Interest rates steadied this past week (March 22-26) after the Fed altered the rules, vowing not to cave to market whims or pressures, instead waiting for the “actual data” to dictate the path of monetary policy. We agree with the Fed’s approach, but worry that the markets’ uneducated view of the causes of systemic “inflation” may push market rates to the point of endangering any chance of a robust recovery.
10-Year Treasury yields fell from 1.74% on Friday, March 19 (the Supplementary Leverage Ratio (SLR) issue) to 1.63% on Thursday (March 25) before retracing back to 1.67% on Friday. The retracement appears to have been caused by a sloppy 7-Year Treasury Note auction (the second weak 7-Year in a row) and by “inflation fears” arising from added supply chain issues due to the Suez Canal blockage.
In past blogs, we’ve talked about the rise in inflation expectations. The last era of systemic inflation was the late 1960s through the early 1980s. Most of today’s market players and commentators weren’t around then, and many have misinterpreted supply chain issues as the beginning of a new “inflationary spiral.” If you ask the old market players that were around in that era, the word “transitory” is generally the descriptor of today’s price issues. This is the word employed by the Fed and their economists, and is why Chair Powell has used the term repeatedly when describing the Fed’s view of inflation. Commentary by FOMC members and Fed Regional Bank Presidents are also on the same page.
There are three factors of production: land, labor and capital. Systemic inflation is a process and it occurs only when whatever is causing it is persistent. In the late 60s, the 70s, and the early 80s, wage growth was far in excess of economic growth. The last time the unemployment rate was 3.5% was late 1969. According to Economist David Rosenberg, wage growth at that time was in excess of 9% and it averaged more than 8% in that era. Last year, when that same unemployment rate again reached 3.5%, wage growth was 4%. Productivity is also relevant here. Productivity growth must be subtracted from wage growth to get an idea of the “margin squeeze” on business, and, therefore, the pressure to raise prices. Last year, during the pandemic, because of the rapid move toward automation, productivity actually grew (4%) much faster than wages (1%). That’s deflationary!
Of course, the cost of other inputs matters too. With interest rates at record lows, the cost of capital can’t be a systemic inflation factor. That leaves land. No doubt, its price is rising. But, automation has allowed existing plant and equipment to produce much more efficiently eliminating, at least for now, the need to expand that plant/equipment. Note that we haven’t seen a capex expansion cycle in a while.
As noted above, we haven’t had a systemic inflation issue for four decades. Markets and market commentators are consumed with Y/Y price index movements, as if these were signs of systemic inflation issues. Remember last April/May when the economy shut down and prices fell? There was a day or two where crude oil prices went negative. So, any Y/Y price comparisons will be large, but would be misleading if used as an inflation indicator. The table below is illustrative.
|Price||Pct. Chg. Y/Y|
Note that the price in Month 1 was 100 and it is 101 in Month 14; less than a 1% annual rate of change. But, because the economy shut down in Month 2, the index change in a Y/Y comparison is greater than 12% (i.e., 101 vs 90). Is this “systemic” inflation?
Supply chain issues are real and are going to temporarily impact prices. But price spikes caused by supply issues are temporary (like the TP issues last April/May!) and “normal” prices will return when supply chains reopen (and, yes, they will reopen the Suez).
In our last blog, we indicated that last week’s improvement in Pandemic Unemployment Assistance Initial Claims (PUA ICs) data was a leading indicator, and that we expected the state data to follow shortly. PUA recipients are the self-employed and independent contractors. State recipients are generally employees, not the business owners. As the economy reopens (now >70%), one would expect the PUA folks to be the first to “return” to work (or to “reopen”). Their “employees” (state unemployment recipients) would be recalled as business resumes or reopens. This appears to be what is happening. The table below shows that the PUA ICs led the State ICs by a week.
|PUA ICs||Change||State ICs||Change|
Given the continuation of reopenings and the continued fall in PUA ICs for the latest week, we believe that there will be a continued fall in State ICs over the next few weeks. Remember, ICs are a proxy for new layoffs which should fall as businesses are allowed to either reopen or operate at a higher capacity. The chart shows the combined state and PUA IC data. Note the beginning of the downtrend at the far right for the latest data.
The series for Continuing Claims (CC), recipients of benefits for more than one week, lags the IC data by two weeks. The latest data here are for the week of March 6, while the latest IC data is as of March 20. We do expect to see progress here over the next two weeks. But, given the overgenerous federal supplementary unemployment benefits in the recently passed American Rescue Plan Act of 2021 (ARPA) which will continue until early September, significant progress here may still be some time off. In addition, because the pandemic has accelerated the move toward automation and has forced businesses to live with less labor, we don’t expect the CCs to return to their pre-pandemic level anytime soon. That means there have been a significant number of “permanently” lost jobs!
When we look at the data showing the underlying economic trends, we aren’t encouraged about the strength of the economic recovery. And this is why we agree with the Fed’s “actual data” stance. Besides the labor market issues discussed above, we think that the expected surge in spending on reopening service businesses (travel, hotels, restaurants…) is going to be offset by a reduction in the consumption of durable goods which saw exceptional growth last year because the service sector was closed. In effect, the demand for durables was “pulled forward.” The table shows the percentage change in retail sales M/M from July to February. Note the volatility.
M/M Change in Retail Sales (Annual Rates)
The positive months appear to be “stimulus” related. The negative months occurred because the “stimulus” was “transitory.” Note especially this past January/February. The January surge was due to the late December “stimulus” (and the more efficient delivery of the helicopter money by the IRS vs. its slowness in delivery of the first “stimulus” package last spring). No doubt, retail sales will show up significantly positive in March and April. But if the pattern in the table holds, there will be less enthusiasm in the late spring and summer months.
Our less than enthusiastic opinion of the strength of the recovery also notes the following economic data:
- Web based retail sales: -5.4% M/M Feb. (can’t be weather related!)
- Industrial Production: -2.2% M/M Feb.
- Housing Feb. M/M: Starts: -10.3%; Permits: -10.8%; Existing Home Sales: -6.6% (and -7.6% annual rate since October); New Home Sales: -18.2%
- Auto Sales: -5.8% M/M Feb.
- Weekly earnings and average hours worked fell in February
On the other hand, all the Regional Fed Manufacturing Indexes are quite robust. Unfortunately, manufacturing is only 11% of GDP. Meanwhile, other indexes bear out the “not so strong” view. The Citigroup Economic Surprise Index, for example, fell to the lowest level in March since the depths of despair last June, and the Chicago Fed National Activity Index, a compilation of over 80 variables, was -1.09 in February vs. +0.75 in January.
One thing mainly ignored by the reopening narrative is the rising sentiment in Congress for higher taxes. The corporate tax rate is sure to be a target, and if it goes to 25% or 28% (or even higher), there will be a significant impact on corporate earnings. For all of you “wealthy” people who read this, there is also talk of higher individual tax rates, taxes on security transactions, and even a tax on “unrealized” capital gains. If the economy doesn’t “roar,” and tax rates rise, what might happen to the prices of financial assets? Food for thought!
The economy will come back. But we don’t think it will “roar” like Wall Street hopes (i.e., a return of the “Roaring 20s”). The labor market is wounded and will take a long time to heal. The “inflation” that will “shake up” the economy that we will surely get in the second quarter will be “transitory” because weak wage growth and rising productivity are anathema to an inflationary spiral.
We haven’t seen systemic inflation for nearly four decades, and there is a lack of understanding as to what “systemic” inflation is. Because of this, upcoming spikes in the price indexes may cause additional surges in interest rates.
If the reopened economy is as strong as the current Wall Street narrative would have you believe, then higher interest rates could be justified. But, we are more circumspect. Labor markets are damaged; they need time to heal. Consumers are more cautious, having been caught short by the unexpected pandemic. The underlying economy just doesn’t look as healthy as the Wall Street narrative paints. If our view is correct, the price spikes are “transitory” and not “systemic,” then any market pre-emptive move to raise interest rates will hurt the economic recovery. We agree with the Fed (always a smart move). Markets should wait for the “actual data.”
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Four Star Wealth Advisors. www.fourstarwealth.com. He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO, and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (the AAA brand) where he chairs the Finance and Investment Committee. Robert is the co-portfolio manager of the UVA Unconstrained Medium-Term Fixed Income ETF (FFIU)