In October of 2000, and well before our current societal awareness, a couple of people with considerable insight into human nature started a website called Hot or Not. The concept was simple, people would upload photos onto the website and then other site visitors would rank the attractiveness of people as they crossed their screen. Brilliantly taking advantage of our human desire to be attractive, and thus see how others would rank us (and our propensity to want to rank others), site visitors would spend hours clicking through pages and pages of photos.
The 2021 version of Hot or Not has nothing to do with human attractiveness and everything to do with human nature. At least according to some analysts. Some other analysts argue that Hot or Not has nothing to do with human nature, but rather everything to do with human cycles and trends, and the actions of the Federal Reserves and Treasury Departments.
I am, of course, referring to inflation. Let’s start off by making sure we are on the same page. There is little zero question we (being the US economy) has experienced considerable inflation over the past several months. I don’t know of anyone staking a position in this argument that would think otherwise. Annual inflation rates for March, April and May at 2.6%, 4.2% and 5% respectively, leave the economy running at a three-month annualized inflation rate nearly 4% higher than last year. And that includes March when accelerating inflation was only just beginning to show in the numbers.
The important questions of Hot or Not are instead looking to the future:
- The Federal Reserve believes that the current inflation is transitory and will revert back to around 2%. Are they correct?
- How the heck is transitory defined?
- Does the length of time of this inflation transition matter? And if so, how?
- How should I be positioning myself as an investor based on the potential outcomes?
Before we jump into the questions themselves, more color on the topic is warranted.
- The Federal Reserve uses the Consumer Price Index (CPI) to provide a proxy of inflation. However, in truth, the CPI doesn’t measure inflation, it measures price change to a very specific, and narrowly defined, group of goods and services.
- This doesn’t mean that CPI isn’t useful. On an economy-wide basis it is impossible to have a measurement that accurately measures changes to prices that impact everyone’s lives.
- This is because no two people have the same spending habits, both in terms of what is purchased and how many of any particular good or service is purchased. I am regular enough in my consumption of Starbucks iced coffee that my family and many co-workers know my order by heart (grande, half sweet, normal cream). That particular beverage has increased in cost from $2.65 to $3.25 over the course of the past 3 years. That is a significant 7% annual (and therefore compounding) inflation rate. It should be noted that much of that increase had already occurred before the pandemic. However, over that same time period the price of televisions has fallen considerably, especially when hedonic adjustment is taken into account (adjustments for quality and features). One $800 TV falling 10% in price is an $80 savings, offsetting the price increase of 133 iced coffees (which is probably about how many I drink a year). But I don’t buy TVs, ever, so the price decreases don’t benefit me. And even if I did buy a TV, I certainly wouldn’t be buying one every year. But there is someone out there that doesn’t drink iced coffee but loves TVs and buys one (or more) every year. They benefit from falling prices without the offsetting increase in drink cost while I am negatively impacted by the increase in drink cost without the benefit of the reduction in TV cost, all while a CPI measurement that includes both the drink and the TV would show very little inflation.
- Where this gets hairy is how it impacts low (or lower) income houses, including retirees living off savings and SSI. Like me, they aren’t likely to purchase a TV each year, but they are impacted by increasing food costs, closing costs, medical transportation costs, etc. In other words, their inflation is likely running much higher (and likely has run much higher for many years) than the headline inflation number as calculated by CPI. Of further impact, those households are unlikely to have much in the way of appreciating asset portfolios. Higher income households are more likely to have stock portfolios and more likely to own their home, both of which provide a wealth growth buffer against cost inflation. Put another way, inflation hurts those the most that can least afford it.
- The difference between a 1.66% inflation rate (roughly what we have seen since 2008) and a 3% inflation rate (a number the Fed seems comfortable with for a couple years) has a meaningful impact on prices and people’s lives. Since 2008 annual spending of $30,000 has increased to $37,152 (using the CPI as the measure for inflation). If inflation was instead running at 3% since 2008 that same $30,000 would now cost $44,056, almost a FIFTY PERCENT ABSOLUTE increase, and a hefty 18.6% increase versus the lower actual CPI inflation number. Most readers of this Insight spend far more than $30,000, and now $44,000 per year, so you can imagine that the absolute impact of inflation is considerably more than shown in this example.
- As I have shared in previous Insights, I am far more worried about net returns than nominal returns. This is why I am such an advocate for hiring strong tax accountants (we have several we can refer if anyone is looking) and having a proactive investment strategy that takes taxes into consideration. Along these same lines, inflation has to be taken into account when determining the strength of investment returns. A 10% return in a time period of zero inflation is considerably better than a 15% return in a time period of 10% inflation. We are in a highly unusual time period right now where despite pretty dramatic increases in inflation rates investment returns have continued to compress, meaning not only are the prices for goods and services increasing, but so is the pricing for assets. Higher asset prices mean lower investment returns (not including appreciation of course). For only the second time in 40 years the 10-year treasury yield is below the inflation rate. That means bonds are very expensive, to the point where people are paying to buy assets with negative real rates of return.
- We must also remember that during March thru June of last year we saw sudden and rapid deflation due to the national lockdown. High inflation readings are in part caused by an artificially low basis in which it is being measured against.
Those in the camp of rising inflation (a Bank of America report called it hyperinflation) have all kinds of recent evidence to point to in support of their argument. And this camp has some investing titans like Stan Drunkenmiller and Warren Buffett. The economy is absolutely running hot with demand up, and supply constrained across the supply chain, but is it sustainable? Those in the Inflation Hot camp will point to a massive spike in the savings rate (13.7% in 2020 versus 7.6% in 2019) indicating staying power for consumption, a commitment to technology improvements by businesses (increased capital spending), and an incredibly tight job market where employers literally can’t open all or part of their businesses because of inability to staff them (supply reduction = price increase). But the real power behind their arguments are the actions of the Federal Reserve and the US government.
Despite the Hot inflation readings over the past several months the Federal Reserve has kept its foot to the inflation accelerator, keeping interest rates where they have been since March of last year, and continuing to purchase a dazzling quantity of debt. Why are bonds trading with negative yields? Because the Fed continues to push down yields by maintaining false demand in the marketplace through their own actions (price and yields move in the opposite direction).
Fiscally, stimulus packages have been massive, with the most recent package from a couple months ago being the true icing on the cake. Roughly speaking, the output gap is the difference between where GDP was over the past twelve months versus where it could have been. The stimulus packages totaled considerably more than the lost GDP. This means that out of thin air (through selling debt to the willing accomplice – the Fed) the Treasury injected more money into the economy than was lost because of the economic slowdown. Never mind that we, our children, our children’s children, etc. will have to pay for this largesse through increased taxes (or increased inflation rates, but that is a subject for another time). The flooding of the economy with those dollars devalues the dollar, which is inflation in its own right.
As mentioned above, the job market is incredibly tight despite absolute employment in the US still being substantially below its pre-COVID peak. Many companies, especially in retail goods and services, simply cannot find enough employees to run their businesses at full capacity. This provides two tailwinds to inflation. The first is what was mentioned above, reduced supply from businesses operating at less than full capacity creates upward pressure on price. The second is that the limited supply of labor puts upward pressure on wages. Both result in decreased profit margins for the companies themselves. This ripples through the economy as the price of inputs has to increase to offset the higher costs, and thus the price of the final product has to increase further to offset both the purchased (materials) and in house (labor) costs. The consumer now has to pay more for a Starbuck’s iced coffee than they did previously. There are only three outcomes: 1. Fewer goods or products are purchased as consumers retrench to affordability. 2. Most consumers are also employed somewhere, so they demand (and often get) increased compensation to keep up with the rising costs, or 3. There is a decrease in the savings rate, which results in reduced investment, which in turn acts as a brake on economic growth.
The majority of this argument I take from Leslie Hunt (a long -time inflation bear) and Dave Rosenberg (previously a raging bull). Maybe bullet points are easiest:
- Mathematically speaking, inflation requires an increase in the money supply. That occurs only through a combined increase in the M1 money supply (currency in circulation) multiplied by the velocity of money (how many times each dollar is spent each year). While the M1 has exploded as outlined above, the velocity of money continues to plummet. Banks are sitting on record cash balances and financing can still be difficult to obtain for the person and/or business on the street. Until the drop in velocity slows enough to not be counteracting the increase in the M1 there can be no lasting inflation.
- Aging populations are highly correlated with, and Lacey would even argue a causation of, falling velocity. This is because retirees have different spending habits than someone in their prime earning years.
- For one, most retirees are earning less from their investment and retirement income than they made during their prime earning years, necessitating a reduction in spending. Reduced spending is reduced velocity.
- Additionally, retirees generally take dramatically different investing actions than those still in their working years. For instance, most wealth managers would give guidance to retirees to increase their bond holdings and decrease their holdings in stocks and private investment. The largest bond market is government debt. Government debt in the US currently has less than $1 of benefit to the economy for each $1 increase in debt, meaning each dollar invested into government debt by a US citizen takes $1 out of the economy while the resulting impact to the economy has less than $1 of benefit. While not directly part of the definition of velocity, it could be said that such an action has negative velocity. A conservative investment in debt (assumed to be safe) further strips investment from more entrepreneurial ventures that have a great impact on economic growth, including through increased velocity. Money raised by a company’s IPO provides a war chest to the company to further invest in the company – the people and capital investment. More people with jobs (or higher paying jobs) means more money spent on consumption, AND more money invested which in turn creates more jobs or capital spending. Capital spending creates other jobs, and that dollar invested in the IPO is spent over and over and over. The government takes a little of it each time through various methods of taxation until there is nothing left. The faster that process happens the greater the velocity, AND the greater the impact to government coffers.
- 2020 saw the largest decline in GDP since 1946, however, the decline in GDP was less than the record decline in employment. That means the economy became more efficient. Despite the uncertainty around the pandemic, business spending on automation increased 7% this past year. Productivity gains are an inflation killer. As an example, this past weekend we visited my parents and they took us out to dinner at a new sushi restaurant in their area. We ordered via an iPad and the food was delivered via a racecar that went table to table on a track. The wait staff was half of what it would have otherwise needed to be. That is an improvement in productivity. And that is anti-inflationary.
- During the pandemic with us all stuck at home and bored, or with our activities limited to very specific categories (camping versus baseball games, boating versus traveling, etc.), consumption of durable good increased dramatically (up 12% in January ‘21 versus pre-pandemic January ‘20). Durable goods are roughly $2 Trillion of the $20 Trillion US economy while services are only $800 Billion. That increase in durable goods spending was funded by dollars not spent on services. Those in the inflation camp say that the increase in spending on services will be a net additive to economic growth. The issue with this argument is the money to be spent on services has to come from somewhere, and that somewhere is likely a reduction in spending on goods. But even without a rotation from goods to services, the truth is that people can only have so many goods. Most families don’t need two boats, most people don’t need two mountain bikes, etc. In other words, the growth we have seen in spending on durable goods is unsustainable, and in fact it may go further by not maintaining the growth rate. We may see true contraction. A contraction in an area of spending that is two and a half times that of the spending on services will offset an awful lot of spending growth in services as the economy continues to re-open.
- Study after study has shown that once government debt crosses a threshold of around 100% of GDP, that the debt is a drag on growth and inflation. The US federal debt is 110% of GDP; and rising.
And My Ranking Is…
I have been asked my opinion on this topic many, many times. In theory, inflation impacts interest rates and interest rates are a key driver to our business decisions, so we have discussed the inflation topic internally ad nauseum. I can’t yet say that I have conviction on the matter, at least beyond the short term. There is no question we are dealing with short term inflation. But I also can’t argue with the math as presented by Lacey Hunt and others. But I am very aware that the impacts of Hot inflation on our business are much, much greater than Not hot inflation, and I think the inflation argument has merit. Risk free interest rates (as measured by the Ten-Year Treasury) should not be trading below inflation. That is market manipulation. Is that manipulation enough for us to break out of the falling velocity trap? If so, all Not inflation bets are off and I am squarely in the Hot camp.
But it isn’t fair to hint at my ranking without giving it, even if it is without convictions. If I had to bet, I would bet on higher inflation through the summer and into the fall with inflation growth rates falling thereafter. Another stimulus package and/or an agreement on an infrastructure bill (even though much of the bill isn’t infrastructure) will keep us running Hot beyond my projections. The Federal Reserve losing their conviction around the “transitory” nature of this inflation and raising interest rates earlier than planned could cause a steeper fall in the inflation rate.
Looking out over a five-to-ten-year horizon I believe we will see sub 2% inflation rates, or even deflation. Though I believe there to be a very real, and very scary, possibility of stagflation.
How does one take aggressive action without a strong conviction? This question is even more relevant to those in or close to their retirement years than those of us with a longer time horizon who usually don’t yet need the returns from our investments to fund our livelihood.
- Be aware of inflation and its impact on savings or investment returns. Risk/reward calculus changes in periods of higher inflation.
- Take advantage of duration premiums where possible, but only when the premium has some direct correlation to inflation upside. For instance, TIPS or real assets that will benefit from inflation.
- There is a massive interest rate/inflation rate incongruence right now. Take advantage of it.
- Consider sacrificing some short term returns for inflation protection. For example, in negotiating a lease as a landlord it may be worth sacrificing a little bit of initial rent if it is necessary to get a tenant to agree to rent bumps tied to inflation versus fixed amounts. It is more work on a landlord to do it this way, but because of the compounding nature of inflation the impact can be dramatic across the term of a lease.
- Conversely, as a tenant it may be worth agreeing to higher annual bumps or a higher initial lease rate to avoid rent bumps tied to inflation. Maybe inflation turns out to not be a big deal and the total lease cost is higher than it could have otherwise been, but a higher cost that is known to be affordable is likely a better option than the potential of a debilitating unknown future cost.
- Focus on structural supply shortages versus cyclical supply shortages. For instance, with the millennial generation (and Gen Z right behind them) growing into household formation and housing already having serious supply constraints, housing is likely to have positive demand characteristics for years to come. Many types of industrial space is much the same. Conversely, shortages in microchips and lumber are largely tied to the pandemic. More specifically, this is due to a severe reduction in production, but in the case of microchips it is also tied to a spike in spending on stuff (goods) while we were all at home. Both are highly cyclical, and both have substantial amounts of money being spent to ramp up production. This doesn’t mean there isn’t short term supply imbalances, but it is likely those will revert, or even reverse to market saturation in the coming years.
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at firstname.lastname@example.org.