Inflation has been high, based on the Consumer Price Index, or CPI. The Bureau of Labor Statistics reported that the CPI was up 0.6 percent in May 2021 and rose 5 percent over the previous 12 months. Both are big numbers and well above historical trends.
The Federal Reserve has repeatedly said that the high inflation is “transitory.” Others expect high inflation to continue unabated.
I don’t understand why people argue either/or. I suspect some forces will push inflation consistently higher but not to a ruinous level. (I do believe that continuing at a 5 percent rate would be ruinous.)
Let’s consider the 0.6 percent CPI rate in May. That’s a whopper. If you annualize that, you get a 7.2 percent inflation rate! In the 1970s, an easy-money policy led to an average 7.1 percent inflation rate throughout the decade and 20 percent interest rates; this led to severely damaged businesses and household pocketbooks.
As scary as the current inflation rate may be, the transitory argument makes sense to me. Let’s think about what the CPI is. The CPI is a weighted average of a basket of goods and services. And that’s it. So, you can put some of those components into groups.
One transitory group of the CPI components is part of the reopening of the economy — the price of hotels, motels, movie tickets, sports admissions, and airfare. Those jumped higher because now we’re doing things like going to the movies and getting on airplanes. Buying will be strong for months, but the growth rate will subside as we exhaust pent-up demand. The reopening of the economy accounted for 1/6 of the 0.6 percent CPI rate.
A second transitory group of the CPI components is the cost of vehicles. Due to a severe shortage of semiconductors, the supply of vehicles is low, which triggered higher prices. Not only will supply chains get back online over the next few months, but the U.S. Senate has proposed a $250 billion spending bill which includes providing $52 billion to fund semiconductor manufacturing initiatives in the U.S. The supply chain issues accounted for 3/6 of the 0.6 percent CPI rate.
Together, these two transitory groups accounted for 4/6 (two-thirds) of the CPI rate for May 2021.
Now, do I think we’re going to have inflation above the Fed’s target of an average of 2 percent? You bet I do. However, it is cresting. It will subside, but remain resilient. I’m thinking closer to 3 percent than 7 percent, or even 5 percent.
What does that mean for your investment portfolio overall? If you are well-diversified, a 3 percent inflation rate is probably marginally good news. It is important to know that the guardrails are working and that we can scratch this off the list of reasons why the market might crash. Not that inflation can’t make the market spin out and bounce off the guardrail. But the Fed’s guardrails are currently doing their job. To be sure, the Fed will have to work for their money. The Fed will have to walk a fine line between fighting higher prices and spooking businesses away from investing and hiring.
According to Bank of America (BoA) CEO Brian Moynihan, there is fuel to stoke the inflation fire. That fuel is a combination of consumer activity and available cash to chase the low levels of inventory out there. That is what causes inflation — too much money chasing too few goods.
Given that BoA has 66 million customers, metrics regarding what’s going on at the bank help us understand what is happening in the rest of America. I’ll give you some of the information Mr. Moynihan provided in raw form, and then we can discuss the implications.
- Consumer spending year-to-date 2021 (as of June 14) is up 20 percnet compared to 2019 (2019, not 2020).
- Pre-pandemic, some BoA customers held an average of $1-2,000 in their savings and checking accounts. Those same customers now hold 6-7 times that amount.
- Pre-pandemic, some BoA customers held an average of $2-5,000 in their savings and checking accounts. Those same customers now hold about three times that amount.
What does that mean for you? Businesses have shifted from performing damage control to struggling to meet demand. The traction in demand that U.S. businesses have experienced contains fuel for sustainability. I’ve written in the past about how people in higher deciles of the income strata have “excess savings.” Many of those with extra savings kept buying throughout the pandemic.
In contrast, many other people held back from spending because they either didn’t have a job or they were worried about losing the job they had. Now the economy has come roaring back, and employees and potential employees have more than options — they have bargaining power. And, due to a combination of plussed-up unemployment benefits, stimulus checks, and deferred spending, they also have savings.
Here’s something that won’t surprise you — I am often wrong. I think inflation will be higher than the trend, but those 5-7 percent annualized numbers will be transitory. Have you ever heard of Paul Tudor Jones? He disagrees with me.
Paul is a billionaire hedge fund manager. He’s richer than me. He’s smarter than me. He’s prettier than me. He’s funnier than me. And I’m pretty sure my mom likes him more than me. It’s probably not a good idea to expect that I’m more likely to be correct than he is. Paul expects higher, more persistent inflation than I do. Paul says he is prepared to “go all-in on the inflation trades” if the Federal Reserve maintains its accommodative policy.
On Wednesday, June 15, 2021, the Fed wrapped a two-day policy meeting. Thirteen of the 18 members expect to hold off on hiking rates until 2023, and five members expect to hold pat until 2023. (Seven of the 18 members did acknowledge that there is a possibility that the Fed could raise interest rates as early as 2022.) This is despite the Fed seeing their key inflation indicator running to 3.4 percent for 2021, above its previous estimate of 2.4 percent. In other words, the Fed said, yeah, inflation is increasing but we are still holding rates low. The stock market’s knee jerk reaction was to sell off because, apparently, 2023 is too soon. Given that U.S. Gross Domestic Product is currently running above 10 percent I suspect that in either days or weeks the stock market will reassess the Fed as accommodative.
Paul and I disagree on magnitude. But we do agree directionally. I intend to align my portfolios to take advantage of those inflation trades. Paul hasn’t revealed how he’d invest to play that inflation trade. I’m not as tight-lipped, so I’ll share my thoughts on possible inflation trades.
Higher inflation means higher Treasury yields, even if the Fed anchors short-term rates. The trade is to short (i.e. bet against the price of) U.S. Treasuries other than TIPS (Treasury Inflation-Protected Securities). I rarely take short positions, so I’ll just keep selling U.S. Treasuries. The Fed will keep short-term interest rates low. However, longer-dated bond yields will rise as people embrace a higher growth forecast and acknowledge the sustainability of higher inflation. Although it’s been dislocated recently, there is typically a close match between the yield of the 10-year Treasury note and inflation. If inflation becomes sticky at 3 percent, that means the yield of the note doubles from current levels. Central banks, especially accommodative ones like the Federal Reserve, will lag the market. That will result in low short-term rates and rising long-term rates, referred to as a steepening yield curve.
What do investors do when the yield curve steepens? They go long U.S. Financial stocks. A steeper yield curve improves the net margins of banks. And a shift from renting to home-owning in the U.S. will benefit mortgage lenders. Also, recently higher interest rates (and the associated rising inflation expectations) have eroded the attractiveness of companies that benefit from or contribute to global deflation. In other words, higher inflation shifts interest from Growth stocks (Tech, Consumer Discretionary) to Value stocks (Financials, Energy). I’ve been rotating some of my holdings in that direction.
And, of course, there are energy stocks. The price of commodities, in general, and oil, in particular, tend increase during periods of rising inflation. I’ve had essentially a market-weight allocation of energy stocks, which is to say they’re in the ETF index funds I own. It’s on my radar to buy more, but I feel as if it’s gotten ahead of itself — so I wait. I fear that my waiting will be a bad idea, and I won’t get an entry point I am comfortable with. But sometimes, the best way to reduce risk is to miss an opportunity.
The Fed’s continued efforts to depress borrowing rates affect mortgage rates and support more home-buying. At the start of the pandemic, people fled the most prominent cities to the suburbs and more remote areas, like the Berkshires. Last week, I spoke with a local realtor who sold a house in the $900,000s. That’s not unheard of in the Berkshires. However, that was $230,000 over the asking price. Another bidder offered $50,000 to have a conversation — a CONVERSATION — with the person who won the bidding war to see if they could convince the winners to back out. And that was for a house that sold for half as much. (The winners declined, by the way.) Price wars like this result from people being able and willing to move from smaller cities due to a combination of remote working and the desire for small-town life.
There are a couple of other bets to consider, but that I won’t be taking directly. One is to short the U.S. dollar, and the other is to go long on Japanese equity. The Fed has a loose monetary policy (which is part of what’s propping up inflation), keeping the dollar low. Further, the U.S. dollar has depreciated meaningfully in each of the last four inflationary periods since the early 1970s. I’ve gone long foreign currencies relative to the U.S. dollar before (which is essentially shorting the dollar). However, I don’t have a high conviction in this trade because U.S. growth is more robust relative to countries with competing currencies, which could strengthen the dollar.
As far as Japan goes, Japan has struggled with bouts of deflation for decades. I suspect they could benefit from global inflation. However, speaking of struggling, I’ve struggled with finding the economic turning points for Japan for decades. It’s easier for me to assess what’s going on in the U.S. and other foreign nations. Japan may be a great inflation trade, but I feel more comfortable sticking with tactics I’ve been more successful with.
Brian Moynihan’s data supports Paul Tudor Jones’ inflation trade thesis. We’ll see if I am right or wrong on the magnitude, but I think Paul and I will be right on the direction — inflation is going higher. For some people, that means their purchasing power will erode. For savvy investors, it’s an opportunity to build wealth.
This column originally appeared in The Berkshire Edge on June 21, 2021.