As Federal Reserve Chairman Powell spoke to the public at the virtual Jackson Hole conference, I wondered if he might admit that the Fed had wildly underestimated inflation and he now saw the need to taper ‘emergency’ money printing. The market was set to hear that as it was prepositioned to be short the US dollar, long Treasury bonds, and disinterested in gold. While the vast majority in the recent Bank of America Money Manager survey think inflation is transitory, inflation is here and is a fact. Using a 3-month annualized rate (to remove base effects), the Fed’s favorite inflation measure – Core PCE – is up at a near-40 year high, at 6.7%. Instead, Powell, who never saw this level of inflation coming, selectively congratulated the Fed on meeting their never-elucidated inflation objective and pressed on with zero interest rates and $120 Billion of ‘emergency’ money printing, which they may discuss reducing this year. This is becoming an ever more dangerous game for the financial markets and the economy.
Inflation is the most dangerous, cowardly, and surreptitious way to handle our massive debts and unfunded liabilities. It is a poster child for the concept of “politically expedient “. Is this the best way for the keepers of our currency’s value to deal with the runaway never-sunsetting fiscal spending from Congress and a debt laden economy where debt is close to 400% of GDP (as opposed to 150% of GDP in 1965, when the ‘great inflation’ started). As Keynes said, “By a continuous process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens”. And it falls, as it is currently doing, on those least able to handle it: the poor, the elderly, and those without assets. As for the financial markets, Milton Friedman summed it up best: “Inflation is just like alcoholism. The good effects come first”. That’s where we are now in markets. We are on a tear in the stock market believing this beneficial inflation is controlled and accruing positively as far as the eye can see. There is little concern about the burgeoning labor imbalance or potential margin compression from skyrocketing commodity input prices. More on these risks later.
To suggest it is Powell’s ‘game’ is to suggest that he, of course, knows these things but plays the strategy anyway. For those who disagree, let me pose some key questions:
1. At the Jackson Hole speech, Powell used the ‘transitory’ word, yet again, to describe inflation. As calculated by Bianco Research, those transitory portions of the Core PCE inflation sum to about 7% of the index. They include car rental, airline tickets, and hotel prices. They probably have peaked. But why did Powell not mention, or discuss, the 40% of the index that is housing/shelter/rent? Surely, he has read his own Fed surveys showing these trending much higher?
2. Why does the Fed insist on buying more than all the issuance of the TIPs market? TIPs are an arcane market instrument that are key measures of future inflation expectations, as used by the Fed. In fact, since the beginning of this round of money printing (3/20), the Fed has bought over $210 Billion of TIPs while the government issued only $60 Billion. Could this be an effort to temper one of the most important measures of future inflation expectations? We could ask Vice Chair Clarida, an expert on inflation expectations, but he seems to be in witness protection until his term ends in January.
3. Powell’s term as Chair ends in February and he wants to be renominated. Is he following the 1974 advice of the Hues Corporation: “Don’t rock the boat baby, don’t tip the boat over?”
4. Have we ever recently seen a large committee of government ‘experts’ increasingly become political and then ignore, dismiss, and prevaricate about obvious signs that the strategy is seriously flawed until it ultimately ends in disaster? (Hint: Starts with A and ends with N).
How will we know this inflation is getting out of hand? Stage one is happening already. Several members of the Fed are speaking out about inflation and they are worried, including prior dove Rosengren of Boston. Not all are voters this year and none of them are Powell, Clarida, or Williams (NY Fed). Thankfully, four of the questioners become voting members in January. Well before then, I expect that we may see action in the three markets that are macro pressure-relief valves: Treasury bonds, the dollar, and gold. Watch them all because paraphrasing Tolstoy, ‘each is flawed in its own way’. Treasury bonds, which will not stay at 1.3% if inflation is staying over 4%, are in the Fed’s hoovering campaign and they have bought virtually all the Treasury issuance during the last year. Also, US Treasuries compete globally with the yield-free German Bunds and Japanese bonds. The dollar is traded in a world of nearly-as-profligate developed nations and still-Covid-stricken developing countries. And, gold, is fighting an on-again, off-again war with Bitcoin for alternate currency champion. Nevertheless, if the markets sense the Fed is losing to inflation, and does not act with urgency, these markets will all move in their historically predictable ways: Bonds and the dollar down and gold up.
I will end with the current GOAT, the US stock market. I see enormous risks building there, as well. Using 1965, the start of the great inflation, as an analog, consider the following: A composite valuation metric, developed by Ned Davis Research, uses dividends, cash flow, sales, and CPI-adjusted price to earnings to value the S&P500. In 1965, it was 20-25% overvalued and by 1974 it was 50-55% cheap; inflation created a terrible decade for stocks. This metric has the S&P500 at 100-120% overvalued today. Using Warren Buffet’s favorite valuation tool, the S&P500 was valued at 70% of nominal US GDP in 1964 and by Nixon’s resignation, in 1973, that had plummeted to 35%. Today, we trade at 204% of GDP. Same message: we risk managers should be worried.
For now, I leave you with the immortal words of Will Rogers: “Invest in inflation. It’s the only thing going up”.
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