Dear Valued Clients,
It was wonderful to see fireworks on the 4th of July, and families getting together again to celebrate. COVID-19 is not fully behind us, with variants like Delta still lurking, and surging in certain parts of the world. Daily life, however, is gradually returning to normal. The markets are somewhat reflective of this, as seen by the CBOE Volatility Index (VIX) being at almost half the levels it was a year ago. The S&P 500 index continues to grind upwards, gaining another 8 percent in the quarter ending June 30. The Federal Reserve remains adamant to maintain an easing stance, although in their last meeting they did signal raising rates slightly earlier – in 2023 instead of 2024.
The accommodative monetary policy, recovering economy, and attempts at further fiscal stimulus through measures such as the infrastructure bill, are naturally bringing to fore concerns about inflation. Admittedly, not all inflation is inherently bad; in fact, a modest amount of inflation is seen as a positive thing for the economy and households. In particular, households or entities that have debt benefit through inflation as their asset prices increase while their debt remains the same. Inflation brought about by gradually rising wages can be helpful as the purchasing power of the population rises faster than the prices of goods, which are ‘sticky’ and adjust with a lag, thus giving the notion of increasing prosperity.
Rapidly rising inflation, or hyperinflation – such as that brought about by an external shock – however, does not allow wages to adjust in time and can cause the purchasing power of any personal savings to deteriorate precipitously. A good example of this was Brazil from 1986 to 1990s, which saw monthly inflation numbers averaging in the low double digits, with some months showing more than a 70% increase! The damage this had on their economy was devastating and long-lasting.
The last time the US saw high inflation was in the 1970s/1980s, when internal policies and external factors, such as the oil price shock, caused a period of stagflation with rising inflation and unemployment. In 1964, when this story began, inflation was 1 percent and unemployment at 5 percent. Ten years later, inflation had spiked to over 12 percent and unemployment above 7 percent. By the summer of 1980, inflation was running near 14.5 percent, and unemployment over 7.5 percent. Fighting inflation was now seen as necessary to achieve the Federal Reserve’s dual mandate of full employment and price stability, even if it caused a temporary disruption to economic activity and, for a time, a higher rate of joblessness.
The Fed, led by Paul Volcker, began raising rates and slowed reserve growth. Lending activity fell, unemployment rose, and the economy entered a recession between January and July of 1980. After a brief recovery in the second half of 1980, the economy entered recession again in July 1981. This time it proved to be more severe and protracted, lasting until November 1982. Unemployment peaked at nearly 11 percent, but inflation continued to move lower and by the recession’s end, year-over-year inflation was back under 5 percent. In time, as the Fed’s commitment to low inflation gained credibility, unemployment retreated and the economy entered a period of sustained growth and stability. The economic lessons of that era transformed macroeconomic theory and the policy stance of the Federal Reserve, lessons that continue to the present.
Many market pundits are viewing the current inflationary pressures as a demand shock exasperated by supply disruptions from COVID. A good example is lumber, where a sudden increase in households looking to build, repair, or remodel their homes due to stay-at-home caused prices to jump to 3-4 times their recent historical levels. Prices have since retreated slightly as demand has moderated and supply has increased. Similar patterns are emerging elsewhere, as the economy reopens and demand is outpacing supply. The bullish narrative is that household and corporate balance sheets are strong, and with businesses able to increase capacity, prices will moderate and help maintain demand, leading to sustained economic growth.
The Federal Reserve is currently backing this viewpoint, positing the inflationary impact as transitionary. This supports their stance of delaying raising interest rates. The treasury market appears to agree, with the 10-year treasury rate now hovering around 1.30 percent, after having peaked close to 1.75 percent back in March. Of course, other factors could be driving the trading in the 10-year rate, including concerns that economic growth might fade once fiscal benefits such as the higher unemployment payments end, or the fact that the rest of the world is still struggling with low rates, driving demand for US Treasuries.
One thing is for certain. The increase in the money supply from the Fed has helped drive asset price inflation. Since the beginning of 2020, the money supply has increased by over 22 percent annually, 4 times higher than the historical average of about 5.4 percent seen since 1990. This has buoyed demand for real assets. We have mentioned previously about equity market valuations hitting levels comparable to the 1990s tech bubble. Over the last 12 months, home values have gone up close to 13 percent, the largest rate of growth since 2005, versus a 25-year average annual increase of 3.5 percent. This seems to be bleeding through to rental prices, which are expected to increase another 7 to 9 percent in the coming year, per the New York Fed and Fannie Mae. Used car prices have risen 36 percent year over year, versus their long-term average growth of 1.2 percent. Since the beginning of 2020, gold is up almost 20 percent despite its recent decline, and we have all heard about the meteoric rise in cryptocurrency values.
If inflation gets out of control, the Fed’s mandate should move it to raise rates to bring inflation lower. Higher rates and reduced money supply could lead to asset price deflation across the board unless economic growth compensates to drive demand – usually a challenge in a rising rate environment. On the other hand, allowing inflation to overshoot for a prolonged period, which the Fed might be willing to do, could lead to a repeat of the 1970s stagflation scenario. The experience over the last decade, however, where we witnessed low rates, low unemployment as well as low inflation gives us room for optimism. In this uncertain environment, we remain committed to not be deterred by near-term volatility and invest for the long-term in quality firms that demonstrate the ability to grow over time.
As always, we welcome an opportunity to speak with you and answer any questions you may have.
Scott Upham, CIMA® CPWA®
Contributions were made to this letter by Amyn Moolji, CIO and COO, Jeffrey Burch, and Taylor Haselgard.
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