US Strategy Weekly: The Ghost of Inflation Past

Our 2021 outlook identified inflation as one of the major hurdles facing equities in 2021. We continue to believe this is true, but to date equity investors have ignored the threat of rising prices. President Biden, current Treasury Secretary and former Fed Chairwoman Janet Yellen and current Federal Reserve Chair Jerome Powell, have all given little credence to the relentless rise in price inflation.

The Federal Reserve is important since it plays a pivotal role in fighting inflation. Because its role is so important to the economy it is designed to be an independent non-political body. The seven members of the Board of Governors are nominated by the President and confirmed by the Senate for a term of fourteen years. Terms begin/end every two years, on February 1 of even-numbered years. The length and staggering of the terms of Board members hopefully result in a political balance on the Board while also removing political pressure on each governor since they can only serve for one term. Terms can only be extended if a Governor is appointed Chair or Vice Chair for four years.

However, the political climate is heated this year and by the end of this week, we should know whether Biden will reappoint Chairman Jerome Powell, a Republican and former private equity executive, for a second four-year term, or, as the media suggests he appoints another front runner, Lael Brainard, a Democrat and former Fed economist and political appointee in both Obama and Clinton administrations. Both Powell and Brainard have similar views on inflation and interest rates so it would appear that this decision could be rooted in politics. Either way, the Fed Chair will face some tough decisions in 2022.

The word “stagflation” has become part of the economic discussion in recent weeks and for good reason. GDP slowed to 2% in the third quarter down from a booming 6.7% in the second quarter. This means that the economy has been growing well below its long-term average of 3.4% in recent months. Meanwhile, inflation is on a tear. October’s CPI rose from 5.4% YOY to 6.2% YOY (NSA) and most underlying components saw significant increases during the month. At 6.2%, headline CPI now exceeds the level seen in 2008 and is rising at the fastest pace seen since November 1990. And inflation is unlikely to die out any time soon. In fact, if November’s monthly CPI increase is zero, the year-over-year headline rate will still be 6.1% YOY next month. However, we believe prices will move higher and therefore inflation could be the worst experienced since 1982. See page 3.

This is important because inflation is a huge burden to the average household, and it increases the cost of non-negotiable necessities like food and shelter. As an example of what families faced in October data shows that food at home rose 5.4% YOY. Household furnishings and operations rose 6.25% YOY. Used car and truck prices rose 26%. Gasoline prices rose 50% YOY. All items less food, shelter and energy rose 5.3% which shows that price increases are not just tied to rising energy and transportation costs or supply chain issues but are broadly based. Anecdotally, our local nail spa just posted a sign indicating an arbitrary $5 increase on all services provided. This increase is not due to higher transportation costs, supply chain problems, or shrinking margins, but due to the fact that all families face a higher cost of living. But more importantly, this is a sign that inflation is becoming engrained in our economic system, and this is serious.

In our view, the Fed is losing the fight against inflation. We agree with Larry Summers, Treasury Secretary under Bill Clinton, director of the National Economic Council under Barack Obama, Chief Economist of the World Bank, and President of Harvard University who said “Biden’s American Rescue Bill made the mistake of pumping up demand too much without taking steps to increase supply. That had resulted in inflation.”

It is not possible to have historically easy monetary policy for an extended period of time, coupled with an historic level of fiscal spending — during an economic rebound — without suffering the consequences of inflation.

October’s PPI report suggests that the CPI will move even higher than 6.2% in coming months. The PPI for finished goods was up 12.5% YOY in October and final demand PPI rose 8.6% YOY. In short, big price increases are already in the manufacturing pipeline which we believe will push consumer prices higher in coming months.

The most unfortunate part of the current inflation trend is that it now exceeds the increase in weekly nonsupervisory earnings. This means buying power is declining this year which is the exact opposite of what happened between April 2020 and April 2021 when earnings increased much faster than inflation. See page 4. Personal income was also boosted by fiscal stimulus in 2020 and early 2021 and led to both higher savings and higher consumption.

It is also important for investors to take notice that “inflated earnings” are worth less than “real earnings.” For example, a 10% increase in earnings in a 6.3% inflationary environment means earnings growth was really 3.7%. However, the same 10% earnings growth coupled with 1% inflation translates into earnings growth of 9%. Overall, rising inflation will have a negative impact on PE ratios. The Rule of 23 is an easy tool for depicting the impact of inflation on the equity market since it is a simple sum of inflation and trailing earnings. At present, a combination of a trailing PE of 23.7 and inflation at 6.2% sums to 30, which is well above the 23-warning level. However, the market has been trading above 23 for a while, due in large part to the support of easy monetary policy. But sentiment could change if inflation begins to erode margins or if the Fed begins to fight inflation through higher interest rates. See page 5. This implies caution.

Inflation is at levels last seen in 1990, but at that time the 3-month Treasury and 10-year Treasury yields were much higher at 7% and 8.5%, respectively. The S&P earnings yield was 11% and still competitive with fixed income, yet the trailing PE was at 14 times and below the long-term average. Today the 3-month Treasury and 10-year Treasury yields are 0.05% and 1.4%, the earnings yield is 4.2% and the PE is 23.7 times. Stocks are competitive to bonds, but bonds are a wasting asset given the level of inflation. In sum, there is a big disconnect between inflation and the financial markets.

Moreover, the jump in crude oil prices is greater today than it was in 1990 and energy prices are apt to stay higher longer than expected due in large part to political and environmental policies around the world. All in all, it is a disturbing backdrop for the 2022 stock market and for the incoming Fed Chair. See page 6.

October’s retail sales beat expectations, rising 1.7% month-over-month and 16.3% YOY. Adjusted for inflation, retail sales growth drops to 11.3% YOY, but remains in double digits. Part of this rebound in sales was predictable due to October’s previously announced increase in unit motor vehicle sales. Census data shows that vehicle dollar sales rose from 8.8% in September to 11.5% in October. See page 7. In our view, the positive seasonality of November, December, and early January, coupled with the fact that quantitative easing is slowing, but still in place, is positive for equities. But we fear the environment for equities could change quickly in 2022 with inflation stubbornly high, earnings growth decelerating significantly and the boost from more fiscal stimulus dissipating. The technical backdrop of the market is little changed from a week ago and it suggests an aging bull market is in place.

Gail Dudack

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