April was one of those months where there was so much going on in the finance and economic world that it is difficult to do a deep dive into anything in particular. Please forgive the relatively shallow depth of this Insight as I touch on several topics worthy of noting from this past month. Of no surprise to anyone, it almost all starts and ends with inflation.
It is commonly reported that inflation is the worst that it has been in forty years. While technically true, accepting that statement at face value is dangerous to our investment decisions. In 1982 (forty years ago) when inflation was last at 8%, the rate was plummeting, having been as high 13% only two years prior, and dropping below 4% by the end of that same year (1982). A collapsing inflationary environment is very different than a skyrocketing inflationary environment. In reality, the current situation is more like 1973, when inflation spiked from less than 3.5% at the end of 1972 to 8.7% by the end of 1973. If we look back, 1982 was the start of one of the greatest stock bull markets in history. 1973 and into 1974 was the worst bear market since the Great Depression. Conversely, housing prices increased dramatically through the 1970s with the US housing index increasing 177% during the decade (and substantially higher in many markets), despite the stock market struggles and general economic malaise. Conversely, home prices in the 1980s, the period after falling inflation, only increased 68%, which is much lower than the 1970’s appreciation rate. 1973 and 1982 were very different times, with very different outcomes.
Maybe this only matters to me, but the last time we were in a similar economic/inflation situation was fifty years ago. There are very few people still active in the investment world (or the Fed) that were making investment (or monetary) decisions the last time we were dealing with what we are dealing with now. Understanding history can be incredibly helpful, but it still can only take us so far. We are largely in uncharted waters.
I have said it before, but it needs to continue to be said. Inflation is worse than is being measured and reported. Partially because of how the Fed currently measures housing inflation. Additionally, if inflation was still measured the same way it was when the western economies last faced a heavy bout of inflation, the measured inflation would be much, much higher. What is not being captured anywhere is the severe decrease in quality being experienced. I can not be the only one to visit a restaurant and be told my first several choices from the menu are unavailable because of supply chain issues. This isn’t an increase in price issue (though that is also present), but rather a decrease in the service provided. Technically I was still able to get what I needed (calories), but I was not able to get what I wanted.
We are experiencing this in spades in our business as well, but in a slightly different manner. Service providers are raising prices, but along with raising prices the quality of the service is often, frankly, horrible. Documentation promised to be delivered in two days is instead delivered in five. Calls and questions go unanswered for far longer than they would have in the past, slowing down our own ability to make progress. One area of extra difficulty in our business has been title and escrow. Out of the dozens of escrows we have been involved with over the past two years (both as principals and as broker of Altus Capital) I can only think of a few escrows that occurred without issue. Smooth escrows used to be a given. Now the opposite is true. Escrow and title officers are completely overwhelmed and overworked leading to delays, and then balls are getting dropped because they are exhausted. This in turn increases our cost of the transaction through additional time requirements on our end. And in some cases, tens (or even hundreds) of thousands of dollars of monetary loss. These title and escrow issues are a microcosm of the larger economy. Organizations simply don’t have enough help. Hiring right now is extremely difficult. Even when there are options to hire more staff, the extreme economic uncertainty creates reticence to take the risk of bringing on more overhead.
While COVID certainly had some impact on availability of labor, the true culprit is simply demographics. Flashback to February 2020 and the number one concern of businesses was the inability to find qualified candidates to fill open positions. Baby Boomers were retiring, the Gen X generation is much smaller and is the first generation with close to full participation of women in the workforce, and millennials were already absorbed into the work force. Two years later Boomer exits has accelerated.
There was another factor that I don’t feel gets enough attention. The previous administrations put measures in place that greatly reduced immigration. This isn’t just the well-publicized efforts around illegal immigration, but also the reductions in legal immigration. Almost by definition, legal immigration was a direct source of job market participants. And often in needed STEM (Science, Technology, Engineering, and Math) openings. The current administration has taken only minimal steps to rectify the situation, but a recent proposal is a great, but small, step in the right direction. However you may feel about it politically, the offer to Russians that have masters or doctorates in STEM disciplines not only drains Russia of much needed skillsets and portions of its middle class, it also is a step in the right direction of increasing needed immigration into the US.
There is no question the war in Ukraine has added fuel to the already burning inflationary fire. While the Fed chooses to exclude these items from their inflation measure (The Federal Reserves excludes food and energy from their inflation measurement due to the volatility in prices of those items, and under the logic that higher food and oil prices show up in the cost of other products anyway, so including them in the inflation measure would result in double counting), not entirely without merit, shortages in those important life/economic inputs has a direct impact on quality of life and the secondary costs that are included in inflation measurements. Restrictions around Russian hydrocarbons and the reduced ability of both Russia and Ukraine to operate normally is severely impacting energy and food prices, with availability a real concern over the next 12 – 16 months (Russia and Ukraine are major suppliers of grains, and Russia and Belarus are large exporters of fertilizer and fertilizer components). I don’t envy Washington in their efforts to determine the appropriate level of US involvement in the war (Biden is the face, but both parties seem to be mostly on the same page), and I certainly wouldn’t want to be the one making the decision. Especially in light of the US not following through on the security assurances agreed upon in the Budapest Memorandum of 1994. You can read about the Budapest Memorandum here and here.
The abandonment of the Ukrainian security assurances is not the only agreement the US has recently broken. The abandonment of the Keystone pipeline (after all contracts were signed) is having a direct impact on energy costs in the US, all while the administration preaches to the oil industry about not pumping enough oil. The breaking of the Keystone agreement was justified on the grounds of environmental reasons, but ironically – as a portion of that oil comes south anyway – it is now coming south via truck and train, both of which have severely higher transport carbon footprints than a pipeline, and additionally have substantially higher probability of an environmentally damaging accident.
The situation is obviously far worse for Europe who doesn’t have the benefit of a meaningful level of energy production (the US was close to fully energy independent as recently as a couple years ago on a net basis). There are already calls for rationing with a high likelihood that forced rationing may be required in the coming months. The current situation is shining a light on the major elephant in the room: conversion to renewal energy. We have previously discussed issues about lack of minerals and equipment needed for renewables to produce the power needed. This exposes a second issue. The western world is simply not yet able to produce the renewable energy needed. Until our leaders recognize the issues, there are going to be shortages and skyrocketing costs.
Unfortunately, those shortages and increased costs, like all the aspects of inflation, have a far more direct (and negative) impact on the lower socioeconomic classes. For one, food and energy make up a far larger portion of their monthly spending. Two, while wage increases are occurring at a higher rate than in many years, the wage increases are not keeping up with inflation, AND the wage increases create what is called a wage spiral, pushing inflation higher and further reducing the purchasing power of the wage earner. Additionally, since the poor and working class almost always have a deficit of items on the asset side of their balance sheet, they don’t see the benefit of the inflationary effect on asset prices that most of us reading this Insight benefit from. This is seen most directly in home ownership. If you own your home and have a fixed rate loan (~90% of home loans) then interest rate increases (because of inflation) don’t impact monthly housing costs. But meanwhile, the inflation is pushing rents higher (up 40% in Austin last year. 40%!!!). Renters are hit with those higher costs at lease renewal. Altus readers are generally among the lucky. It can be hard for us to understand the impact on budgets and the associated angst it is creating. While I have personally experienced the increased living costs, the reduction in selection and service qualities has had a larger impact on my life. That simply isn’t the case for those with less spending power.
The impact isn’t just through the decrease in spending power. Studies have shown that the renewable energy transition is disproportionately benefiting areas of high wealth (and white populations) at the expense of poorer areas, even here in the US. You can read more about it here and here. When looking at the world at large, the current energy policies are resulting in increased pollution in nonwestern countries as dirty fossil fuels are shipped to poorer countries who then burn those fuels in facilities without the same pollution capture capacities as similar facilities in more advanced economies. The populace of those countries ends up with higher energy costs (like all of us) to create worse pollution. And since it is the same hydrocarbons being burned, just burned at a different local and without the same cleanliness considerations, the world as a whole ends up being more negatively impacted than it would be otherwise.
I don’t know anyone who isn’t in favor of transitioning to clean power. Everyone wants clean air, clean water, etc. The question really is how we get there without blowing up our economies and disproportionally punishing those that can least afford it. But that comes down to doing what needs to be done instead of doing what messages a concern, even if that concern is more for reelection than true improvement.
Elon Musk is a bit kooky, but he arguably has done more for electric vehicle acceptance than anyone else in history. His boring company is doing projects that greatly reduce carbon emissions through reduced congestion. Despite his insane wealth he is said to live a fragile life, even shacking up on the couches of friends rather than having his own home. You would think he would be beloved. Instead, people are freaking out that he is buying Twitter. Maybe my memory is bad, but I don’t remember people freaking out to the same level when Jeff Bezos bought the Washington Post in 2013. Twitter is (supposedly) not news. The Washington Post (supposedly) is. It is interesting, and quite entertaining to watch.
Fake news is bad. Bad enough that our country has long had laws in place to protect against it (libel, slander, etc.). And, unfortunately, both sides of the political spectrum have no problem creating their own fake news if it supports their narrative as a means to an end. But the thing about fake news is eventually the truth comes out, IF (and it is a big IF) people are able investigate and report on their investigation. Far worse than fake news is censoring anyone. Those with the power to censure, even if well intentioned, simply can’t know everything that is true (or not). And even well-intentioned folks still have biases. We all have biases. Fake news is dangerous in the moment, but censorship in effort to control or reduce fake news is a slippery slope of cure that is far worse than the cause. I had the privilege of traveling to Africa, Asia, and Europe in March/April and seeing the impacts of censorship first-hand (Look for the bonus edition Altus Insight “Lessons from the Road” that will be sent out in the next week). Not just in today’s reality, though it certainly is present, but throughout thousands of years of empires. Censorship is the first, and crucial, step towards despotism. European history is full of examples (Napoleon, Hitler, and more). Putin and Xi are infamously excelling at it today. But they aren’t the only ones. I fear that our own country is heading that same direction. On one side, the afore mentioned Twitter has shut down the voice of many (though it is hard to argue with their right to do so as a private enterprise). On the other side books are getting pulled from the shelves of libraries because they are deemed objectionable. Which side ends up having greater censorship success is yet to be seen. Those that control the narrative control the people.
When it comes to understanding narratives, there is no one I am aware of that does a better job of identification and analysis than Ben Hunt of Epsilon Theory. I don’t always agree with him, but I can never fault his logic and thought process. He has long deconstructed the actions of the Federal Reserve through the lens of the narratives created, and more often than not, has been shown to be well ahead of the curve in understanding what outcomes will be.
And a discussion of the Federal Reserve brings us back to inflation. Studies have shown that Federal Reserve forecasts are wrong more than pure chance. And yet this miss on inflation is hard to understand even in the context of consistently being inaccurate. Despite having more data and economics PHDs than any organization on the planet, it was only a few months ago that Fed officials were denying that inflation was a concern. A slap in the face from reality resulted in a rapid recalibration to rapid interest rate increases and Fed balance sheet reductions (or at least a slowing in the rate of growth). These actions will almost certainly lead to a recession, and in fact has already resulted in an inverted yield curve.
The inverted yield curve is the most reliable indicator of coming recessions that we have, even showing itself in the months before the pandemic flash recession. However, generally the correlated recession occurs well in the future. Eighteen months on average. If we assume that the yield curve inversion is still a reliable predictor (some don’t because of the Fed intervention), and we want to play the averages, what do we do from an investing perspective? Inflation is creating real losses on cash balances of between 8–12% per year (depending on which calculation of inflation you fancy). The stock market is already falling. Inflation generally lifts valuations of real assets (commodities, real estate, metals, etc.). Private debt, my favorite “safe” investment, is basically breakeven in real terms. And yet, there is (on average) another 18 months until the recession occurs. Are we willing to lose 15% of our investment value by holding cash? Should we use the lessons of the 1970s (as discussed above) and move into the housing market, despite it already being white hot and arguably overvalued? These are not easy decisions to make.
And remember, eighteen months from inversion to recession is the average. It could be substantially more or less than that. In fact, the Q1 GDP growth rate was negative. One quarter does not equate to a recession, but high inflation and a shrinking economy is getting very close to a textbook definition of stagflation. Generally, stagflation is defined as also having high unemployment, which is certainly not currently an issue.
So many factors. So many unknowns. And it will likely mean lots of opportunity for those willing to spend the time looking for them.
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 fjinks@altusequity.com.