The Flawed Inflation Narrative; And “V” vs. “U”
The equity markets finally took a breather last week (ended January 15th), with the S&P 500 falling a mere 1.5%; that’s down from its record high a week earlier. Perhaps the really poor economic data played a role, but then again, equity markets like such poor data because it means more stimulus (Biden’s $1.9 trillion plan), and markets know that much of the stimulus always finds its way into the financial system. Nevertheless, for the economy, if the December and January data continue, we could very easily have a negative GDP quarter.
The 10-Year Treasury Note reached as high as 1.15% on January 11th, 12th and 14th. It was 0.93% on January 4th, so quite the up-move. It closed the week down 6 basis points from that 1.15% peak at just under 1.09%. While nuts and bolts economics indicates that deflation is still an issue going forward, inflation fears appear to be the driving force in this recent up move, with such fears ignited by the recent price spikes in commodities.
The Economic Data
It appears that, after nearly a year of business havoc, real structural damage has been done to the labor market. The longer a body is out of work, the lower the likelihood of re-employment. According to the Bureau of Labor Statistics (BLS), as of December, that likelihood for a person out of work for more than 52 weeks and still looking is a lowly 7.3%. And it is only 15.4% for a person unemployed between 15 and 52 weeks.
The number of newly unemployed continues to be a big issue. The week ended January 9th saw Initial Claims (ICs)(i.e., a proxy for new layoffs) spike. The combined state and PUA (Pandemic Unemployment Assistance) programs rose to 1.44 million from 1.08 million the prior week, the highest level since the week of September 19. For the state programs alone, the spike put the ICs at the highest level since the week of August 22! Granted, some of this may be due to the holidays (i.e., the lull followed by the spike), but the pain in the labor market is quite intense. The accompanying chart tells the story. The four weeks shown on the far left are pre-pandemic (pre-shutdown). The spike occurs and then the slow grind down. Looking at the right-hand side of the chart, note a flattening (lack of further progress) beginning in October with a very concerning move higher beginning in December, and now apparently spiking.
The continuing level of new layoffs is due to reimposed business closures/restrictions in some states as the virus surged and morphed into an even more infectious strain. And, while we now have effective vaccines, it appears that the initial rollout has been anything but smooth. (Should have assigned it to the private sector!) Dr. Fauci says herd immunity occurs at 80%. Surveys show that 35%-40% either won’t take a vaccine or want to wait to see if they are safe. This looks like it moves (delays) a return to some semblance of “normal.”
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Because the original CARES Act stimulus occurred back in April/May ($1,200/adult; $500/child), much of its impact had passed by late summer/early fall. As a result, for the last few months there have been negative readings on the consumer side (70% of GDP!). Retail sales fell -0.7% M/M in December (a disappointing retail holiday season). That was the third month in a row of such sales declines. Credit card debt outstanding continues to fall and bank loans outstanding are flat to negative. About the only consumer debt that is still growing is student debt (likely because the public believes that some sort of “forgiveness” will be forthcoming in the Biden Administration).
Pent-Up Demand and Inflation
Meanwhile, the equity markets have ignored the underlying recession as the economy is now reliant on cash subsidies from Uncle Sam, borrowed from future generations. The narrative in the financial markets contains two themes:
- As soon as vaccines are distributed, there will be a large “V”-shaped recovery because there is so much “pent-up” demand;
- The large volume of debt caused by the stimulus borrowings (and more still to come) together with rising commodity prices will cause inflation in the near-term (thus, the rise in the Treasury yield curve).
Pent-Up Demand: We all know that the economic pain is in the services sector; that’s where consumption has been lost. Ask yourself: Will you “make-up” for all those missed restaurant meals? Will you go to the amusement park more often than usual because you didn’t go this past year? Are you going to fly twice as much as you used to because you didn’t fly at all since March?
The lost consumption in services is gone forever; it isn’t going to be “made-up.” While consumers may go back to something close to what they did before, they aren’t going to “make-up” for the missed services. And one can argue that since consumers have invested a lot in the “cooking at home” theme (remodeled the kitchen, purchased new pots/pans, appliances, Tupperware, and cookbooks), they are not likely to eat out as much as they used to. Similar for many other services, i.e., the “new normal” will be different with more savings and self-reliance.
Furthermore, as outlined in a past blog, consumers, aided by more than 100% income replacement from Uncle Sam, altered their consumption towards goods and away from the then closed or restrained services sector. The spending on items like furniture, appliances, home improvement, autos… has been significantly “above normal.” So, in a scenario where there is some return to “normal,” spending on such goods will, at least partially if not totally, offset the return of spending on services. Thus, I can make a solid argument that the “V”-shaped recovery expected sometime in 2021 will turn out to be more of a “u.” That’s contrary to the current narrative now dominating the thinking of equity investors.
Inflation: From the point of view of economic theory, today’s inflation scare is puzzling.
- Commodity prices are rising and, as a result, the narrative says, inflation is imminent. Commodity cycles occur every four or five years and they don’t really cause inflation unless the price spikes are severe (lie the oil crisis of the 1970s). Normally, supply constraints occur causing prices to rise followed by new supply that pushes prices back down. Furthermore, the weight of commodities in the CPI is quite low, especially compared to the weight of services;
- Rents, for example, have a 30% weight in the CPI. They are clearly deflating. Medical care costs, almost always rising, fell -0.1% M/M in December and have now fallen for three months in a row. That three-month fall is the first in the history of the series, going back to the 1950s. Trucking (transportation) costs fell -0.1% M/M in December, are down in four of the last five months, and have fallen -3.5% Y/Y;
- Core CPI in the U.S. rose +0.1% in December. The Cleveland Fed’s five-year inflation expectation model was +1.24% in December. For context, that inflation measure was +1.64% last January (2020) and +1.87% in January 2019.
Where is the inflation fear coming from? I’m told to look at the existing federal deficit, the proposed new Biden package ($1.9 trillion) and the inevitable “infrastructure” package (at least another $1 trillion). With all this debt, rates must rise because supply will overwhelm demand at today’s rates.
To answer: Look at the chart of sovereign 10-year yields. At 1.12% (1/14/21), the rate on 10-Year U.S. Treasuries, the gold standard in the world, is nearly twice that of junk-rated Greece, and near junk-rated Italy and Spain. Look at the negative rates on the stronger European countries: Germany, the Netherlands, and France. Tell me bondholders, worldwide, aren’t flocking to U.S Treasury paper! Rates can’t rise much in this environment. No wonder last week’s Treasury auctions (week of January 10th) were such a success.
The federal government can and will print money and borrow from the future. For equities, in today’s world, it doesn’t matter how bad the job/labor market is because those who are unemployed still have income via seemingly unending stimulus. But that will inevitably end as more and more stimulus becomes less and less effective. The biggest risk is becoming a third world country. Today’s markets don’t yet care about that – that’s for another day/another politician. Every heavily allocated equity investor thinks they are smart enough to ‘get out’ before the bust. Trust me – they aren’t!
The inflation narrative, at least for the short- and intermediate-term, is just that, a narrative, as is the “V”-shaped recovery. Given the “value” in U.S. Treasury yields relative to the rest of the developed world, and, given that the inflation “narrative” will likely disappear as time passes and inflation remains comatose, it is hard to see the Treasury yield curve rising much from current levels, based on the “normal” underlying economic fundamentals.
Then, again, we don’t live in a “normal” world!