mangent de la brioche
I will save you a trip to Google and translate it for you. “Let them eat cake,” goes the famous phrase allegedly spoken by Marie Antoinette. The story goes that the Queen Marie Antoinette of France uttered the infamous line in response to her rioting subjects as they were unable to afford the high cost of bread. As you might suspect, bread is an essential food item in the French diet, so skyrocketing prices of the necessity caused a bit of social unrest. The Queen’s inability to recognize the negative impact of inflation landed her a spot on the guillotine. The story is actually historically inacurate, but the French Revolution was very much stoked by hyperinflation, amongst other things. Hyperinflation was caused by a massive increase in money supply as the French literally printed paper money in hopes of restoring an economy struggling from perpetual conflicts with England. The massive influx of supply caused a devaluation of the currency. Additionally, more money led to increased demand for goods, pushing prices higher.
Over a century later, in post-World War I Germany, inflation hit an extreme. After the war, Germany, having lost, was forced to pay reparations to the winning countries. The German Weimar Republic was not permitted to pay with German paper currency, so the republic printed lots of notes (not backed by assets) which would be used to purchase the foreign currency for reparations. The increased money supply caused a massive devaluation of the currency, then known as the Papiermark. German consumers panicked over the rapidly declining value of currency and responded by spending it as quickly as possible. The massive surge in spending compounded the devaluation and caused prices of goods to rise. The hyperinflation caused massive social unrest and ultimately contributed to the hostilities which led to World War II.
While we never experienced hyperinflation in the US, we did experience double digit inflation in the 1970’s. Attempting to stoke the economy, a falling stock market, and high unemployment, the Fed increased the money supply. Sounds familiar. The aggressive increase in money supply led to inflation, just as it had so many times before in history. Inflation was exacerbated by high crude oil prices artificially created by an oil embargo by the then dominant OPEC. Thankfully, no heads were lost on the guillotine, but it was a time of social unrest and a recession. Not to mention long lines at the gas station.
I think we all know by now that inflation can be bad. As we have learned in our brief history above, it can cause social unrest and lead to recession. Recession typically occurs when inflation is running so hot that the central bank must take aggressive measures to tackle it. Those crude, aggressive measures typically overshoot, not only slowing an economy, but also sending into a contraction. An example is when the Fed Funds Rate was ratcheted up nearly 20% in order to tackle almost +15% inflation in 1980, which led to the 1981 recession.
“Wait, did I read that correctly,” you ask? You did. A little inflation is actually healthy for an economy. If an economy is operating under capacity, increased demand will cause producers to, well… produce more to meet demand. Higher prices also act as an incentive to produce more. In order to produce more, companies need to employ more workers, which leads to lower unemployment, which we can all agree is a good thing. If you are a long-term holder of certain assets you would welcome inflation. Examples would be precious metals like gold, or real estate, two assets which gain in value with inflation.
It’s all about moderation
You have, I am sure, heard that before. It also applies to inflation, as we now know. So, what is the right balance? Many economists agree that inflation between 2-3% is just enough to keep the wheels of the economy turning. Growth less than 2% can be a drag while greater than 3% can lead to a drop in consumer demand. Beyond that, inflation, as we have learned can get out of control and require the Fed to undertake draconian measures, which may lead to recession.
How about some of that cake?
The pandemic has been referred to as a once-in-a-generation event. While we are making progress, we are far from out of the woods. From a financial standpoint, an economic recovery is afoot, however it comes with some hitches. Massive amounts of stimulus have been applied to the global economy in order to spark the recovery. Here in the US, $5 trillion worth of stimulus has been pumped into the economy by the Federal Government, while the Fed continues to pump $150 billion of liquidity into the financial system monthly. Interest rates are near 0% placing borrowing costs at record lows. In the past year the savings rate in the US rose significantly as homebound consumers stashed away stimulus checks. This has led to pent-up demand which many economists expect to take effect in the second half of the year. That surge in demand combined with easy money is expected to cause inflation (demand-driven). As a result of the massive amounts of stimulus and rapid economic reflation, employers are forced to pay up for workers, increasing their costs. Those increased costs along with rising raw materials costs and supply bottlenecks are expected to be passed along to consumers in eventual price hikes, which would lead to cost-driven inflation. We have already witnessed signs of inflation in the Consumer Price Index which shot up unexpectedly last month from +1.7% to +4.2%, far higher than the Federal Reserve’s 2% target. Bond investors have been selling bonds in anticipation of higher inflation, demanding greater yields. Those higher yields have put pressure on the valuations of growth stocks which are diminished by higher rates. The Federal Reserve has referred to the current inflation as “transient”, expecting it to diminish by the end of the year. They have further pledged to keep stimulus intact for the near future. Markets, in response have largely traded in a sideways pattern awaiting the Fed’s next move, or lack of it. It is too early to tell whether the inflation we are experiencing now will persist or abate by year end. It is clear however that rates will go up at some point in the future as will the bond purchases be tapered, regardless of inflation. While we will likely experience some market turbulence as we have in the past, it is important to note that stocks have risen by some +130% since the 2013 taper tantrum and roughly +105% since the Fed began hike interest rates in late 2015. While I prefer bread, I certainly don’t mind cake.
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