Muggers, Robbers, Hit Men….And Inflation

“Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man.”
Ronald Reagan

Equity markets rallied during the second quarter as economic growth continued to recover from the steep but short recession we suffered in Q2 2020. In tandem, a majority of listed companies enjoyed a robust recovery in both revenues and earnings.  Clearly COVID vaccines have helped stem the pandemic, and we are edging toward business as usual.  We’re hopeful the emergence of the Delta variant will be short lived , though can offer no interesting views on where the world stands in its defense against the virus other than to say we would prefer not to catch it. 

The balance of this brief will be dedicated to a discussion on inflation. We have concerns and share how the consequences of those concerns might weigh on one’s investment expectations.  Interestingly, the business news this morning is replete with articles on unfilled job opportunities.  As reported by the labor department, there are 10.1 million job openings and about 8.5 million people reported as unemployed and looking for work.  Seldom, if ever, does the number of opportunities for employment exceed the total of those seeking work.  We will let you draw your own conclusions relative to this unusual phenomenon.  However, logic requires one to at least conclude that higher wages and salaries are on the horizon.  And the elder economist in this firm will tell you that wage pressure is inflationary.

A long-respected view on bull markets is that they are fueled by walls of worry.  Conditions over the past two years have offered some pretty sizable walls.  High unemployment, alarming levels of debt accumulation (personal, corporate, and government), political polarity, and now inflation are but just a few of the concerns equity markets have managed to discount on their relentless grind higher.  As prices have risen, so to have the ratios which constitute many of the tools we use to measure whether we consider equity prices attractive or not. 

As we have written this year, our view has been that equities were historically expensive, but we weren’t sure enough in this assessment to not own them.  We do own them, but we also maintain some cash positions we expect to deploy if and when prices become more enticing.  Our concerns about pricing have not been limited to equities.  We have questions that can only lead us to equal concern for bonds.

In the 80’s Dire Straits sang about “money for nothing.”  Although “nothing” is an exaggeration, it’s not that big of one at present.  Imagine buying your first home with a 30-year mortgage financed at 3% and deducting the interest on your personal income taxes.  The Treasury can fund 10-year debt today at around 1.3% and corporations (credit worthy and less so) at small spreads to that rate.  Funding debt at these levels has occurred before but never as such a sustained phenomenon.  Perhaps history won’t repeat itself, but we can say with conviction that Hamlet’s quote on debt is now particularly inaccurate.  Without permission we will put our own spin on Shakespeare and state that for today “it’s better to be a borrower than a lender be!”

Towards the end of 2020 we began to write about the stunning out-performance of growth shares compared to value shares.  And as sure as the pendulum swung, the performance gap narrowed in the first half of 2021.  We also discussed the possibility that inflation showed signs of heating and that commodity shares looked inexpensive and so took what proved to be rather prescient steps to strengthen our weightings in value and commodity sensitive equities.

At the risk of being both repetitive and somewhat boring, we continue to urge caution in your investment perspective.  We won’t regurgitate all of our (to this point unfounded) concerns with our government’s propensity to spend money it hasn’t earned and funding it with money it can only pay back with more borrowing – oh yeah and by significantly raising taxes!  

Yet we regress.

Inflation has been prominent in headlines this month. Shoppers exit grocery stores with sticker shock. Commuters exit service stations enraged. Employers reluctantly jack wages while used cars sell for more than they cost new.  And homes are now selling for significantly higher than asking price.  Even more importantly for most reading this – prices are soaring for financial assets, which effectively (and sadly) is widening the gaps in wealth equality.

But worry not say our leaders!  Fed chairman Jerome Powell calls current inflation “transitory” or “transient.”  President Biden calls inflation “temporary.”  Treasury Secretary Janet Yellen says inflation will be “short-term.“ and suggest there is “no way the Fed will screw it up.”  We can’t refute any of these comments.  We can’t prove them either.  However, most interesting are Yellen’s recent comments intimating that Fed Policy might just be the reason inflation is still soaring!

Traditionally the Federal Reserve has tempered inflation with tighter monetary policy.  Government has done so with fiscal restraint.  We would welcome any thoughts on the probability of either being approved today.  But rest assured –  no need to worry!  Our current bout of inflation is only transitory!

Inflation has not been a US issue for over a decade.  Many of those running government and corporations today didn’t’ live through the terrible bout we suffered in the sixties and seventies. From 1960 through 1980 inflation averaged 5.32%.  PER YEAR!  What $1 bought in 1960 took $2.79 in 1980.  Inflation interestingly rose to 5.4% in June of this year.  And though admittedly some of the current reasons for a surge in prices are indeed a function of temporary conditions related to the reopening of the economy, (think of COVID idled semiconductor producers trying to fill orders, or furloughed workers choosing a government check over a wage) pricing pressure for energy and food can’t be so easily explained.

Over the past four decades several macro factors have been responsible for what can only be referred to as a benign period of inflation accompanied by impressive economic growth:
1) Remarkable developments in technology that helped businesses produce a unit of output with less labor.  Wage pressure, a major contributor to inflation, has until recently been benign.
2) Rapid growth in global trade.  US businesses have been forced to compete with foreign businesses to keep prices low. And as importantly, US companies have been able to move production to parts of the world which demanded less in wages or taxes or both.
3) The advent of e-commerce which has made comparative shopping from home or the office effective and convenient. As a consequence, businesses must compete on price.

We can’t predict if the deflationary effect on prices from these trends will continue on pace or not. However the geopolitical and US political climate create some angst that we have witnessed the best of the days from these factors.

As our world population grows and less developed areas develop, we expect these trends to exert more pressure on the supplies of natural resources.  During the short COVID induced recession, many businesses scaled back, temporarily closed or permanently closed.  As the economy reopened and then accelerated, demand for so many items outstripped the economy’s capacity to supply them. As mentioned, leaders are suggesting that price pressures you feel today will abate as the economy recovers to normal.  We shall see.

We can state without caveat that the markets will need to adjust to higher expectations for inflation. Interestingly the bond markets are trading at yields which refute that assertion.  And to be fair, the price of gold has declined as reported inflation has soared.  So we can say with some confidence the markets don’t seem to share our concerns!  But then the markets really don’t appear to reflect anyone’s concerns.  We will stay a bit defensive in case they do!