Whatever Your Views of the Future, Inflation Will Be a Critical Portfolio Risk for Your Clients
When I last shared my views about inflation with Wealth Solutions Report in April’s Noteworthy Notes section, perspectives across the asset management community about whether inflation was a meaningful risk continued to be mixed.
Back then, I made it clear that dismissing inflation risks would be unwise, pointing to the dramatic increase in the US money supply (M2) and how we viewed it as a very likely driver of future inflation.
As a reminder, we saw M2 recently grow at a rate greater than during World War II. We talked about the famed economist Milton Friedman’s view that inflation is driven by “too much money chasing too few goods.”
Since then, we’ve heard a lot of talk about rising prices being “transitory” and largely impacted by COVID-related supply constraints. Most importantly, we have heard that the Federal Reserve has our economy and monetary system under tight control.
What’s Actually Happening?
The first concerning evidence is CPI statistics. While we view M2 as a better long-term indicator of inflation, CPI gives a good sense of short-term moves. As shown by the following chart, during Q2 of this year, prices have risen at an annualized rate of 8.1%.
And while we’ve all seen charts of large increases in the price of oil and some foods, this chart shows CPI without food and energy.
We see the same trend in the price of all commodities. So it is quite clear that, at the moment, prices are rising. Transitory or not, this should catch the attention of any investor.
From Capital to Labor – A Shift in Power Dynamics
Add to the mix, all of the uncertainties about what the future of the workplace will look like for most people.
While some firms have mandated that employees return to the office (James Gorman of Morgan Stanley stated that “If you can go to a restaurant in New York City, you can come into the office”) it is far from clear how “work from home” will play out over time.
Of course, many workers have no choice but to show up at “the office”. But the key issue is price. The following chart, from the Federal Reserve’s JOLT study, quantifies the number of job openings and the number of “hires.”
What do these numbers mean? In the last few years, our belief is that we are seeing a shift from “capital” back to “labor” in terms of leverage.
Indeed, starting in 2015, we have begun to see a slight shortage of employees hired versus actual job openings. And now, after the volatility surrounding the early days of Covid, we are seeing a definite shortage of workers.
Some may be waiting until unemployment benefits have ended, but we’re seeing stories of employers offering bonuses and hourly wages increasing. Even at firms like Goldman Sachs, based on recent news coverage, entry level investment bankers are getting 30% raises. As a colleague of mine has said, wage increases aren’t temporary. Sooner or later, a sustained and significant increase in labor costs will be reflected in the prices businesses and consumers pay.
Follow the Stimulus Money…
Ok, we’ve seen some increases in prices. But doesn’t the Federal Reserve has the situation under tight control? Perhaps, although a few statistics are noteworthy. The first key point is where all this stimulus money has gone.
In the 2008 financial crisis, the bulk of stimulus money was focused on assuring the creditworthiness of the financial system. Much of the funding went to dealing with leverage and defaulted securities. During the pandemic, however, the money went straight to consumers. However, rather than spending it all on paying bills, as the chart above displays, it seems as though much of it ended up in banks.
In a traditional environment, banks maintain a tight relationship between reserves held at the Fed and lending. The FED purchases funds from the banking system as reserves and generally purchases US Treasury securities.
More recently, the Fed has also used these reserves to purchase mortgage-backed securities as well as corporate bonds. It is clearly in the interest of the Federal Reserve to have tight control over both interest rates as well as credit spreads now close to historically tight levels.
Banking on Surplus Reserves?
Now, bear in mind that banks generally use reserves held at the Fed to support lending and there are tight limits as to the relationship between the level of reserves to collateralize loans.
This means that banks, at the moment, hold far more in reserves at the Fed than is necessary. Why? We suspect it’s a function of a relatively flat yield curve limiting loan profitability as well as the essentially riskless nature of Fed reserves. It’s also interesting that inflation is highly beneficial to borrowers as they pay back debt with devalued currency. Perhaps banks view this as a risk for longer-dated loans, but this is speculative on our part.
Another point of interest is the Fed program titled “Overnight Reverse Repurchase Agreements”. This is a complex term describing the Federal Reserve borrowing money from the banking system.
Essentially, the Fed sells Treasuries to banks with the agreement to repurchase them the next day. The Fed recently raised the rate it would pay to 5 basis points which is currently higher than other opportunities. Here is a chart of the amount the Fed is borrowing each evening.
The Bottom Line
The bottom line is this: We are beginning to see prices in the economy rise. This is true across food, energy and other products in the economy. We are also beginning to see what looks like increasing labor costs which, once started, are nearly impossible to reverse.
Perhaps even more importantly, an enormous level of funds have been pumped into the economy by Congress with a strong likelihood of more on the way. At the moment, banks are fine holding reserves at the Fed as well as lending dollars to the Fed overnight.
It’s unclear what might change this situation but there is no shortage of “dry powder” for banks to pull reserves from the Fed and expand lending. And in our fractional reserve banking system, this is the primary mechanism to expand money supply in the broad economy.
Could all of this just be a short-lived phenomenon? Yes.
But our view is that we will see an onset of longer term inflation. To be a successful financial advisor, you should avoid guiding your clients towards “bets” on events that may or may not occur.
Instead, in our view, the appropriate strategy is to own a “hedge” against rising prices. As I’ve stated in my last commentary for Wealth Solutions Report, we believe that CPI is a poor long-term measure of inflation. When you combine this fact with negative real yields in much of the bond market, what kinds of investment strategies make the most sense?
In our view, the best strategy to hedge inflation is to own equities with some very specific characteristics. First, we believe that current profitability as well as value are critical. To the extent we see higher interest rates, higher price/earnings ratios may decline. Companies with low debt and capital requirements are attractive as they also have less interest rate risk. And most importantly, these firms need to benefit from higher prices either from some direct connection to “real assets” or perhaps with unique product pricing power.
Will we definitely see inflation? There are no guarantees in financial markets.
Is inflation an “actionable risk”? I’ve said it before, and I’ll say it again: There is zero doubt that it is.
Andrew Parker is Managing Director of Horizon Kinetics, a global asset manager with $6.6 billion in assets as of March 31, 2021.
