Da Bear’s Perspectives
By Ron A. Rhoades, JD, CFP®
Associate Professor of Finance,
Gordon Ford College of Business
Director, Personal Financial
Planning Program, Western Kentucky University
Financial Advisor and Content Specialist,
ARGI Investment Services, LLC
To contact Ron, please email: bear@argi.net.
Will High Rates of
Inflation Return?
As I traveled over the past two
months visiting colleagues and clients across the eastern United States, it was
indeed a pleasure to get out. And I had a greater appreciation for the small
things – the laughter of children, the smiles on the faces of often-overworked
servers, and greetings of hotel desk clerks. My biggest takeaway – it sure was
nice to get out and connect with other people again!
“Da Bear’s Perspective” is a new
publication designed to offer insights into both current topics of interest to
investors, as well as insights into obtaining the most out of life. I hope to
educate and inform through a “deeper dive” into many of the economic and
capital markets issues. And, at times, I hope to share insights that may lead
my readers to lead more fulfilling lives.
In this edition, I focus on a
question often posed as I met with colleagues and clients – fears of high
inflation.
Much of the recent rise in
prices – particularly in used cars and housing – is likely temporary in nature.
In particular, used car prices – a major contributor to the past year’s rate of
inflation – will likely fall over the next two years. Home prices will likely
not increase as much, as more inventory from builders becomes available over
the next few years. This suggests that much of the recent inflation seen – 5.7%
from June 2020 to June 2021 – is “transitory.”
However, the surge in commodity
prices (which prices can swing widely over time), and the substantial increase
in wages, suggest that the rate of inflation may continue. The large increase
in the money supply can also lead to inflation, particularly if the velocity of
money (i.e., the rate of money changing hands in the economy) picks up
if interest rates rise (and banks have more incentive to lend). A wage-price
spiral, last seen in the 1970’s and 1980’s, may serve as a trigger which leads
to higher interest rates.
In Da Bear’s view,
a 25% or greater chance of non-transitory (embedded) inflation exists.
Contents
Executive
Summary. 1
Inflation Basics. 2
How Has the Rate of Inflation Changed
Over Time?. 4
Should We Be Concerned About Inflation?. 5
Is Inflation High Today?. 5
Is the Recent Surge in Inflation
“Transitory” or “Embedded”?. 7
Money Supply, the Velocity of Money,
and Inflation. 8
The Potential for a Wage-Price Spiral 9
On the Many (Other) Factors Affecting
Inflation. 11
Inflation and Your Investment Portfolio. 12
Inflation is typically measured, in the United States, by
the U.S. Bureau of Labor Statistics, through a measure called “Consumer
Price Index for Urban Consumers” (“CPI-U”). CPI-U is a measure of the
average change in prices paid by an urban consumer for a certain “basket” of
goods and services. To determine this statistic, each month shoppers are sent
out across the country to measure prices, and the data is then utilized to
determine the rate of inflation.
As seen in the chart below, housing (the prices of
single-family homes and condominiums, and rents) accounts for over 42% of the
measure of inflation. Medical care only accounts for 8.87% of CPI-U.
“Core CPI” is the measure of inflation that excludes
food and energy prices, which can be quite volatile. While policy makers often
pay attention to Core CPI, for consumers CPI-U is the better measure to watch.
Your personal rate of inflation – i.e., how
much you spend for the same basket of goods and services – can vary
significantly from the government’s measure. If your consumption patterns are
different, your personal rate of inflation will be different.
For example, suppose you own your own home. If you have a fixed
rate mortgage, or no mortgage at all, the cost of your home does not vary
significantly, and your personal rate of inflation may be lower. Refinancing a
mortgage to a lower rate can also cause you to lower the cost of home
ownership. However, certain housing costs, such as taxes, insurance, and
maintenance, can still increase over time.
Likewise, if you spend a lot on medical care, and the costs
of medical care increase substantially, your personal rate of inflation can be
higher. For example, health care spending increased substantially from 1980 to
2008, but since then health spending growth has slowed to a similar rate as the
overall measure of inflation.[1]
The rate of inflation (CPI-U) has been modest over the past
decade. But this was not always so. In the 1970’s and 1980’s, the rate of
inflation was much, much higher, as seen in this chart from EconoFact:
Here are the rates of inflation by decade:
Inflation is always a concern. Inflation is the
unstoppable economic force that slowly and steadily drains the purchasing power
from your dollars by driving the cost of everything up over time.
Modest inflation, such as that desired by the Federal
Reserve’s target of 2%, is It only somewhat facilitates the repayment of
long-term debt, provided that incomes increase over time. It also facilitates a rate
of return for savers in CD’s, bonds, and other fixed income investments. A
modest rate of inflation also stimulates spending by both businesses and
consumers, which in turn can drive economic growth. And modest inflation allows
wages to be adjusted upward.
But very high inflation, as seen in the late 1970’s and
early 1980’s, can be devastating – and difficult to stop – once it begins. High
rates of inflation create economic uncertainty, which can lower investment by
companies. Lending by banks becomes more precarious. The foregoing impacts
(lower investment, lower lending) can lessen economic growth. For consumers,
savings can fall in value (the “real return” – also known as the
“inflation-adjusted return” – on savings can be negative) when inflation is
high. If wages don’t keep up with inflation, “real wages” (wages, less the rate
of inflation) can go lower. And, if a high rate of inflation occurs in the
United States, but is less prevalent in other countries, over time inflation
can reduce our international competitiveness.
A high rate of
inflation is present, today, when comparing prices now to prices a year ago.
The U.S. Consumer
Price Index (CPI-U), the nation's key inflation measure, jumped 0.9% in June
2021 from the prior month; this was the largest one-month increase in 13 years.
Over the last 12 months, prices were up 5.4%, the biggest jump in annual inflation
in nearly 13 years.[2]
The recent
surge in inflation is driven by many short-term factors, including:
·
Car Prices. The rise in new and used car
prices, due to shortage of computer chips for new vehicles, and the disruption
in 2020 of rental car fleets. Surging prices of used cars and trucks accounted
for more than one-third of the inflationary spike seen over the past year. The
retail price of used cars jumped 10.5% between May and June, following a 7%
jump the month before. However, The prices dealers pay for used cars at massive
auctions across the country dipped in June 2021 after hitting record highs for
much of early 2021, according to the Manheim Used Vehicle Value Index.[3]
o
The 10.5% increase in June in used car prices
was the largest one-month jump in records that go back nearly 70 years, and a
stunning 45.2% increase over the last 12 months. New car prices are also up
5.3% over the last year, hitting record levels.[4]
o
Car prices are being driven up by strong
consumer demand for cars, along with a limited supply due to a shortage of
computer chips needed to build the cars. Rental car companies, a key seller of
used cars, already sold off much of their fleet of cars last year to raise cash
during the pandemic and now don't have enough cars to rent. Yet, as the supply issues are resolved over
time, car price increases are likely temporary. Expect the prices of both used
and new cars to fall during 2022 and 2023.[5]
·
Home Prices and Rents. Due to low
interest rates, demand from millennials reaching peak homebuying age, and a
general shortage of single-family homes, housing prices have risen dramatically
recently. The National Association of Realtors estimated the rise of existing
home prices at 15.4% for the 1st quarter of 2021, from a year
before. New home prices increased 5.1% from the year prior.[6]
Prices, however, are projected by CoreLogic economists to only increase 3.4% over
the next year (from May 2021 to May 2022), as affordability challenges hit some
buyers and cause a slowdown in price growth.[7]
o
Soaring home prices have had the effect of also
raising rents, with a bit of a lag present. Data from Apartments.com shows
average rent prices are up 7.5% year-over-year, which is three times the normal
growth rate. CoreLogics’ April 2021 data shows a national rent increase of 5.3%
year over year, up from a 2.4% year-over-year increase in April 2020. Rent
prices vary widely, however, with rents actually on the decline (on average)
over the past year in Chicago and Boston, while even higher rent increases than
the national average were seen in many areas of Arizona, Nevada, Georgia, and
Texas.[8]
The future of home prices and rents is uncertain, as demand may be affected by
many factors (including mortgage rates, demographic trends, etc.
· Oil prices. The following chart shows the 5-year trend of oil prices:
Source: Crude Oil Price Today, retrieved
7/13/2021.
As seen, the substantial dip in oil prices due to
decreased travel and decreased economic activity at the inception of the
COVID-19 pandemic has, over the past year, been negated by jumps in oil prices.
This has occurred largely via production cuts by OPEC countries (and Russia),
and by the increases in travel and other economic activity in recent months.
Yet, OPEC’s ability to stick to oil production cuts
are in large part unpredictable, due in large part to continued arguments among
OPEC countries about market share.[9]
It should be noted that since July
10, 2020 the number of oil rigs in production, in the United States and Canada,
increased from 287 to 616.[10]
Furthermore, the number of crews finishing off previously drilled wells in the
United States has increased this year from 70 to 234, indicating more oil
production is posed to come online.[11]
The U.S. Energy Information
Administration stated on July 6, 2021: "We expect rising production will
reduce the persistent global oil inventory draws that have occurred for much of
the past year and keep prices similar to current levels, averaging $72 per barrel
during the second half of 2021.” For 2022, EIA said it expects growth in
production from OPEC+ and U.S. tight oil production, along with other supply
additions, will outpace growth in global oil consumption and contribute to
declining oil prices.[12]
To summarize the prior section, car prices – which have
contributed one-third of the rise in the Consumer Price Index (year-over-year)
as of June 2021 (per BLS), will likely decline over the next couple of years.
The “supply shock” cause of increased car prices (driven in part by a shortage
of consumer chips) is temporary in nature.
Oil prices are largely unpredictable, due to OPEC politics,
but increased production in the U.S. and Canada may lead to greater increases
in oil production than increases in demand over the next year or so. (Source:
U.S. Energy Information Administration, This Week in Petroleum, July 8, 2021.)
OPEC may, however, further cut production. Or, at time OPEC countries may
diverge due to disagreements on market share, and OPEC countries might increase
production when OPEC nations fail to reach consensus.
Housing prices may be in a “bubble” in some markets, at
present, as the cost of housing exceeds the reasonable cost of construction in
many suburban areas. While housing prices may well continue to rise for another
year or more, at some point new home construction will likely catch up with
demand, resulting in a lowering of home prices. Housing rental rates will
likely increase over the next year, as they are affected by housing prices, but
may stabilize thereafter.
If we were to stop there, we might assume that the rate
of inflation seen in 2021 – now at 5.4% year-over-year – might fall in future
months, and certainly the rate of inflation would appear destined to fall in
2022. In part this is because depressed pandemic levels from a year ago
translate to artificially higher year-over-year rates, but that explanation is
less sufficient for June. While the base effect hasn’t entirely faded, it is
diminishing. Also, stripping out volatile items like food and energy, “core”
CPI rose only 4.5% year-over-year in June 2021.[13]
However, economists, as well as those undertaking policy
decisions at the Federal Reserve are engaged in a fierce debate about the risk
of runaway consumer prices fueled by ultra-accommodative fiscal and monetary
policy. In other words, vast government spending, combined with low
short-term interest rates (influenced by the Federal Reserve) and purchases of
fixed income securities by the Federal Reserve (which has the effect of
introducing more cash into the banking system – resulting in money supply
growth).
Hence, an even deeper dive is warranted, to even attempt to
answer the question – is higher inflation in our future.
According to traditional economic theory, money supply
growth and inflation are inexorably linked. As seen in the following chart from
the Federal Bank of St. Louis, money supply (as represented by M2 Money
Stock) has substantially increased since the pandemic began:
The "M2 Money Supply," also referred to as
"M2 Money Stock," is a measure of the amount of currency in
circulation. M2 includes M1 (physical cash and checkable deposits) as well as
"less liquid money," such as saving bank accounts and money market
mutual funds.
Yet, the “velocity” of money – the rate at which
money changes hands (typically measured over a one-year period) has declined
substantially over the past twenty years, as seen in this chart from the
Federal Reserve Bank of St. Louis (showing money velocity from 1959 through
2020):
The velocity of money in the United States is calculated by
dividing the nation’s economic output, nominal GDP — GDP not adjusted for
inflation — by the money supply. When the velocity of money is high, a dollar
is changing hands frequently to purchase goods and services — suggesting that
the economy is doing well. It reflects high demand, which generates more
economic activity. When the velocity of money is low, a dollar is not changing
hands often to buy things — meaning that economic activity is sluggish.
Instead, it is being saved and invested.
To get sustained inflation, we will likely need a pickup in
the velocity of money. In other words, we need banks to hold less in their
reserves, and to loan out that money to businesses and consumers (which is
largely not occurring today, relative to the amount of cash available. And we
need consumers to spend their savings (which is occurring, to a degree).
So, to summarize – a huge increase in the supply of money is
inflationary, but not so much if the velocity of money has declined (as it did,
substantially, from March 2020 to today). Whether the velocity of money
will substantially increase is unknown, as it is affected by many factors,
although I believe a slight pick-up in money velocity in the second half of
2021 is likely. This, in turn, would tend to favor higher inflation.
But inflation is driven by many other factors, other than
just money supply and the velocity of money (which many economists and
investors have focused upon).
In my personal opinion, while the large money supply and
the potential for higher interest rates (and increases in the velocity of
money) are a substantial concern, the largest inflation threat comes from the
potential of a wage-price spiral – which would in turn trigger higher interest
rates.
Wages across the United States are increasing – often
dramatically.
When wages rise steadily and consistently over time, those
higher earnings don’t trigger sharp inflation. But sudden and dramatic
economy-wide wage increases certainly can. That kind of fast nationwide pay
raise usually comes from one of two economic drivers — a hike in the minimum
wage or a dramatic reduction in the supply of labor.
As reported in NFIB’s monthly jobs report, 46% of owners
reported job openings that could not be filled, a decrease of two points from
May but still historically high and above the 48-historical average of 22%.[14]
Many companies big and small are increasing compensation,
but even that has not been enough to do the trick. This year a record number of
firms raised wages and benefits in an effort to lure new hires and to retain
valued employees. Large businesses voluntarily increasing their wages include
Target ($15 per hour), Hobby Lobby ($17 per hour), Starbucks (10% increase in
all wages), Costco ($16 per hour), Walmart ($13 to $19 per hour for workers,
with half of company’s employees making $15/hour or more), McDonald’s 650
corporate locations ($11 to $17/hour for entry-level crew), and Amazon $15 per
hour). A recent study found that Amazon’s pay raise resulted in a 4.7% increase
in the average hourly wage among other employers in the same labor market
(commuting zone).[15]
A net 39% (seasonally adjusted) of small businesses reported
raising compensation, a record high. A net 26% of small businesses plan to
raise compensation in the next three months.[16]\
Wage increases are
not just voluntarily undertaken by companies. Many states and localities have
enacted minimum wages which are far above the federal minimum wage of $7.25, as
seen in this recent map produced by Workest:
To help offset the higher cost of supplies and labor, a net 47%
of small business said they raised prices in June — the highest reading in 40
years. [17]
The question remains, however, as to whether the higher
wages recently seen, which have led (and will lead) to increases in the prices
of goods and services, will then trigger further wage increases. In other
words, as the prices of goods increases, will workers demand even higher wages
– which will then trigger higher price increases – which then trigger higher
prices – etc.
And that is the great unknown. Still, I personally
estimate a 25% chance of wage-price inflation becoming “embedded” in the
economy, and persisting until fiscal and monetary policy changes (higher
interest rates, lowering the supply of money, reduced federal spending, etc.)
bring such a wage-price cycle under control.
The uncertainty about inflation occurs because inflation is
driven by many different factors, not just those discussed above.
Several longer-term trends and near-term developments are
supportive of higher rates of inflation:
·
A decrease in “globalization” may occur.
The import of low-cost goods has tampered inflation over the past 30 years.
Core prices for goods rose just 18% between 1990 and 2019, while prices for
core services (produced domestically) rose 147% over that time period.[18]
However, will trade wars erupt (including less imports from China)?
·
The labor force is not expanding as rapidly,
and in some areas is shrinking, due to the decline in the number of working-age
adults in many countries. According to a United Nations report, U.S.
working-age population growth will slow to just 0.2% a year between 20202 and
2030, down from 0.6% in the decade earlier. (Increased immigration, if
permitted, could offset some of the labor shortages projected, especially among
skilled workers.)
·
Another trend favoring a higher rate of
inflation is the large fiscal stimulus that may occur via
direct-to-consumer payments (expansion of the child tax credit, for example)
and increases in government spending (whether on infrastructure, renewable
energy incentives, or otherwise). On July 13, 2021, leading U.S. Senate
Democrats agreed on a $3.5 trillion spending plan, that will form the basis of
the reconciliation package (that can be enacted without Republican support,
later this year, if all Democrats support the final package).
Yet, there are forces present which would tend to lower
inflation, and even lead to deflation, such as:
·
An increase in productivity can be an
inflation-killer. Due to investments made by companies during the pandemic
in information technology and robotics, productivity on a year-over-year basis
is at its highest point in a decade. From the second quarter of 2020 to the
first quarter of 2021, labor productivity in the nonfinancial corporate sector
jumped 5.3% while hourly compensation rose 2.0%.[19]
·
The concentration of wealth, now at its
highest since World War II,[20]
can result in less consumer spending. Those who have amassed more wealth
possess a far lower marginal propensity to consume, when they receive
additional income, than those who are far less wealthy. However, with strong
indications that the U.S. equity markets (overall), bond markets, and real
estate markets are all overpriced, a downward correction in prices would
mitigate some of the wealth inequality seen.
·
Commodity prices have already surged,
and projections of commodity prices going forward (particularly food, energy) indicate
the potential for lower prices. Commodity price increases appear to have driven
in part by supply-side constraints, which tend to correct over time.
(However, there is always a great deal of uncertainty about commodity prices,
especially in the near term.) Also, by 2025-2030 peak demand for oil might
occur, due in large part to the continued deployment of solar, wind, and other
renewable energy sources, and the rapid decline in the sale of gas-fueled
vehicles expected from 2025 through 2035.[21]
·
The chief problem facing most of the world's
developed economies today is the level of outstanding debt, both private and
public. Whilst the creation of debt can represent an expansion in the broad
money supply, the destruction of debt conversely equates to a contraction in
the money supply. As all debts must eventually be repaid, debt by nature is
deflationary over time.
In conclusion, while much of the rise in recent wages and
prices appears to be one-time adjustments, there is the possibility of
sustained inflation over the next few years. While the Federal Reserve has
stated that it has the tools to constrain inflation should it continue, there
is a fear that the Federal Reserve is over-confident in its own abilities,
given the historical difficulties seen in bringing past wage-price spirals
under control.
If inflation does continue for a few years (or longer),
what does it mean for your investment portfolio?
Traditionally, commodities have been an inflation edge. But,
increases in commodity prices have already occurred, as noted above.
Another hedge against inflation has been real estate. Yet,
home prices appear to be in a “bubble,” and office vacancies continue in large
numbers. Vacancy rates for industrial properties, such as warehouses, are
already quite low, with rents for industrial buildings already rising 7.1% in
the first quarter of this year from a year prior.[22]
Should interest rates increase, the valuations of growth
stocks will be put under pressure. Value stocks, while not an inflation hedge,
will likely perform well relative to growth stocks, although value stocks are
not necessarily an inflation hedge.
The following investment strategies, in particular, from
ARGI may perform well in a higher inflation environment, should it occur (and
should also perform well, relative to the market, due to overvaluations in U.S.
large cap growth stocks, as will be discussed in a future edition of Da Bear’s
Perspectives):
Dividend
Select Portfolio
Defensive Equity Portfolio
Factor 15 Small Cap Portfolio
Note that higher interest rates, often used to combat
inflation, can result in lower returns for growth stocks (as a broad asset
class), in part because future earnings of growth stocks are subjected to a
higher discount rate under traditional stock valuation methodologies. All of
the above ARGI investment strategies employ investment “factors” that tend to
tilt away from growth stocks, to some degree.
Over the very, very long term, stock prices often adjust
with inflation. This is because, as prices increase, so do corporate revenues,
which in turn ultimately drive higher earnings. However, as evidenced by
the performance of the U.S. stock market in the 1970’s, the overall valuation
of stocks can be driven substantially lower should inflation, and interest
rates, rise dramatically. In combatting inflation via higher interest rates,
bond investments are made more attractive to investors, and equities (stocks)
less attractive, leading to potential undervaluation in stocks (relative to
norms).
Long-term bonds would likely fare poorly should inflation
surge, as interest rates would also likely rise. (Bond prices fall when bond
yields rise.) Short-duration bond portfolios are likely to perform better. A
bond ladder, observant to making proper investments given the present yield
curve, is also a good strategy for the long-term, regardless of inflation.
Inflation-adjusted bonds would appear at first to be a wise
choice. Treasury inflation-protected securities (TIPS) and I-bonds are issued
and backed by the U.S. government. However, TIPS operate a bit differently than
traditional U.S. Treasury bonds. Investors receive regular interest payments
based on the face value of the bond until it matures. Investors also receive
inflation protection, via a yearly adjusted par value that derives from CPI-U,
the U.S. government’s primary measure of inflation. This changing yearly value
is intended to maintain the TIPS’ purchasing power over time. However, recent
demand for TIPS, which are now issued in 5-, 10-, and 30-year terms, has been
quite strong; as a result, TIPS’ yields are currently negative, with investors
betting that TIPS’ future inflation payments will make holding them worthwhile.
Still, a shorter-duration TIPS bond ETF may form part of a portfolio, and
provide some protection against possible future higher inflation.
Timing the market is difficult, as is predicting future
inflation. Hence, any adjustments in your investment portfolio should
ordinarily be undertaken using a longer-term view, and considering the
consequences if inflation increases or remains low.
Until the next time …
Very
truly yours,
Ron (Da
Bear)
Email: bear@argi.net
Dr. Ron A. Rhoades serves as Director of the Personal Financial Planning Program at Western Kentucky University, where he is a professor of finance within its Gordon Ford College of Business.
Called “Dr. Bear” by his students, Dr. Rhoades is also a financial advisor at ARGI Investment Services, LLC, a registered investment advisory firm headquartered in Louisville, KY, and serving clients throughout most of the United States.
The author of the forthcoming book, How to Select a Great Financial Advisor, and numerous other books and articles, he can be reached via: bear@argi.net.
[1]
KFF analysis of National Health Care Expenditure (NHE)_ date Personal
Consumption Price Index (PCE) from Bureau of Economic Analysis
[2] U.S.
Bureau of Labor Statistics
[3]
Scott Horsley, “Inflation Is Still High. Used Car Prices Could Help Explain
What Happens Next.” NPR (July 13, 2021).
[4] U.S.
Bureau of Labor Statistics
[5] Tim
Levin, “Why used cars are so expensive now — and when prices may drop,”
Business Insider, July 12, 2021.)
[6]
National Association of Realtors, U.S. Economic Outlook: May 2021
[7] CoreLogic
U.S. Home Price Insights, July 6, 2021
[8] CoreLogic,
June 15, 2021 release
[9] BOE
Report, “OPEC+ impasse risks price war as demand surges, says IEA”
[10] Baker
Hughes Rig Count Overview
[11]
Julianne Geiger, U.S. Rig Count Rises in Volatile Week for Oil, oilprice.com
(July 9, 2021), citing the Frac Spread Count provided by Primary Vision.
[12]
Devika Krishna Kumar, “U.S. 2021 crude output to decline less than previously
forecast, EIA says,” Reuters, July 7, 2021
[13] U.S.
Bureau of Labor Statistics
[14] National
Federation of Independent Business, which represents small businesses in the
U.S., monthly jobs report
[15] Derenoncourt,
Ellora and Noelke, Clemens and Weil, David, Spillover Effects from Voluntary
Employer Minimum Wages (February 28, 2021)
[16] National
Federation of Independent Business, monthly jobs report
[17]
National Federation of Independent Business, which represents small businesses
in the U.S., July 13, 2021 release
[18] The
Wall Street Journal, July 12, 2021
[19]
Gary Shilling, “How Labor Shortages Help Profits and Hurt Inflation,” Bloomberg
(July 1, 2021)
[20] Ray
Dalio, Bridgewater Associates
[21] Noah
Browning, “Factbox: Pandemic brings forward predictions for peak oil demand,”
Reuter (April 21, 2021)
[22] CBRE
U.S. Industrial and Logistics Figures Q1 2021
