Inflation

"Americans are getting stronger, twenty years ago it took two people to carry $50 of groceries.  Today, a five-year-old can do it."  Henny Youngman

The funny thing about inflation is that for normal people, we define it as the increase in price for the stuff we buy.  If the cost of the same basket of groceries goes up overtime, that is inflation.  However, if you have a fancy PhD and call yourself an economist, it is something different.  They will torture the number with a battery of adjustments that will result in cars and phones being "cheaper" despite the price being significantly higher than in the past.  Are you looking to buy a house?  I am sure you have noticed the surge in prices over the past year.  It is even worse if you are trying to build a new home.  The surge in building materials has added $36,000 to the cost of the average home over the past year, an increase of 9.4%.  And yet Economists don't even count houses for inflation because they are not considered a consumer good.  How about gasoline?  The price at the pump has gone up.  Nope! Gas is considered too volatile to include in their inflation measure.  We can look around and find rising costs everywhere, meanwhile economists prefer to bury their head in the sand and say there is no inflation.  The biggest challenge we face at present is preserving the purchasing power of our savings in an environment with zero interest rates.  

I have written several times since the start of the pandemic that it is important to be on the watch for consequences to the government's monetary and fiscal policy.  After the latest round of stimulus, the US Government spent 300% of the estimated economic loss due to the pandemic restrictions.  For comparison, Government spending covered approximately 50% of the estimated economic loss due to the financial crisis.  It should come as no surprise that we have seen the quickest economic recovery in history and consumers have an estimated $2 trillion more in savings than prior to the pandemic.

We are starting to see the side-effects; inflation is popping up everywhere and even in places you wouldn't expect.  Berkshire Hathaway noted a couple weeks ago, at its' annual meeting, that it is seeing significant inflation across its business empire and it is passing along price increases to its customers and seeing very little pushback.  Procter and Gamble, Kimberly Clark and JM Smucker recently announced a round of price increases as well.  One of the most peculiar places I have seen inflation is in the hospitality industry.  Hotels were among the hardest hit industries in the pandemic and still have a long recovery ahead of them.  Yet, despite running at approximately 50% capacity, I have spoken to several hotel companies that increased room rates by several percentage points.  That certainly contradicts the law of supply and demand that I was taught in school.  After a year of being locked down, consumers have plenty of extra money and are ready to spend it. 

Political Considerations and the Case Against Inflation
Regardless of which team in Washington you root for, it is pretty fair to say that politicians are uniformly against inflation while also unanimously in favor of the policies that produce it.  Our leaders in Congress aren't completely delusional; after-all, they have indexed their pension to a cost-of-living index.  Inflation is a government created phenomenon and should be thought of as an invisible regressive tax.  

The Federal Reserve Chairman, Jerome Powell, has repeatedly stated that his goal is to drive a 2% annual rate of inflation and would be comfortable if it exceeded 2% for a period of time.  Why does he want 2%?  A relatively low level of inflation balanced with low interest rates helps manage the affordability of the national debt.  A 2% inflation rate effectively reduces the principal on debt maturing 10 years from now by 20%.  If the Federal Reserve runs the economy too hot with its stimulative measures, voters will feel the pain at the cash register.  

Chairman Powell has repeatedly stated his intent to continue his accommodative policy and views inflationary signals as temporary.  His chief reason is the supply/demand imbalance, which will eventually correct, and lower prices will result.  Inflation has been defined as "too much money chasing too few goods."  With $2 trillion of excess savings how long will that take and what will happen in the interim?  Perhaps my favorite reason cited for inflation being temporary is that we can't afford to have inflation.  With debt-to-GDP increasing to 407%, a surge greater than any single year in history, higher interest rates would crush economic activity.  Historically, past debt surges produced deflation rather than inflation because additional resources were allocated to debt payments, rather than the purchase of goods and services.

*Disinflation = decline in rate inflation rate.  Economist way of saying there is less inflation.

What if Mr. Powell is wrong about inflation?  Have you ever heard a politician admit to negative consequences of their policies in advance?  It is the Fed Chairman's responsibility to take away the punch bowl when the party gets out of control.  Otherwise, runaway inflation and asset bubbles will be the result.  Will he have the courage of Paul Volcker (the hero pictured above) to sit in front of Congress with a cigar and say, "the standard of living for Americans has to decline."  

Interest Rate = Inflation + Expected Return
For the past two thousand years, this equation has been reasonably accurate in tracking interest rates charged in the free market.  Like the stock market, predicting short-term movements in interest rates is extremely difficult, if not impossible because both the inflation rate and expected return are not constant figures.  But let's walk through an example with what we do know.  The interest rate on a US 10-year bond is 1.60% and the Federal Reserve is targeting a 2.0% annual rate of inflation.  So, let's solve for the expected rate of return:  1.60% - 2.0% = -0.40%.  In my time managing money, I have never had a client with a negative rate of return as their base expectation.  That would be a very easy person to please.  In fact, most of the readers of this letter have asked where they can get a safe 3-5% annual return.  So, let's try the equation again and solve for expected inflation: 1.60% - 4.0% = -2.4%.  Is the price of the stuff you buy falling 2% or more per year?  Something seems broken, doesn't it?  Is it the equation, inflation or investor expectations?

The unprecedented money printing and stimulus from the US government has increased inflationary pressure.  Meanwhile the active bond purchasing program by the Federal Reserve has manipulated interest rates lower and caused the distortions in the examples above.  If we try the equation one more time with 2% inflation and 2% expected return, the interest rate on the US 10-year bond would be 4.0%.  If you own a 10-year US treasury and this happens, you just lost 20% of your investment.  

But let's look at inflation from the perspective of a retiree.  If a person goes to Prudential and purchases an annuity that pays 3.0% with a 1.2% annual fee to their financial advisor, they net 1.80%.  The retiree will then have to pay taxes of 20% netting 1.44%.  If we then add in the additional tax of lost purchasing power from 2% inflation, this unfortunate retiree has been saddled with a tax rate of 138% of their income.  If you have heard me say, I would rather stuff a pit-viper down my shirt than put a dime of my money into an annuity, this is why.

Trying to solve the equation above is giving me a brain aneurysm.  It is a very difficult problem and at this point the best I can do is say - "I don't know what will happen."  Inflation, deflation, change in interest rates and/or investor return expectations.  It is multi-variate calculus, and I don't think anyone can confidently claim to solve the problem.  The best I can do is to put us in a position to achieve a reasonable result regardless of the outcome.  

Outlook
"The illiterates of the 21st century will not be those who cannot read and write, but those who cannot learn, unlearn, and relearn."  Alvin Toffler

Last month you may have noticed that I omitted my six rules of investing that are normally at the conclusion of every letter.  I have been going through a period of unlearning and destroying one of my best loved ideas.  Those six rules have served me well over the past decade, but I am not sure they are applicable anymore.  When the old map is wrong, we need a new map, or we will be following roads that have closed. 

I have been steadily reducing exposure to bonds while increasing the mix of stocks and cash.  I view the expected return embedded in equity valuations as much closer to the historical norm than the bond markets.  If the US Government is able to maintain elevated levels of spending and money printing, without any consequences then I would expect more of the same behavior.  After all, voters love a strong economy and free money.  In this scenario, at current levels, bonds would be fairly valued, and stocks would be very, very cheap.  

If there are consequences in the form of inflation rates well above 2-3% and the Federal Reserve is unable to maintain its manipulation of interest rates; then bond prices will need to reset in line with historical norms, resulting in sizeable losses.  It would also be an unfavorable development for the equity market, but again I believe valuations are in closer harmony with the "normal" rate of interest.  In this case, high growth unprofitable tech companies would feel the most pain, while stable cash flow producing businesses would likely outperform.

The risk/reward for owning medium and long-term bonds does not seem favorable at all and therefore I am presently substituting cash and a higher mix of equities to maintain the risk profile of my portfolio.  The off-the-shelf financial advisor continues to adhere to a standard 60/40 stock and bond portfolio because it has worked for over 40 years.  But the conditions that produced those results were from a steady decline in interest rates and that no longer seems possible.  I have no idea what will ultimately happen; however, I am trying to position my portfolio for a reasonable result in either scenario.  Stocks purchased at appropriate prices are probably the best of all the poor alternatives in an inflation era.  Therefore, I continue the hunt for high quality mature businesses that have the ability to pass on inflationary pressures to their customers. 

This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice.  Past performance of any market result is no assurance of future performance.  The information contained herein has been obtained from sources deemed reliable but is not guaranteed.