Upbeat data continues to make headlines. (The not-so-upbeat are relegated to the back pages.) This week it was the +6.4% spurt in real GDP. And, while the financial markets do feel a bit toppy, the S&P 500 still managed to eke out another record close on Thursday, April 29 (4211.47).
“Help Wanted” signs continue to be ubiquitous. Companies are raising wages just to attract applicants. The prices of lumber and other commodities are skyrocketing (did the sun stop shining and trees stop growing?) “Oh my! The awful 1970s inflation must have returned!” Really! Does anybody remember the price of oil at $140/bbl. in 2008? Did we get 1970s style inflation from that?
Why the Fed Lowered Rates
September 2019 wasn’t all that long ago, although it seems like we’ve lived years and years with pandemic restrictions. But it was only slightly more than a year and a half ago. The Federal Funds Rate (rate the Fed charges banks to borrow overnight) was rising in a stair-step fashion as the Fed was trying to “normalize” rates, i.e., bring them back to levels seen prior to the Great Recession. In December ’06, the Fed Funds rate was as high as 5.24%, and 6.5% back in August ’00. But, at a rate of less than 2.5%, the repo market (rates charged by banks to lend reserves to other banks) imploded, and the Fed had to abandon its rate raising regime. The Fed lowered that rate to 1.5% and propped up the repo market. Then the pandemic hit and the Fed Funds rate has been at the effective lower bound (0%) since, with the Fed pledging to keep it there, perhaps well into 2023.
We’ve read that too much debt saps the vitality out of an economy – instead of growing, cash is used to pay debt service. Since the autumn of 2019, debt has ballooned. A significant number of Below Investment Grade (known as BIG) companies have issued heaps of new debt. Then there is the Federal debt. The huge Obama stimulus package was less than $1 trillion; today, just about every spending bill is expressed in “T”s. Today, there is so much new U.S. government debt that, despite being rated the highest quality of all sovereign debt, and despite sporting the highest yield of any major sovereign issuer, there is so much of it that the auctions for new paper are considered “sloppy,” meaning that the bid/cover ratio is well below “normal.” In last week’s blog, we spotlighted the amount of leverage and “margin” in the equity markets and the fact that U.S. households are now holding record amounts of equity securities. What happens to household spending if there is an equity market “correction,” especially a significant one?
We read and hear often about how much money the Fed has created, M2 growing at more than 25% Y/Y. “That has to be inflationary,” we’re told. Now, that depends on your definition of “inflation.” If you define it simply as a rise in prices, then we’ve seen it in spades in the prices of equities and real estate (homes). But, that’s not the definition in play. The official definition limits “inflation” to “goods and services.” And, that is what the CPI measures. When the Fed buys the new issue of Treasury paper to finance the deficit, it pays for that paper with checks it writes. These are deposited into commercial banks, and become bank reserves (i.e., the banks clear them and end up with deposits at the Fed, which are, by definition, “reserves.’) In a normal economy, the banks would lend these and we would get the “bank reserve multiplier” as taught in the traditional “Money and Banking” college course. But, if the banks don’t lend them because there is no demand (i.e., the economy is locked down), then while M2 grows, its V (velocity) contracts at the same rate. So, in the MV=GDP equation, M rises but V falls at a similar rate, and GDP stagnates. This is what has happened. No traditional “inflation” (goods and services) here because there is no demand. And it will stay that way if demand does not reappear.
Home and Equity Observations
Over the past year, we’ve seen record annual home price increases (17+% Y/Y), yes, higher than in the Housing bubble. In that bubble, while home prices were rising double digits, wages were also rising (6%+/year). Wage growth today is well below that despite news stories about companies offering higher starting wages. We’ve already seen slowing in existing home sales and in new mortgage applications due to the rise in interest rates over the past few months. The cost to build homes has risen because commodities have become scarce. But, as we said earlier, did lumber prices rise because the sun stopped shining and trees stopped growing? No, lumber prices have risen because mills closed, because of new tariffs, and because of transportation issues due to pandemic rules. This will correct once the economy completely reopens. Some of the other commodities, like copper, have also risen in price because China was stockpiling. But, now China’s economy isn’t growing as it was pre-pandemic, and, in fact, their stock market peaked last September. So, we may be seeing a topping process in the commodity markets.
Equities are the other important asset in today’s world. Here are some facts:
- Today’s earnings forecasts for Q4/2021 S&P 500 earnings is $48.20.
- In December, 2019, the earnings forecast for the same quarter (Q4/2021) was $52.20. Thus, today’s earnings forecast is 7.7% lower.
- On the last trading day of 2019, the S&P 500 was 3230.78. On Friday, April 30, it was 29.4% higher (4181.17).
To say valuations are sky high is an understatement. One popular valuation metric is the Shiller Cyclically Adjusted PE ratio (known as the CAPE ratio). It is currently at 36.5X, higher than it would have been in 1929 if it were around then. This is the second highest valuation ever for this metric (only higher in dot.com). It is currently 2.5 standard deviations above its mean. For those who believe in mean reversion…
There are many market historians who are now saying that in periods after record valuations, forward (historical) returns on equities tend to be low. Capital Markets economist John Higgins, in his April 25 note on Asset Allocation, concluded “that the upside for the S&P 500 over the next few years will be limited.”
More on Inflation
Prior to the pandemic, the Fed tried, and failed, to “normalize” interest rates. Some still consider “normal” interest rates to be what we had in the 90s or 00s. But, clearly, those rates can’t occur in today’s economic world. A 2.5% Fed Funds rate caused distress in the overnight bank lending markets. Despite years of easy money, the Fed couldn’t get the “inflation” rate (as they define it) to 2%. The developed world has aging populations. In the U.S., the last decade was the slowest population growth since the Great Depression. Demographics have a lot to do with long-term economic growth potential. So, if growth was hard to come by, pre-pandemic, what has the pandemic changed to bring it back? Can we really think that a deflationary pandemic shock like the world has experienced for the past year has somehow rekindled “systemic” inflation?
What we’ve had for the past year is a confluence of a short-term boost in demand from helicopter money and, at the same time, supply chain disruptions from the shut-downs and resulting work rules. Think about this: Would real GDP have surged 6.4% Q/Q (annual rate) without the helicopter money drops? Clearly not. Then, why is the financial media so convinced that we have entered a “boom” economy? To us, while the economy is approaching where we were pre-pandemic, the “boom” part looks to be illusory.
Perhaps we have this “illusion” of an “economic boom” because the data have been distorted by base effects (low numbers in the comparable period caused by the pandemic). Here are some facts:
- Q1/2021 real GDP (just released) of $19,088 billion is still nearly -1% lower than the Q4/2019 peak ($19,254 billion). And, don’t be deceived by that 6.4% number. The real Q/Q growth was 1.56%, but BLS always reports as an annualized number. Q4/2020 real GDP was $18,794. Here is the math: (19,088/18,794 = 1.015643; and 1.01565434 = 1.064057, e.g. 6.4%).
- In Q1/2021, real Personal Income (from which households consume) excluding government transfers, stagnated (i.e., did not grow).
So, where does the “boom” mentality come from? Most likely it comes from the “party” that still appears to be in progress on Wall Street (although it looks like the party could be winding down). The punch bowl is still there, and it has been spiked with margin and leverage juices. When the party does end, the rush to sell will be compounded by the leverage, e.g., margin calls.
Progress in the labor market slowed the week of April 24. While the Department of Labor’s Thursday morning weekly release claimed that, at the state level, Initial Unemployment Claims (ICs) fell -9.4K to 575.4K (week of April 24) from 584.8K (week of April 17), that latter number was revised up from 566.5K. For the market, then, the new 575.4K number was really an increase of +8.9K (from 566.5K to 575.4K). No wonder it wasn’t mentioned and only appeared on the back page of the paper. The Pandemic Unemployment Assistance ICs, fell -11.7K to 121.7K, perhaps a little disappointing given that the economy is now almost totally reopened (on May 1, even the Nevada brothels were back in operation)! As seen from the chart, the downtrend of the combined state and PUA ICs has flattened over the past three weeks. Still a long way to go to get to pre-pandemic levels (left side of chart).
Nevertheless, the market expects that April’s Payroll Employment Report, due out on Friday May 7, will show payroll gains of more than a million. The financial markets are likely to react badly if that number misses such expectations.
As we’ve said for several blogs, the big economic issue will continue to be the 16.6 million Continuing Unemployment Claims (CCs)(those receiving benefits for two weeks in a row or more)(week of April 10, the latest data). The pre-pandemic “normal” was just over 2 million! (see left hand side of chart)
Of the 16.6 million CCs, 12.2 million are from the temporary PUA programs. It appears that, until the PUA programs end (right now scheduled for early September unless extended again), there will be this overhang of unemployed at the same time that “Help Wanted” signs remain ubiquitous. When the PUA programs do end, it is likely that most of those “Help Wanted” signs will disappear. After all, JOLTS (Job Openings and Labor Turnover Survey) says there are 7+ million unfilled jobs. Will those 16.6 million fight over those 7+ million jobs? Oh yes, forgot about the 6.8 million labor force drop-outs who just might re-enter the labor force. In this context, it is possible that today’s “wage inflation” will turn to “wage deflation.”
Still More on Inflation
We’ve had an internal debate about whether or not what we are currently seeing in rising prices can be called “inflation.” The prices of some goods/services have risen – take airline fares as an example. Is this really “inflation?” Depends on the time period used. It might be “inflation” (i.e., rising prices) if measured from May 2020 to May 2021, but it might not be if measured from December 2019. And, indeed, some companies may take the opportunity to raise their prices using the pandemic as an excuse, and never lower them once their high input prices (due to transportation issues) recede. But, this “inflation” isn’t the dangerous “systemic” kind like we had in the 1970s because it is “one and done.” In the 1970s, built into any union contracts were COLA (cost of living adjustment) clauses. A rise in prices caused wages to rise which, in turn pushed up prices – a nasty spiral.
Today, COLA clauses are rare. And unions aren’t nearly as strong as they were then. As Fed Chairman Powell insisted again this past week (week ending May 1), the “inflation” we are seeing is “transient.” It is caused by base effects (falling prices a year ago), some pent-up demand, and supply chain issues. All of these are temporary.
The question we asked earlier about the drivers of economic growth is quite relevant in this discussion. Despite offers of higher starting wages to attract applicants, dis-incented by the overgenerous unemployment benefits, when such benefits end, there will be no reason to raise wages as 16+ million people try to land one of the 7+ million jobs available.
Markets believe that as a result of the “boom” and current “inflaation,” interest rates will rise. And, so far, that sentiment has pushed the 10-Year Treasury Note yield from 0.51% last July to 1.63% at the end of April. And, rates may go higher, as market players, with little inflation experience, add an “inflation premium” to the yield curve. But, as indicated, we see this as “temporary,” or “transient” to use FedSpeak.
When underlying economic forces reassert themselves, markets will wake up to forecasts of much slower growth and the “boom” will be off the rose. Since we are financial economists, our next conclusion is that current equity market valuations are unsustainable, and that interest rates a year from now will be lower. We just don’t know the timing or the nature of the triggering event.
Robert Barone, PhD.
May 3, 2021
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)