Image Credit Marco Verch (Flickr)

We Still Haven’t Reached the Inflation Finale

 

Inflations have an inbuilt mechanism that works to burn them out.

Government (including the central bank) can thwart the mechanism if they resort to further monetary injections of sufficient power.

Hence inflations can run for a long time and in virulent form. This occurs where the money issuers see net benefit from making new monetary injections even though likely to be less than for the initial one which took so many people by surprise.

Ultimately at some point the cost-benefit calculus shifts in favor of government not blocking the operation of the burn-out mechanism.

Let’s try to work out which model of burnout the Great Pandemic inflation in the US will follow.

 

About the Author: Brendan Brown is a founding partner of Macro Hedge Advisors (www.macrohedgeadvisors.com) and senior fellow at Hudson Institute. He is an international monetary and financial economist, consultant, and author. He is also a Senior Fellow of the Mises Institute. Brendan is the author of Europe’s Century of Crises under Dollar Hegemony: A Dialogue on the Global Tyranny of Unsound Money with Philippe Simonnot, among other books.

 

Our process of discovery starts with Milton Friedman’s observation about the nature of the “inflation gap.” Paraphrasing this we can say that monetary inflation is where the supply of money is persistently veering ahead of demand for money. Ideally this comparison is for base money (rather than broad money).

This gap between supply and demand is always in the future. Like the mirage on a hot road, when we get to the place where we saw the gap it is no longer there. Prices have adjusted upwards (and maybe other economic variables have shifted) so as to lift the demand for money in nominal terms into line with the initial increase in supply.

Meanwhile, however, the issuer has injected a new supply of money. And so the gap is still out there when we look into the future (along the inflation highway).

We can think of the burn-out mechanism as a rise of prices (and possible swing in other variables) which keeps lifting demand for money (in nominal terms) into line with increased supply. The essence of the burn-out mechanism is the destruction of real wealth in the form of money (and government bonds) by the rise in prices. These wealth losses and the need to replenish money holdings in real terms to some extent bear down on demand in goods and services markets.

 

The laboratory of monetary history provides some insights here.

Take first the extreme case of the German hyperinflation. The government in Berlin, desperate for funds, kept making monetary injections even as the burn-out mechanism functioned. In real terms the revenue gains for government got smaller and smaller as individuals switched out of mark money into dollars instead. Eventually the gains were so tiny from new injections and the social political costs so great that these halted.

Fast-forward to the monetary inflation of World War II. From 1946–48 the Fed made no new monetary injection (monetary base constant) despite prices galloping ahead as driven by the excess of money created during the war. A very mild recession in 1948 and the vast run down in military spending which had occurred meant there was no incentive for the government/Fed to make new injections as consumer prices reached a plateau after their sharp jump. Nominal yields on long Treasury bonds remained close to 2 percent throughout.

It was quite different in the “greatest US peacetime inflation” from the early/mid 1960s to the end of the 1970s. Then the Fed responded multiple times to inflation burnout by new injections; think of 1967–68; 1970–72; 1975–77; and yes, 1980.

Each injection during the Greatest Monetary Inflation had its own distinct cost-benefit analysis. In 67/8 a priority was to hold down the cost of government borrowing in the midst of the Vietnam war; in 70/72 Chair Burns was a top member of the Richard Nixon reelection campaign; later in 75/7 his aim was promoting recovery in the context of challenging elections ahead for the Republicans (1976); in 1980 there was a looming election and recession fright.

Two overriding comments apply to these continued injections through the Greatest Peacetime Inflation.

First, the injectors (the Fed and more broadly the Administration economic team) persistently overestimated the severity of the economic downturn which seemed to be emerging. Given all the revisions in the data since the analyst today would be hard-pressed to use the term severe recession or indeed recession at all in some cases with respect to the episodes of economic weakness in 1970, 1974–75, or 1980s. Yet at the time the injectors saw the current data as justification for interfering with the burn-out mechanism.

Second, a whole Keynesian/neo-Keynesian mythology has developed about how high and rising inflation expectations were the challenge which prevented the monetary authority from allowing a “natural” burnout to take place. It is difficult, however, to substantiate such a claim. In the counterfactual of the Fed resolutely refusing to reinject, expectations would surely have fallen.

Jumping forward to today, Spring 2020, is the Fed at last allowing the burn-out mechanism to work, having consummated its “hawkish turn?”

A key problem in answering this question is how to estimate in a non-anchored monetary system what burnout is occurring. How to measure demand for money in a system which has become so distorted?

Examples of such distortion include bank reserves, a large component of monetary base, paying interest and at a rate above market. Base money has lost much of its special qualities in an environment where banks or individuals are confident of liquidity provision, whether in form of “too big to fail,” “lender of last resort,” or “deposit insurance.”

Without any precision we can say that substantial monetary inflation has emerged during the pandemic with prices of goods and services surely rising by more than what could be explained by supply shortages and dislocations such as would occur under sound money regimes. But by how much?

Whatever the unmeasurable inflation gap has been the near 8 percent rise in consumer prices in the past year has surely helped narrow it the nearer we get to the point in the highway of inflation where we initially saw it.

Chief Powell is now telling us that he has no intention of accommodating inflation. For this top monetary bureaucrat and his colleagues this means projecting a series of rises for the fed funds rate which seems to be impressive both whether measured by frequency or cumulative size. No one, of course, has a clue about how interest rates would be moving in the counterfactual case of just allowing the burnout to take place and no new monetary injections.

So, it is far too early for any sober-rational commentator to announce that the burn-out mechanism is now healthily at work and will accomplish its purpose. And yes, it is possible that the Fed will at some point constrain (by mistake amidst the general fog) the money supply such that this lags behind demand for money, meaning a period of monetary deflation.

It is hard to form a diagnosis of the monetary inflation gap based just on contemporaneous readings of CPI inflation or taking the speculative temperature in asset markets.

Notably the distortions of price signals in asset market as caused by monetary inflation can persist well beyond the closing of the inflation gap—as was the case with both the crash of 1929 and of 2008.

The central scenario of this writer is that the pandemic monetary inflation theatre still has several acts before its finale.

One of these would feature the apparent onset of recession and asset deflation to which the Fed responds ultimately by further inflationary injections of money. And even though there is an inflation curse on all fiat monies, one act entitled flight from the dollar will most likely come into the schedule before this monetary theater season is over.

 

Suggested Reading

How the Cost of Owning a New EV Could Also Climb Quickly

Nancy Pelosi’s Coattail Investors Get an Update

Since 2008, Monetary Policy Has Cost American Savers about $4 Trillion

Lessons from How the Back of Inflation Finally Broke in 1982

 

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Why a Growing or Shrinking Fed Balance Sheet Can Impact Your Investments

 

From an accounting standpoint, a balance sheet is a list of those things owed and those things owned. In a household, one may own what’s in their bank account, their car, and possibly a percentage of the dwelling’s value; those are counted as a person’s assets. What one may have in student loan debt, or mortgage or other debt balances, are liabilities. A list of the two that includes subtraction of one total from the other is the household’s “balance sheet.”

For the Federal Reserve, the list of liabilities includes, money in the economy held by individuals or companies, and cash at commercial banks (that then hold reserves at the Fed). Treasuries and other securities, on the other hand, are counted as the Fed’s assets. 

Federal Reserve Assets

Securities (primarily bonds) held outright account for most of the Fed’s total balance sheet. Nearly two-thirds of these assets are Treasury securities, (Bills, Notes, Bonds). Mortgage-related securities account for almost 25% of the assets on the Feds balance sheet. Through special “lending facilities” during the first year of the coronavirus, the Fed also purchased corporate bonds, municipal bonds, and ETFs that invest in debt.

Federal Reserve Liabilities

The liability side of the balance sheet, used primarily to conduct monetary policy, can be resized as needed. That is to say, the central bank can decide to expand its balance sheet by electronically “printing” money and simultaneously purchasing securities from primary Treasury broker/dealers. This new money used to buy bonds injects money into the economy as the sellers then have money in their hands that didn’t exist before the purchase. This pushes rates downward as there is more of a supply of money to be lent and more demand for bonds. More available money usually pushes asset prices higher.

Similarly, the Fed can shrink its balance sheet by selling its bonds.

Investment Impact

When the Fed either buys bonds (adds money) or sells bonds, including letting them mature (pulls out money) asset prices can be impacted because the availability of funds is reduced and becomes more expensive. The impact may be felt in everything from real estate prices, stocks, bonds, and goods and services.

Explore More:

What
is the PCE Index?

What is
the Yield Curve?

Orchestrating a Soft Economic Landing

 

The Fed’s “easy” monetary policy has been compared to a substance addiction since at least Y2K. Those that have used this analogy compare the 2008 economic problems to an individual that is addicted who crashes. They complain the treatment should not be more of what has caused the addiction in the first place. That is, easier monetary policy, including even stronger “medicine” in the form of quantitative easing.

Following 2008 the markets had the longest rally in history. For pandemic-related reasons the Fed stopped unwinding the previous stimulus in 2020 and instead increased the dosage to include buying a broader array of assets during the pandemic. This week the Fed announced it has more aggressive plans than even before the pandemic to pull the massive amount of stimulants out of the economy.

FOMC Plans

The March FOMC minutes suggest the Fed plans to shrink its balance
sheet sooner than expected and may start selling some of the $3 trillion in mortgage-backed securities it has accumulated since the early days of the pandemic. It plans to reduce the balance sheet by no more than $95 billion a month, phasing this in over the coming months (beginning after the May FOMC meeting). That could add up to more than $1 trillion a year. This would be much more rapid than the last time the Fed tried to shrink its balance sheet and added to it instead.

Can the Fed orchestrate a soft landing while raising overnight rates and reducing its bond holdings?

The minutes showed little discussion of how much a huge reduction will impact the economy. It was not too long ago the Fed was concerned about tapering or reducing how much it added to bond purchases. This new tact is even more extreme. The discussions may not have been had at the meeting or included in the minutes because there is no experience to pull from. It has never been done before. So anything contributed would be an educated guess, economists like empirical data…there is none. In January Chairman Powell openly admitted that it was much clearer how rate increases worked than quantitative tightening.

The educated guess seems to be that letting inflation run rampant is not part of their mandate, so the way forward is to begin and adjust. Attacking the longer end of the yield curve may be like using more leverage than increasing overnight lending rates; quantitative tightening (QT) might cause more pronounced negative reactions in consumer demand.

Will weaning the economy off up to $1 trillion a year be disastrous for investors? The minutes say that the Committee is “prepared to adjust the details of its approach.” This can be read as “IDK.”

 

Paul Hoffman

Managing Editor, Channelchek

 

Fed Governor Lael Brainard (April 5, 2022)

 

They’re early which says they are concerned. Many Fed watchers and market participants thought QT would begin in July, which would have been considerably earlier than the last time the Fed reversed quantitative policies, (2017-19, from 2009). Over the past two years the Federal Reserve has doubled its balance sheet to $9 trillion. The meeting minutes show officials debated how they would begin to reduce the trillions of dollars in bond purchases it agreed to over in the previous two years. The minutes, barring any unforeseen calamities, suggest the beginning will be after the next two day meeting which ends May 4. It was indicated in the minutes that they would have raised the overnight rates 50 bp last meeting if not for uncertainty of the war in Europe. Chairman Powell recently indicated that expectations should be for 50 bp after the May meeting.

The 95 million per month sales should be considered a cap, $60 billion for Treasuries, securities and $35 billion for mortgage bonds. The actual sales may start out much smaller and let the Fed step back and weigh the impact. Either way, the US is on track for less accommodative policy from the Fed.

 

Suggested Reading

What is the Fed’s Balance Sheet?

The Detrimental Impact of Fed Policy on Savers

New Economic Variables Confound Fed’s Future Path

Michael Burry Says Covid19 Cure Worse Than Disease (March 2020)

 

Sources

https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

https://www.federalreserve.gov/monetarypolicy/fomcminutes20220316.htm

https://www.cnbc.com/video/2021/06/29/growth-will-see-a-tailwind-in-the-coming-months-veritas-financial-groups-branch.html

https://www.marketwatch.com/investing/barrons

 

Stay up to date. Follow us:

Orchestrating a Soft Economic Landing

 

The Fed’s “easy” monetary policy has been compared to a substance addiction since at least Y2K. Those that have used this analogy compare the 2008 economic problems to an individual that is addicted who crashes. They complain the treatment should not be more of what has caused the addiction in the first place. That is, easier monetary policy, including even stronger “medicine” in the form of quantitative easing.

Following 2008 the markets had the longest rally in history. For pandemic-related reasons the Fed stopped unwinding the previous stimulus in 2020 and instead increased the dosage to include buying a broader array of assets during the pandemic. This week the Fed announced it has more aggressive plans than even before the pandemic to pull the massive amount of stimulants out of the economy.

FOMC Plans

The March FOMC minutes suggest the Fed plans to shrink its balance
sheet sooner than expected and may start selling some of the $3 trillion in mortgage-backed securities it has accumulated since the early days of the pandemic. It plans to reduce the balance sheet by no more than $95 billion a month, phasing this in over the coming months (beginning after the May FOMC meeting). That could add up to more than $1 trillion a year. This would be much more rapid than the last time the Fed tried to shrink its balance sheet and added to it instead.

Can the Fed orchestrate a soft landing while raising overnight rates and reducing its bond holdings?

The minutes showed little discussion of how much a huge reduction will impact the economy. It was not too long ago the Fed was concerned about tapering or reducing how much it added to bond purchases. This new tact is even more extreme. The discussions may not have been had at the meeting or included in the minutes because there is no experience to pull from. It has never been done before. So anything contributed would be an educated guess, economists like empirical data…there is none. In January Chairman Powell openly admitted that it was much clearer how rate increases worked than quantitative tightening.

The educated guess seems to be that letting inflation run rampant is not part of their mandate, so the way forward is to begin and adjust. Attacking the longer end of the yield curve may be like using more leverage than increasing overnight lending rates; quantitative tightening (QT) might cause more pronounced negative reactions in consumer demand.

Will weaning the economy off up to $1 trillion a year be disastrous for investors? The minutes say that the Committee is “prepared to adjust the details of its approach.” This can be read as “IDK.”

 

Paul Hoffman

Managing Editor, Channelchek

 

Fed Governor Lael Brainard (April 5, 2022)

 

They’re early which says they are concerned. Many Fed watchers and market participants thought QT would begin in July, which would have been considerably earlier than the last time the Fed reversed quantitative policies, (2017-19, from 2009). Over the past two years the Federal Reserve has doubled its balance sheet to $9 trillion. The meeting minutes show officials debated how they would begin to reduce the trillions of dollars in bond purchases it agreed to over in the previous two years. The minutes, barring any unforeseen calamities, suggest the beginning will be after the next two day meeting which ends May 4. It was indicated in the minutes that they would have raised the overnight rates 50 bp last meeting if not for uncertainty of the war in Europe. Chairman Powell recently indicated that expectations should be for 50 bp after the May meeting.

The 95 million per month sales should be considered a cap, $60 billion for Treasuries, securities and $35 billion for mortgage bonds. The actual sales may start out much smaller and let the Fed step back and weigh the impact. Either way, the US is on track for less accommodative policy from the Fed.

 

Suggested Reading

What is the Fed’s Balance Sheet?

The Detrimental Impact of Fed Policy on Savers

New Economic Variables Confound Fed’s Future Path

Michael Burry Says Covid19 Cure Worse Than Disease (March 2020)

 

Sources

https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm

https://www.federalreserve.gov/monetarypolicy/fomcminutes20220316.htm

https://www.cnbc.com/video/2021/06/29/growth-will-see-a-tailwind-in-the-coming-months-veritas-financial-groups-branch.html

https://www.marketwatch.com/investing/barrons

 

Stay up to date. Follow us:

Why a Growing or Shrinking Fed Balance Sheet Can Impact Your Investments

 

From an accounting standpoint, a balance sheet is a list of those things owed and those things owned. In a household, one may own what’s in their bank account, their car, and possibly a percentage of the dwelling’s value; those are counted as a person’s assets. What one may have in student loan debt, or mortgage or other debt balances, are liabilities. A list of the two that includes subtraction of one total from the other is the household’s “balance sheet.”

For the Federal Reserve, the list of liabilities includes, money in the economy held by individuals or companies, and cash at commercial banks (that then hold reserves at the Fed). Treasuries and other securities, on the other hand, are counted as the Fed’s assets. 

Federal Reserve Assets

Securities (primarily bonds) held outright account for most of the Fed’s total balance sheet. Nearly two-thirds of these assets are Treasury securities, (Bills, Notes, Bonds). Mortgage-related securities account for almost 25% of the assets on the Feds balance sheet. Through special “lending facilities” during the first year of the coronavirus, the Fed also purchased corporate bonds, municipal bonds, and ETFs that invest in debt.

Federal Reserve Liabilities

The liability side of the balance sheet, used primarily to conduct monetary policy, can be resized as needed. That is to say, the central bank can decide to expand its balance sheet by electronically “printing” money and simultaneously purchasing securities from primary Treasury broker/dealers. This new money used to buy bonds injects money into the economy as the sellers then have money in their hands that didn’t exist before the purchase. This pushes rates downward as there is more of a supply of money to be lent and more demand for bonds. More available money usually pushes asset prices higher.

Similarly, the Fed can shrink its balance sheet by selling its bonds.

Investment Impact

When the Fed either buys bonds (adds money) or sells bonds, including letting them mature (pulls out money) asset prices can be impacted because the availability of funds is reduced and becomes more expensive. The impact may be felt in everything from real estate prices, stocks, bonds, and goods and services.

Explore More:

What
is the PCE Index?

What is
the Yield Curve?

Image Credit: Monstera (Pexels)

Tilt Confidently – A Perspective on Financial Markets and the Economy

 

Tilt Confidently

Economic excesses often create potential investment opportunities. When a key economic factor reaches a ridiculous level, it frequently proves profitable to expect a reversal: Recall the 10-year bond yield at 0.5% in mid-2020 (those who tilted investment bets toward rising-yield beneficiaries have since profited)—or the early-1981 extreme of 16%? Another example was 1995, when the U.S. dollar spiked to levels never seen before—nor since. In the 1990s, the labor participation rate peaked near 68% after having never risen above 60% prior to 1970. And, in the mid-1990s, following a decline of nearly 20% from its 1973 post-war high, the real-wage rate finally bottomed.

Although short-term timing on any economic trend is always a challenge, when something gets severely out of bounds, the favored odds are that it is apt to soon adjust. Today, there are several matters that could be considered remarkably out of the norm, including economic policies, inflation, various commodity prices, and geopolitical turmoil. However, in our view, the greatest economic extreme, at this time, is “confidence.”

 

Extreme Main-Street Pessimism?

Chart 1 shows a measure of U.S. consumer confidence from the 1950s to date. At present, confidence is lower than 98.5% of the time since 1952! Obviously, pessimism is at an extreme—there have been only a handful of readings as low as today. But what makes this extraordinarily uncommon is, for the last two years, confidence has plummeted while stocks have been in a strong bull market driven by a robust economic recovery. Yes, inflation is currently very high, and there is a war in Ukraine. All the same, inflation was even higher, for longer, in the 1970s when the Vietnam War was ongoing, and, yet, outside of recessions, consumer confidence sustained at much higher levels.

Nearly every significant decay in confidence occurred when the U.S. was in a recession. While an imminent recession is always possible, the likelihood that the U.S. is now in a recession—or even headed for one this year—seems rather remote. Outside of recessions, there was only one other time that confidence was as low as it is today: After a solid recovery in confidence at the start of the 2009 expansion, there was a brief confidence breakdown in mid-2011. Then, renewed fears that the expansion would fail is probably why confidence again declined. Those fears, however, proved unfounded; confidence quickly revived and embarked on a multi-year advance until the 2020 pandemic.

Is confidence about the contemporary expansion following a similar path? It bounced from about 70 to 90 during the first year of this recovery, but since last April, it has again collapsed (like in 2011). Despite strong economic growth and the S&P 500 within 5% of its all-time high, Main Street confidence remains depressed due to a combination of Federal Reserve and interest-rate fears, the highest inflation rate in decades, and Putin’s war.

In our view, even if some or all of these fears continue to fester, confidence will not likely fall much further. Indeed, it would truly be “extreme” if it did. Rather, some of the current nightmares facing the recovery will probably turn out better than feared, causing Main Street sentiment to soon lift, as it did after its 2011 break- down.

According to a Bloomberg survey of private-sector economists, the consensus for U.S. real-GDP growth in 2022 is a robust 3.5%. With Main Street characterized by excessive pessimism and solid real growth, in our view, an opportunity exists for investors to exploit the likelihood that confidence is poised to rise.

Portfolio Tilts For “Rising Confidence?”

Confidence as subdued as today’s is reminiscent of being in a recession that is nearing the start of a new economic expansion. Consequently, many of the investment options highlighted here are typically favored in the infancy of a new economic expansion. It is very odd for conviction to be so low when starting the third year of a recovery.

Nonetheless, if confidence does perk up from today’s extraordinarily low level—whether it is the start of a new expansion or the third year of an ongoing recovery—greater enthusiasm will likely run through both the economy and the stock market in a fashion similar to how it has traditionally done in a fresh recovery.

The following charts illustrate six distinct investments whose relative performance corresponds closely with consumer confidence. Investors may want to consider some of these as possible portfolio tilts.

1. Cyclicals Need Some Confidence! Chart 2 overlays the relative return of the S&P 500’s major cyclical sectors with the Consumer Confidence Index. At least since 2002, there has been a close relationship between cyclical stock leadership and Main Street confidence. Indeed, cyclicals led after the March 2020 bear-market bottom until May 2021, when confidence rolled over. Could cyclical stocks be nearing a “mini-replay” of 2020, driven by a renewed spike in consumer confidence?

 

2. Low Quality? With the S&P 500 Index still trying to recover from a recent correction, and yields rising at an aggressive pace, most are advocating to boost the “quality” in portfolios. However, as illustrated in Chart 3, not only is the relative price of low-quality stocks nearly the same today as at the bottom of the 2009 bear market, but a trend of improved confidence could prompt a period of leadership for low-quality stocks.

 

3. High-Beta’s Run To Continue? High-beta stocks have led the stock market throughout most of this bull run (Chart 4) and may continue to be superior investments should Main Street confidence finally improve. Most recently, after confidence peaked last May, high-beta has slightly underperformed but has not suffered as aggressively as other confidence-sensitive investments. Nevertheless, since at least 1990, it has paid to be overweight high-beta stocks during periods of improving confidence.

 

4. An IPO Leadership Replay? IPOs and SPACs had a massive run earlier in this bull market, followed by an epic collapse (Chart 5). The pattern is similar to the surge and plunge of Main Street confidence. While far from a perfect relationship, since at least 2009, when confidence improved, IPOs directionally outpaced. Likewise, periods of rising pessimism on Main Street have been associated with underperforming IPOs. Many perceive the IPO run as a speculative frenzy that has now been left for dead. Is it possible, though, if confidence again turns up, IPOs could have another “curtain call” in the balance of this bull market?

 

5. Smaller Cap For A Confidence Run! Not surprisingly, as illustrated by Chart 6, smaller-cap stocks do best when consumer confidence rises. The blue line represents the price return of micro-cap stocks relative to mega-caps. The notable periods when consumer confidence surged (2009, 2011, and 2020) were all associated with solid leadership by microcap stocks. As confidence collapsed over the last year, versus the largest stocks, micro caps have relinquished about two-thirds of their cumulative outperformance since this bull market began in March 2020. If consumer confidence is poised for another revival, it may be time to tilt away from your mega-cap winners toward smaller stocks!

 

6. Tilting Toward EM Debt? It is not obvious why EM debt tends to outpace when U.S. consumers are confident. As shown in Chart 7, since 2008, EM debt has significantly rewarded investors whenever Main Street sentiment was improving. Currently, the price of EM debt relative to Treasuries is nearly as low as it was at the stock-market bottoms of 2009 and 2020. It is not a coincidence these were periods when consumer confidence had also declined substantially. This chart is a good reminder that if Main Street confidence does soon improve, investors may need to adjust exposure to bonds as well as stocks.

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Final Comments

 

Consumer confidence is now as low—or lower— than it has been in any recession in the post-war era. Considering that economic growth looks healthy and the stock market is near record highs, today’s excessive level of Main Street pessimism is odd.

Understandably, many investments that typically do poorly as pessimism rises have been severe underperformers in the last year. Even if a recession is imminent, neither consumer confidence nor sentiment-sensitive investments are likely to do much worse because both are already priced for a recession. But should today’s economic fears prove overblown, Main Street confidence is likely headed for a substantial recovery that should boost the relative results of a number of investments, including cyclicals, low-quality, high-beta, IPOs, small caps, and EM debt.

If you, too, believe there is simply too much pessimism today, get your shopping list ready and “Tilt Confidently.”

---

The above was reprinted with permission from Paulsen’s Perspective an institutional newsletter published by THE LEUTHOLD GROUP.

Authored by James W Paulsen, Ph.D.  Chief Investment Strategist of The Leuthold Group, LLC. Jim is a member of the investment committee, authors market and economic commentary, and works with the Leuthold investment team in serving institutional, financial advisor, and investment professional clients.

The Leuthold Group has been producing original analysis for the institutional marketplace for nearly half a century. Driven by the research, its investment management arm is centered on tactical asset allocation and disciplined quantitative methodologies.

 

 

Stay up to date. Follow us:

Image Credit: Monstera (Pexels)

Tilt Confidently – A Perspective on Financial Markets and the Economy

 

Tilt Confidently

Economic excesses often create potential investment opportunities. When a key economic factor reaches a ridiculous level, it frequently proves profitable to expect a reversal: Recall the 10-year bond yield at 0.5% in mid-2020 (those who tilted investment bets toward rising-yield beneficiaries have since profited)—or the early-1981 extreme of 16%? Another example was 1995, when the U.S. dollar spiked to levels never seen before—nor since. In the 1990s, the labor participation rate peaked near 68% after having never risen above 60% prior to 1970. And, in the mid-1990s, following a decline of nearly 20% from its 1973 post-war high, the real-wage rate finally bottomed.

Although short-term timing on any economic trend is always a challenge, when something gets severely out of bounds, the favored odds are that it is apt to soon adjust. Today, there are several matters that could be considered remarkably out of the norm, including economic policies, inflation, various commodity prices, and geopolitical turmoil. However, in our view, the greatest economic extreme, at this time, is “confidence.”

 

Extreme Main-Street Pessimism?

Chart 1 shows a measure of U.S. consumer confidence from the 1950s to date. At present, confidence is lower than 98.5% of the time since 1952! Obviously, pessimism is at an extreme—there have been only a handful of readings as low as today. But what makes this extraordinarily uncommon is, for the last two years, confidence has plummeted while stocks have been in a strong bull market driven by a robust economic recovery. Yes, inflation is currently very high, and there is a war in Ukraine. All the same, inflation was even higher, for longer, in the 1970s when the Vietnam War was ongoing, and, yet, outside of recessions, consumer confidence sustained at much higher levels.

Nearly every significant decay in confidence occurred when the U.S. was in a recession. While an imminent recession is always possible, the likelihood that the U.S. is now in a recession—or even headed for one this year—seems rather remote. Outside of recessions, there was only one other time that confidence was as low as it is today: After a solid recovery in confidence at the start of the 2009 expansion, there was a brief confidence breakdown in mid-2011. Then, renewed fears that the expansion would fail is probably why confidence again declined. Those fears, however, proved unfounded; confidence quickly revived and embarked on a multi-year advance until the 2020 pandemic.

Is confidence about the contemporary expansion following a similar path? It bounced from about 70 to 90 during the first year of this recovery, but since last April, it has again collapsed (like in 2011). Despite strong economic growth and the S&P 500 within 5% of its all-time high, Main Street confidence remains depressed due to a combination of Federal Reserve and interest-rate fears, the highest inflation rate in decades, and Putin’s war.

In our view, even if some or all of these fears continue to fester, confidence will not likely fall much further. Indeed, it would truly be “extreme” if it did. Rather, some of the current nightmares facing the recovery will probably turn out better than feared, causing Main Street sentiment to soon lift, as it did after its 2011 break- down.

According to a Bloomberg survey of private-sector economists, the consensus for U.S. real-GDP growth in 2022 is a robust 3.5%. With Main Street characterized by excessive pessimism and solid real growth, in our view, an opportunity exists for investors to exploit the likelihood that confidence is poised to rise.

Portfolio Tilts For “Rising Confidence?”

Confidence as subdued as today’s is reminiscent of being in a recession that is nearing the start of a new economic expansion. Consequently, many of the investment options highlighted here are typically favored in the infancy of a new economic expansion. It is very odd for conviction to be so low when starting the third year of a recovery.

Nonetheless, if confidence does perk up from today’s extraordinarily low level—whether it is the start of a new expansion or the third year of an ongoing recovery—greater enthusiasm will likely run through both the economy and the stock market in a fashion similar to how it has traditionally done in a fresh recovery.

The following charts illustrate six distinct investments whose relative performance corresponds closely with consumer confidence. Investors may want to consider some of these as possible portfolio tilts.

1. Cyclicals Need Some Confidence! Chart 2 overlays the relative return of the S&P 500’s major cyclical sectors with the Consumer Confidence Index. At least since 2002, there has been a close relationship between cyclical stock leadership and Main Street confidence. Indeed, cyclicals led after the March 2020 bear-market bottom until May 2021, when confidence rolled over. Could cyclical stocks be nearing a “mini-replay” of 2020, driven by a renewed spike in consumer confidence?

 

2. Low Quality? With the S&P 500 Index still trying to recover from a recent correction, and yields rising at an aggressive pace, most are advocating to boost the “quality” in portfolios. However, as illustrated in Chart 3, not only is the relative price of low-quality stocks nearly the same today as at the bottom of the 2009 bear market, but a trend of improved confidence could prompt a period of leadership for low-quality stocks.

 

3. High-Beta’s Run To Continue? High-beta stocks have led the stock market throughout most of this bull run (Chart 4) and may continue to be superior investments should Main Street confidence finally improve. Most recently, after confidence peaked last May, high-beta has slightly underperformed but has not suffered as aggressively as other confidence-sensitive investments. Nevertheless, since at least 1990, it has paid to be overweight high-beta stocks during periods of improving confidence.

 

4. An IPO Leadership Replay? IPOs and SPACs had a massive run earlier in this bull market, followed by an epic collapse (Chart 5). The pattern is similar to the surge and plunge of Main Street confidence. While far from a perfect relationship, since at least 2009, when confidence improved, IPOs directionally outpaced. Likewise, periods of rising pessimism on Main Street have been associated with underperforming IPOs. Many perceive the IPO run as a speculative frenzy that has now been left for dead. Is it possible, though, if confidence again turns up, IPOs could have another “curtain call” in the balance of this bull market?

 

5. Smaller Cap For A Confidence Run! Not surprisingly, as illustrated by Chart 6, smaller-cap stocks do best when consumer confidence rises. The blue line represents the price return of micro-cap stocks relative to mega-caps. The notable periods when consumer confidence surged (2009, 2011, and 2020) were all associated with solid leadership by microcap stocks. As confidence collapsed over the last year, versus the largest stocks, micro caps have relinquished about two-thirds of their cumulative outperformance since this bull market began in March 2020. If consumer confidence is poised for another revival, it may be time to tilt away from your mega-cap winners toward smaller stocks!

 

6. Tilting Toward EM Debt? It is not obvious why EM debt tends to outpace when U.S. consumers are confident. As shown in Chart 7, since 2008, EM debt has significantly rewarded investors whenever Main Street sentiment was improving. Currently, the price of EM debt relative to Treasuries is nearly as low as it was at the stock-market bottoms of 2009 and 2020. It is not a coincidence these were periods when consumer confidence had also declined substantially. This chart is a good reminder that if Main Street confidence does soon improve, investors may need to adjust exposure to bonds as well as stocks.

---

Final Comments

 

Consumer confidence is now as low—or lower— than it has been in any recession in the post-war era. Considering that economic growth looks healthy and the stock market is near record highs, today’s excessive level of Main Street pessimism is odd.

Understandably, many investments that typically do poorly as pessimism rises have been severe underperformers in the last year. Even if a recession is imminent, neither consumer confidence nor sentiment-sensitive investments are likely to do much worse because both are already priced for a recession. But should today’s economic fears prove overblown, Main Street confidence is likely headed for a substantial recovery that should boost the relative results of a number of investments, including cyclicals, low-quality, high-beta, IPOs, small caps, and EM debt.

If you, too, believe there is simply too much pessimism today, get your shopping list ready and “Tilt Confidently.”

---

The above was reprinted with permission from Paulsen’s Perspective an institutional newsletter published by THE LEUTHOLD GROUP.

Authored by James W Paulsen, Ph.D.  Chief Investment Strategist of The Leuthold Group, LLC. Jim is a member of the investment committee, authors market and economic commentary, and works with the Leuthold investment team in serving institutional, financial advisor, and investment professional clients.

The Leuthold Group has been producing original analysis for the institutional marketplace for nearly half a century. Driven by the research, its investment management arm is centered on tactical asset allocation and disciplined quantitative methodologies.

 

 

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A Changing Dollar Value Impacts Investment Returns and US Inflation

 

In his upcoming book, “Bonfire of the Sanities,” author and investment advisor David Wright warns that “actions have consequences” and that the move toward electric vehicles and the progression to eliminate reliance on fossil fuels could weaken the US dollar. In recent weeks his warnings are heightened by reports that China has been in discussions with Saudi Arabia to price barrels of oil in something other than dollars, in this case, the Chinese Yuan. If successful, how would US dollar-denominated investments fare?

Background

When the US took its currency off the gold
standard in the 1970s, it negotiated to tie greenbacks to energy in that most oil around the globe is bought and sold in US dollars. This, in effect, made dollars backed by oil, (petrodollars) and added constant demand for greenbacks which helped its strength relative to other currencies.

When the US imposed sanctions on Russian foreign currency holdings, the power and risks of relying on the US currency did not go unnoticed by other nations. China as reported recently took steps to have oil denominated in its own currency, the Yuan, which would likely add to higher demand for the Yuan while reducing demand for dollars. If China’s Yuan is “upgraded” in the world, it could in effect be seen as a downgrade to the US dollar.  It could also cause a devaluation that translates into more inflationary
pressures and a reduced desire to own US assets, including stocks. Imports, especially from China could cost more.

Further impacting the dollar’s dominance, in recent weeks, Russia and India entered talks to enact a Ruble/Rupee exchange ledger for transactions. Moscow has also said Europe would have to use Rubles to pay for its natural gas and that it may consider Bitcoin as well.  Fewer global transactions are taking place in dollars.

 

Potential Impact

Baizhu Chen a professor in the Clinical Finance and Business Economics department at the University of Southern California is quoted in Business Insider as saying, “The use of Chinese currency will inevitably expand and play a much bigger role in the world.” Chen explained, “Some countries feel their economies could be held hostage to US policies because the dollar is dominant, and countries want to diversify their risk.” So, while reduced demand for oil could play a role in valuation, current policies that use dollar-denominated finances have caused eyes to open to the risks of not diversifying currency use in financial dealings.

The Yuan has been gaining popularity. Approximately 70 central banks hold some yuan as a reserve currency, while many African and Middle Eastern nations have adopted it for transactions. Central banks, according to the International Monetary Fund (IMF), have been diversifying their holdings, and reducing the dollar’s share of global reserves.

“Were the dollar to lose its status as the world’s reserve currency, it would raise interest rates for our historically large debt relative to the economy,” warned Tomas Philipson, former Acting Chairman for the White House Council of Economic Advisers. This of course causes concern as it would mean US consumers and businesses would face higher borrowing costs along with higher import prices.  

 

Current Status

For now, greenbacks comprise 60% of global reserves versus the yuan’s 2.5%. In global payments, the dollar accounts for 40% while the yuan has about 3%, even though China is the second-largest economy, trailing closely behind the US, Philipson said. That could change, but it would take massive reforms.

 

A More Competitive Yuan

China would have to open up its market and relax controls, according to Baizhu Chen. He noted that historically, no currency that has had heavy-handed control has become one of the dominant global reserve currencies.  China would also need to refrain from currency manipulation. This takes place now in the form of devaluing the yuan to boost exports, according to Chen. This could be facilitated by allowing for an independent central bank with transparent decision-making.

In addition, the yuan must become as stable, reliable, and trustworthy as the dollar. “Countries generally trust that the US isn’t going to screw up. But whether the yuan could be perceived as a store of value — a safe haven during uncertainty or war — that is a much more difficult thing,” Chen said.

The current trend in China has been more control, not less. There have been signs that the government will ease up on its recent tech sector crackdown – the market (Chinese stocks) reacted positively. It’s uncertain whether this will lead toward more easing of control.

Paul Hoffman

Managing Editor, Channelchek

 

Suggested Reading

Add This to the List of Inflation Drivers

Alternative Vehicle Fuel Types

Publicly Traded Chinese Companies Duty to Shareholders

The Case for More US Produced Uranium

 

Sources

https://www.imf.org/en/Publications/WEO/Issues/2022/01/25/world-economic-outlook-update-january-2022

https://www.imf.org/en/publications/weo

https://wrightfinancialgroup.com/resources/newsletter

https://markets.businessinsider.com/news/currencies/dollar-vs-yuan-china-currency-global-reserves-central-banks-russia-2022-3?utm_medium=ingest&utm_source=markets

 

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Soaring Crude Prices Make the Cost of Pretty Much Everything Else Go Up Too – Because We Almost Literally Eat Oil

 

The price of oil has been spiking in recent weeks in response to concerns that the war in Ukraine will significantly reduce supply. But what happens in oil markets never stays in oil markets.

The price of U.S. crude oil jumped to a 13-year high of US$130 of on March 6, 2022. It has come down but has been trading above $110 since March 17. That’s over 60% higher than it was in mid-December, before fears of a Russian invasion began to mount.

Of course, this has pushed up the cost of gasoline, which hit an average of $4.32 per gallon in the U.S. on March 14. But it’s less well understood how rising energy prices leak into the prices consumers pay for toys, electronics, food and almost every other product you could think of.

Energy is becoming one of the main causes of inflation, by which I mean a sustained, generalized increase in the prices of goods and services in an economy. The latest data shows prices are rising at an annualized pace of 7.9%, the highest in 40 years.

 

This article was republished with permission from The Conversation, a news site dedicated to sharing ideas from academic experts. It was written by and represents the research-based opinions of Veronika Dolar, Assistant Professor of Economics, SUNY Old Westbury.

 

In my economics classes, I like to joke to my students that we eat petroleum. Students have a hard time imagining drinking crude oil or gasoline, but in fact it’s both figuratively and almost literally true – and I’m not even referring to how humans ingest about a credit card’s worth of oil-based plastic every week.

Let me explain:

 

 

Planes, Packages and Polyester

Oil prices affect the prices of other goods and services in a few significant ways.

The most obvious is that petroleum powers the vast majority of cars, planes and other vehicles that move stuff around. About 71% of the 6.6 billion barrels of petroleum the U.S. consumed in 2020 was used for various types of fuels, such as gas, diesel and jet fuel.

This pushes up transportation costs and makes shipping everything from refrigerator components to everyday items like toothpaste more expensive. Businesses can choose to absorb the cost – for example, if their market is highly competitive – but usually pass it on to customers.

But oil is also a key ingredient in much of the stuff people buy, both in the packaging and in the products themselves, especially food. That’s where most of the other 29% of the oil Americans use comes in.

Petrochemicals derived from petroleum are used to manufacture clothes, computers and more. For example, the quantity of oil-based polyester in clothing has doubled since 2000. Over half of all fibers produced around the world are now made from petroleum, requiring over 1% of all oil consumed.

In addition, the cosmetic industry is heavily dependent on petroleum since items such as hand cream, shampoo and most makeup are made out of petrochemicals. And like with many products, all those creams and beauty liquids are put in single-use plastic containers made from oil.

Similarly, the vast majority of toys produced today are made out of plastic.

 

Crude In Our Cookies

The food industry is especially sensitive to the price of energy, more so than any other sector because petroleum is such a key component of its supply chain at every step of the way, from planting and harvesting through processing and packaging.

Interestingly, the biggest usage of petroleum in industrial farming is not transportation or fueling machinery but rather the use of fertilizers. Vast amounts of oil and natural gas go into fertilizers and pesticides that are used to produce and protect grains, vegetables and fruits.

That’s one of the reasons it takes 283 gallons of oil to raise one 1,250-pound steer. And it’s why even a loaf of bread requires an unusually high amount of energy.

Oil is also an ingredient in the food we consume. The main food product that comes from petroleum is known as mineral oil. It’s commonly used to make foods last longer because petroleum doesn’t go rancid. Packaged baked goods like cookies and pizza often contain mineral oil as a way of preserving their shelf life.

Petrochemicals are also used to make food dyes, which can be found in cereals and candy.

Paraffin wax, a colorless or white wax made from petroleum, is used in the production of some chocolates and sprayed onto fruits to slow down spoilage and give them a glossy finish. It also helps chocolates stay solid at room temperature.

And plastic is a vital part of food packaging because it is relatively cheap, durable and lightweight, it provides protection and is sanitary.

 

Oil Inflation and the Fed

The importance of oil to the U.S. economy has been a big concern since the oil crisis of 1973, when prices spiked, prompting calls to conserve energy.

Since then, the amount of oil consumed for every dollar of economic output has declined about 40%. In 1973, for example, it took just under one barrel of oil to produce $1,000 worth of economic output. Today, it takes less than half a barrel. That’s the good news.

The bad is that, because the U.S. economy is now 18 times bigger than it was in 1973, it requires a lot more oil to function.

That’s why the surging price of oil is now the main driver of inflation – and why the Federal Reserve is preparing for some big increases in interest rates to fight it.

 

Suggested Reading

Where Investors Should Turn if Spiking Oil Prices Feed Stagflation

Enough US Produced Lithium to Exceed Today’s Demand

The Case for More US Produced Uranium

Is it Too Late to Benefit From Higher Oil?

 

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Image Credit: Image: Frankieleon (Flickr)

A Changing Dollar Value Impacts Investment Returns and US Inflation

 

In his upcoming book, “Bonfire of the Sanities,” author and investment advisor David Wright warns that “actions have consequences” and that the move toward electric vehicles and the progression to eliminate reliance on fossil fuels could weaken the US dollar. In recent weeks his warnings are heightened by reports that China has been in discussions with Saudi Arabia to price barrels of oil in something other than dollars, in this case, the Chinese Yuan. If successful, how would US dollar-denominated investments fare?

Background

When the US took its currency off the gold
standard in the 1970s, it negotiated to tie greenbacks to energy in that most oil around the globe is bought and sold in US dollars. This, in effect, made dollars backed by oil, (petrodollars) and added constant demand for greenbacks which helped its strength relative to other currencies.

When the US imposed sanctions on Russian foreign currency holdings, the power and risks of relying on the US currency did not go unnoticed by other nations. China as reported recently took steps to have oil denominated in its own currency, the Yuan, which would likely add to higher demand for the Yuan while reducing demand for dollars. If China’s Yuan is “upgraded” in the world, it could in effect be seen as a downgrade to the US dollar.  It could also cause a devaluation that translates into more inflationary
pressures and a reduced desire to own US assets, including stocks. Imports, especially from China could cost more.

Further impacting the dollar’s dominance, in recent weeks, Russia and India entered talks to enact a Ruble/Rupee exchange ledger for transactions. Moscow has also said Europe would have to use Rubles to pay for its natural gas and that it may consider Bitcoin as well.  Fewer global transactions are taking place in dollars.

 

Potential Impact

Baizhu Chen a professor in the Clinical Finance and Business Economics department at the University of Southern California is quoted in Business Insider as saying, “The use of Chinese currency will inevitably expand and play a much bigger role in the world.” Chen explained, “Some countries feel their economies could be held hostage to US policies because the dollar is dominant, and countries want to diversify their risk.” So, while reduced demand for oil could play a role in valuation, current policies that use dollar-denominated finances have caused eyes to open to the risks of not diversifying currency use in financial dealings.

The Yuan has been gaining popularity. Approximately 70 central banks hold some yuan as a reserve currency, while many African and Middle Eastern nations have adopted it for transactions. Central banks, according to the International Monetary Fund (IMF), have been diversifying their holdings, and reducing the dollar’s share of global reserves.

“Were the dollar to lose its status as the world’s reserve currency, it would raise interest rates for our historically large debt relative to the economy,” warned Tomas Philipson, former Acting Chairman for the White House Council of Economic Advisers. This of course causes concern as it would mean US consumers and businesses would face higher borrowing costs along with higher import prices.  

 

Current Status

For now, greenbacks comprise 60% of global reserves versus the yuan’s 2.5%. In global payments, the dollar accounts for 40% while the yuan has about 3%, even though China is the second-largest economy, trailing closely behind the US, Philipson said. That could change, but it would take massive reforms.

 

A More Competitive Yuan

China would have to open up its market and relax controls, according to Baizhu Chen. He noted that historically, no currency that has had heavy-handed control has become one of the dominant global reserve currencies.  China would also need to refrain from currency manipulation. This takes place now in the form of devaluing the yuan to boost exports, according to Chen. This could be facilitated by allowing for an independent central bank with transparent decision-making.

In addition, the yuan must become as stable, reliable, and trustworthy as the dollar. “Countries generally trust that the US isn’t going to screw up. But whether the yuan could be perceived as a store of value — a safe haven during uncertainty or war — that is a much more difficult thing,” Chen said.

The current trend in China has been more control, not less. There have been signs that the government will ease up on its recent tech sector crackdown – the market (Chinese stocks) reacted positively. It’s uncertain whether this will lead toward more easing of control.

Paul Hoffman

Managing Editor, Channelchek

 

Suggested Reading

Add This to the List of Inflation Drivers

Alternative Vehicle Fuel Types

Publicly Traded Chinese Companies Duty to Shareholders

The Case for More US Produced Uranium

 

Sources

https://www.imf.org/en/Publications/WEO/Issues/2022/01/25/world-economic-outlook-update-january-2022

https://www.imf.org/en/publications/weo

https://wrightfinancialgroup.com/resources/newsletter

https://markets.businessinsider.com/news/currencies/dollar-vs-yuan-china-currency-global-reserves-central-banks-russia-2022-3?utm_medium=ingest&utm_source=markets

 

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Why the Fed Can’t Stop Prices from Going Up Anytime Soon – But May Have More Luck Over the Long Term

 

The Federal Reserve has begun its most challenging inflation-fighting campaign in four decades. And a lot is at stake for consumers, companies, and the U.S. economy.

On March 16, 2022, the Fed raised its target interest rate by a quarter-point – to a range of 0.25% to 0.5% – the first of many increases the U.S. central bank is expected to make over the coming months. The aim is to tamp down inflation that has been running at a year-over-year pace of 7.9%, the fastest since February 1982.

The challenge for the Fed is to do this without sending the economy into recession. Some economists and observers are already raising the specter of stagflation, which means high inflation coupled with a stagnating economy.

 

This article was republished with permission from   The Conversation, a news site dedicated to sharing ideas from academic experts. It represents the research-based findings and thoughts of Jeffery S. Bredthauer, Associate Professor Of Finance, Banking and Real Estate, University of Nebraska Omaha.

 

As an expert on financial markets, I believe there’s good news and bad when it comes to the Fed’s upcoming battle against inflation. Let’s start with the bad.

Inflation is Worse than You Think

Inflation began accelerating in fall 2021 when a stimulus-fueled demand for goods met a COVID-19-induced drop in supply.

In all, Congress spent US$4.6 trillion trying to counter the economic effects of COVID-19 and the lockdowns. While that may have been necessary to support struggling businesses and people, it unleashed an unprecedented bump in the U.S. money supply.

At the same time, supply chains have been in disarray since early in the pandemic. Lockdowns and layoffs led to closures of factories, warehouses and shipping ports, and shortages of key components like microchips have made it harder to finish a wide range of goods, from cars to fridges. These factors have contributed to a worldwide shortage of goods and services.

Any economist will tell you that when demand exceeds supply, prices will rise too. And to make matters worse, businesses around the world have been struggling to hire more workers, which has further exacerbated supply chain problems. The labor shortage also worsens inflation because workers are able to demand higher wages, which is typically paid for with higher prices on the goods they make and the services they provide.

This clearly caught the Fed off guard, which as recently as November 2021 was calling the rise in inflation “transitory.”

And now Russia’s war in Ukraine is compounding the problems. This is mostly because of the conflict’s impact on the supply of gas and oil, but also because of the sanctions placed on Russia’s economy and the ancillary effects that will ripple throughout the global economy.

The latest inflation data, released on March 10, 2022, is for the month of February and therefore doesn’t account for the impact of Russia’s invasion of Ukraine, which sent U.S. gas prices soaring. The prices of other commodities, such as wheat, also spiked. Russia and Ukraine produce a quarter of the world’s wheat supply.

 

Image: San Francisco, March 2022 (rulenumberone2 – Flickr)

 

Inflation Won’t be Slowing Anytime Soon

And so, the Fed has little choice but to raise interest rates – one of its few tools available to curb inflation.

But now it’s in a very tough situation. After arguably coming late to the inflation-fighting party, the Fed is now tasked with a job that seems to get harder by the day. That’s because the main drivers of today’s inflation – the war in Ukraine, the global shortage of goods and workers – are outside of its control.

So even dramatic rate hikes over the coming months, perhaps increasing rates from about zero now to 1%, will be unlikely to make an appreciable impact on inflation. This will remain true at least until supply chains begin to return to normal, which is still a ways off.

Cars and Condos

There are a few areas of the U.S. economy where the Fed could have more of an impact on inflation – eventually.

For example, demand for goods that are typically purchased with a loan, such as a house or car, is more closely tied to interest rates. The Fed’s policy of ultra-low interest rates is one key factor that has driven inflation in those sectors in recent months. As such, an increase in borrowing costs through higher interest rates should prompt a drop in demand, thus reducing inflation.

But changing consumer behavior can take time, and it’ll require more than a quarter-point increase in rates at the Fed. So consumers should expect prices to continue to climb at an above-normal pace for some time.

Higher interest rates also tend to reduce stock prices, as other investments like bonds may become more attractive to investors. This in turn may lead people invested in stock markets to reduce their spending because they feel less wealthy, which may help reduce overall demand and inflation. The effect is minimal, however, and would take time before you see the impact in prices.

The Good News

That is the bad news. The good news is that the U.S. economy has been roaring at the fastest pace in decades, and unemployment is just about down to its pre-pandemic level, which was the lowest since the 1960s.

That’s why I think it’s unlikely the U.S. will experience stagflation – as it did in the 1970s and early 1980s. A very aggressive increase in interest rates could possibly induce a recession, and lead to stagflation, but by sapping economic activity it could also bring down inflation. At the moment, a recession seems unlikely.

In my view, what the Fed is beginning to do now is less taking a big bite out of inflation and more about signaling its intent to begin the inflation battle for real. So don’t expect overall prices to come down for quite a while.

 

Suggested Reading

New Economic Variables Confound Fed’s Future Path

Money Supply is Like Caffeine for Stocks

The Detrimental Impact of Fed Policy on Savers

The importance of Dependable Energy, Even Nuclear, is Heightened in Recent War

 

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America’s Cost of ‘Defending Freedom’ in Ukraine: Higher Food and Gas Prices and Increased Risk of Recession

 

This article was republished with permission from   The Conversation, a news site dedicated to sharing ideas from academic experts. It represents the research-based findings and thoughts of  William Hauk, Associate Professor of Economics, University of South Carolina.

 

Americans may be tempted to view the war in Ukraine as an unfortunate, but far away, crisis. As an economist, I know the world is too connected for the U.S. to go unaffected.

On Feb. 22, 2022, President Joe Biden warned Americans that a Russian invasion of Ukraine – and U.S. efforts to thwart or punish it – would come with a price tag.

“Defending freedom will have costs, for us as well and here at home,” Biden said. “We need to be honest about that.” His statement came one day before Russian President Vladimir Putin ordered an attack on targets throughout Ukraine, including western parts of the country.

Now that war has broken out, the biggest costs for the U.S. will likely be in higher prices – on top of what is already the fastest pace of inflation in 40 years.

How much worse inflation could get will depend on how far Putin goes, the severity of the sanctions placed on Russia and how long the crisis lasts. Will Putin cut off oil or gas to Europe? Will the invasion thoroughly disrupt Ukraine’s ability to export food and other products to the rest of the world?

We do know that Russia is one of the world’s biggest energy exporters and Ukraine’s nickname is the “breadbasket of Europe.” And beyond that, the crisis has been rattling markets for months, sending the price of oil and other commodities soaring.

These higher prices will ripple through Europe, of course, but many other countries as well, including the U.S. – which will make the Federal Reserve’s job of fighting inflation a lot harder and pose a bigger threat to the economy.

 

Pain at the Pump

The most obvious costs to Americans will be at the gas pump.

Russia produces approximately 12% of the world’s oil and 17% of its natural gas. That makes it the world’s third-biggest producer of oil and second-largest for gas. It’s also the biggest supplier of natural gas to Europe, which gets nearly half of its supply from Russia.

The risk is that Russia might cut off gas or oil supplies to Europe or other countries that issue sanctions or otherwise condemn its actions in Ukraine.

Europe may face the most immediate effects if some of Russia’s energy supplies are removed from the world market – which is why the U.S. has been trying to assure its allies it can supply them with liquid natural gas to make up for any shortfall. But world petroleum markets tend to be highly integrated, so the U.S. won’t be immune.

The crisis has already driven up the price of oil to the highest level since 2014, when Russia annexed Crimea from Ukraine, pushing up average gasoline prices in the U.S. to over US$3.50 a gallon.

The most serious sanction implemented against Russia so far is Germany’s freeze on the Nord Stream 2 pipeline, which would have carried liquid natural gas from Russia to Western Europe while by-passing Ukraine.

A disruption in one regional market will eventually affect the world market. Since the invasion, crude prices have spiked above $100 and are likely to go even higher.

Higher Prices at the Supermarket

While Russia is a major producer of fuels, Ukraine is a big exporter of food.

Ukraine produces 16% of the world’s corn and 12% of its wheat, as well as being a significant exporter of barley and rye.

While many of Ukraine’s exports go to countries in Europe and Asia, agricultural products, much like oil, tend to trade on increasingly integrated global markets. Again, the implication for U.S. consumers is that while Europe might be affected more immediately in terms of shortages, prices will likely rise everywhere.

U.S. grocery prices were up 7.4% in January from a year earlier. Because demand for food is typically not very sensitive to changes in price – people need to eat no matter the expense – an increase in the cost of food production typically gets passed along to consumers.

 

The Bigger Risk to the U.S. Economy

That brings us to the Federal Reserve.

The U.S. central bank is very worried about the pace of inflation in the U.S. and plans to raise interest rates to fight it. What’s happening in Ukraine could complicate its plans. If the crisis in Ukraine adds to the upward pressure on prices, that can feed inflation and it could force the Fed to take more drastic measures.

Some economists believe the U.S. could soon see 10% inflation – up from 7.5% now – in the case of a full-scale invasion, as we’re witnessing now. The U.S. hasn’t seen inflation that high since October 1981.

If the Fed decides it has to act more forcefully to tame inflation, that would not only raise borrowing costs for companies and consumers – affecting everything from business loans to mortgages and student debt – but could put the economy at risk of a recession.

At the same time, the crisis could have a moderating effect on interest rates. During times of crisis and uncertainty, investors often move their money into the safest assets they can find – in a so-called flight to quality. U.S. government bonds and other dollar-denominated assets are often considered the safest around, and increased demand for these assets could result in lower interest rates.

Ukrainians themselves will of course pay the steepest costs of the Russian invasion, in terms of loss of life, economic costs and potentially the loss of their government. But the conflict, though it may seem far away, will have an impact on people everywhere. And the hit to Americans’ pocketbooks may be nearer than you think.

 

Suggested Reading

Traditional Energy Resources Have Been Shrinking (August 2021)

Two Companies that May Benefit from Oil’s March Higher

Russia/Ukraine War and Reliance on Crypto and Blockchain

Bond Market Understanding is Again Critical for Stock Investors

 

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  Image: US Dept. of State (Photo Archive)

Biden’s First State of the Union and Possible Impact on Markets

 

President Joe Biden has never given a State of the Union address. He’s heard countless SOTUs, and on Wednesday, April 28, 2021, the eve of his 100th day in office, he did speak before a joint session of Congress. But, this is the first official SOTU and accounting of the country’s state of affairs since February 4, 2020.

A lot has changed, including the President that is giving the address. Some of the market and sector-moving expectations from his Build Back Better initiatives seem to be facing a great deal of pushback recently, many seem to have taken a backseat to other events at home and abroad. Will tonight’s speech revive the focus and elevate the industries most likely to benefit?

Big Changes

Since the last State of the Union, the fear of deflation has reversed, the current state is the U.S. is experiencing its worst inflation in 40 years, with the risk of prolonged price increases now the focus of economists and market participants. 

Inflation isn’t the only thing that has changed. On February 4, 2020, when the last SOTU was given, the novel coronavirus was so “novel” that it was not yet named. It was later in February The World Health Organization (WHO), named the disease Covid19. A few weeks earlier, the U.S. had seen its first case, but it was not yet impacting life in the States.

Energy

There have been trillions approved to be spent on revamping how the U.S. is fueled. These energy initiatives include increased and eventual total reliance on non-fossil fuel forms of energy. Since early 2021, systems have been organized to help develop what is to be the Build Back Better energy initiatives. These plans contrast sharply with two years ago and are now more in-line with initiatives of other developed nations. Now in the early stages, it has left the U.S. vulnerable to shortages during the transition to cleaner fuels. So vulnerable that last year it became necessary for President Biden to ask OPEC+ to pump more oil to fulfill the needs of the U.S. 

At the 2020 SOTU, the U.S. was considered “energy independent” and was a net exporter of petroleum. Change to new technologies has its hiccups, but the current state of the U.S. is that we consume more oil than we produce and we’re reliant on other nations. If in his address he believably reassures commitment to alternative fuels and needed infrastructure spending, clean energy market sectors that have been beaten up this year may move in the direction of previous highs. If his economic plan is instead redefined to play down a green focus, further weakness in the alternative fuels sector could follow.

Pandemic

While the last address did not cover Covid19, as it was not a named disease at the time, this address will provide an opportunity for the country to hear an official White House position on whether it expects the steps taken related to the pandemic are expected to be short-lived. These expectations may contribute to how the market opens on Wednesday and behaves.

Russia/Ukraine

The invasion of Ukraine by Russia is on everyone’s minds. The President will have to address this as well as the risks China relations may present. If his talk is too hawkish, this may rattle markets that involve energy. If too weak, investors may lose confidence in his leadership.

Inflation

In a fact sheet provided on February 28th from the White House, it appears that inflation will get a lot of focus in the address. The speech is likely to talk about manufacturing and making more things in America. Also, moving goods around the country more efficiently and developing a stronger supply chain appears to have been added to his economic plan for the U.S. There could even be talk of reducing the deficit and how working family expenses can be lowered. Also likely to be spoken about is promoting competition to help lower prices to help consumers and stave off some inflation. These are things most American consumers listening at home want to hear.

For investors, getting a sense that inflation will not be persistent, that supply chains are not permanently gunking up the economy, and that money will continue to flow out of Washington in a way that builds or rebuilds infrastructure and provides growth capital to infant industries would set a more bullish tone. It’s a tall order, and worth hoping for.

Biden is scheduled to speak at 9 p.m. Eastern.

 

Paul Hoffman

Managing Editor, Channelchek

 

Suggested Reading

Cryptocurrencies with the Help of DAOs Provide a Means to Support Ukraine’s Efforts

Pros and Cons of a Company Like Berkshire Hathaway in your Portfolio

Is GDP Growth Transitory and Inflation Persistent?

Why 2022 Investing Will Need to be Different

 

Sources

https://www.whitehouse.gov/briefing-room/statements-releases/2022/02/28/fact-sheet-background-on-president-bidens-remarks-on-the-economy-during-his-first-state-of-the-union-address/

https://www.bls.gov/opub/mlr/2021/beyond-bls/consumer-inflation-during-the-covid-19-pandemic.htm

https://www.wsj.com/articles/some-democrats-push-biden-to-embrace-normalcy-as-covid-19-cases-ease-11644667202

 

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