For a generation of investors, inflation is something read about in history books but never experienced. This is about to change. The combination of relaxed COVID restrictions, forced savings to be spent, fiscal stimulus, and an inability to match labor with demand are all resulting in higher prices. In this case, “higher prices” means higher than the pre-COVID times that came to an end March of 2020.
The first issue is whether this bout of inflation is temporary or speaks of a change in consumer expectations. In the temporary camp is the Federal Reserve, whose members, led by Chairman Powell, speak of the need to permit inflation to provide the incentive by business to hire more workers in order to capture the rising profits that inflation brings. By the Fed’s reckoning, by year-end, rising prices will be met by rising supply, and prices will come back to earth. Letting prices rise is the incentive business needs to bring on more capacity, hire more people, etc. If the Fed is correct, businesses will overshoot, and the excess capacity generated will bring prices back down in 2022.
The second school of thought believes that the Fed has let the inflation genie out of the bottle and it will not go back on its own volition. This school believes that inflation is a factor of expectations, and once consumers and businesses expect inflation, they will conduct themselves to act to avoid it. Ways to avoid inflation include buying items with borrowed funds at low rates of interest, on the expectation that rising prices will, in effect, provide a monetary return on the excess debt deployed. Thus, consumers are outbidding each other to buy homes on the expectation that the home will prove an inflation hedge. Some buyers are contracting to buy homes with no set price, giving the contractor a way to pass on higher costs like lumber, steel, and labor.
In terms of consumer conduct, this period is reminiscent of the time just after World War II. Thousands of servicemen came home to a housing market that had been moribund for fifteen years. The economy was geared to war production and could not transition to peacetime immediately. The result was significant inflation, as wartime savings chased too few goods. While the time frame was longer then than now, the artifacts of pent-up demand were the same.
Aside from a home, the purchase of a car is the second-largest expenditure for most households. Here the news is not much better. A worldwide shortage of semiconductor chips compatible with auto assembly has caused production to slow even as demand rises. Used car prices are up ten percent in the month of March alone. Even rental companies are buying used cars; they thinned out their fleets during the lack of demand in the pandemic and now need to bulk up. New cars are not available at a reasonable price. Automakers are putting what computer chips they have in their most expensive models to maintain profits even as volume declines. The shortage of chips was caused by the upswing in demand and years of under-investment by the semiconductor industry. It is predicted to last two years. It affects everything from cars to appliances and almost all industrial products.
So, with this level of entrenched shortages, what is the Fed seeing that we are not? The Fed wants a robust economy with full employment and is willing to risk inflation to get it. The casualties in this situation are those owning bonds of any maturity beyond five years. As inflation increases, bond values decline. And while the decline may be rectified by maturity, the damage done to the purchasing power of the funds the bond represents is real and lasting. While some may predict a decline in the inflation rate, no one is predicting a decline in inflation itself.
The best defense an investor has against inflation is owning investments that have the potential to increase cash flow and their nominal value. Bonds as a group cannot do this, as their interest rate is in some cases already less than inflation and their principal appreciation is contractually limited. Only reasonably priced common stocks have an inflation hedge. Most preferred stocks act like long-term bonds. Remember that the longer the time to maturity, the greater the potential for a decline in value.
In the 1970s, there was coined a term, “bond vigilantes.” These were bond speculators that would sell bonds short, driving bond prices down and yields up at the first sign the government was backing down on inflation. Since the federal government is the world’s largest debtor, each rise in yields set back the budget into more red ink. It also led to a decline in the dollar’s value relative to other currencies. This stoked inflation further still, as imports did not provide price competition with domestic goods. While history may not repeat itself, it does seem to rhyme with an era fifty years ago. We will see how it plays out.
In the meantime, high-flying growth stocks, which rely on cheap money for their outrageous valuations, are being laid low by value stocks that do not grow as fast but pay dividends of some size. They also may increase their dividends over time. Many speculators have moved on from the stock market to cryptocurrency. Their predicament mirrors WWile E. Coyote in the “Road Runner” cartoons; after they realize they have gone off a cliff, there is nowhere to go but down. Owning bitcoins also seems to ensure a lifetime of audits from the IRS, who assume such investments are for tax evasion. Not exactly the investment that keeps on giving.
Restarting an economy as large as that of the United States is not a smooth affair.
With the fact that not everyone has been vaccinated (often their choice), parts of the landscape look more restored than others. However, there are three things to keep in mind.
First, there are fewer workers than there were a year ago. This is an outcome of demographics (fewer births than deaths). As mentioned in prior issues of the Perspective, immigration can be applied to this problem, but there first must be the political will to discuss the issue and reach a solution palatable to most Americans. We are not there yet.
Second, COVID seems to have had a psychological effect, prompting people to retire earlier and enjoy life because the future is not a given. With almost 600,000 people having died from the virus, many knew someone who contracted the disease and did not survive. The shrinking of the workforce on the older end opens career paths for younger workers. However, many are wondering about the safety of the workplace given the conflicting accounts of COVID’s eradication and relapse.
Third, a majority of those who lost their jobs in the pandemic were women. Lacking re-opened public transportation, childcare, schools, etc., many cannot find a way to work given home responsibilities. Whether efforts to reduce unemployment payments while continuing decreased public transport will have to be seen.
Interest rates have been rising since last fall. They will rise more. As raising the rate of interest paid is the only defense of the bondholder against inflation, rates will have to rise with the inflation rate. The ten-year US Treasury bond currently yields 1.62 percent per year. Look for something over two percent by year-end. The 30-year bond returns 2.4 percent. It should be over three percent by December.
At some point, bondholders will tire of holding investments whose return does not keep pace with inflation. Should bond buyers go on strike for higher yields, the Federal Reserve and Treasury Departments will know that attention must be paid.
Inflation is hot and getting hotter. If this is accepted as a given, the investment landscape will be changed materially.
Inflation is one of the things the government is not very good at measuring – for a good reason. As the largest provider of cost-of-living adjustments (COLA), the government has the most at stake should inflation rise. A five percent increase in Social Security benefits would increase the budget deficit by $60 billion a year, with more people qualifying all the time. At some point, the government will have to address the inflation issue. We have not yet reached the crisis point that makes action unavoidable.
The Stock Market
Stocks are grinding higher, aided by the surge in value names and the treading water of many of the former growth issues. The overall Standard & Poors Index is up about 11 percent year to date. However, the overall Price/Earnings ratio is currently over 44. The average for the past 50 years is 16. Much of its outlier status is the result of losses suffered in the pandemic. Yet, the current high valuation signals how much of the recovery is already factored into the current price of the market and how much the market will fall if the recovery in profits does not materialize.
Going forward, selection is the key. While the overall market may be priced at 44 times earnings, not every stock is so richly valued. Bear in mind also that the indexes put more weight on larger firms, many who sport the high valuations like Amazon at 62 times earnings, or Tesla, which sports a multiple of 581 times earnings. Packaged investment products like index funds and ETFs blindly purchase such names in proportion to the relevant index.
Warren M. Barnett, CFA
May 18, 2021