I don’t mean to add to the chorus of doomsayers but do believe I came across an analysis not mentioned on the financial porn channels (ie CNBC) who are quick to speak of “peak inflation” having already passed. I’m also not aware of any real substantive analysis of the inputs into inflation (one in particular I will return to) among the real “pros” but I’m not plugged into those circles so who knows… maybe they’re keeping it a secret.
I’m just some dude who basically won the lottery and made life changing bank on TSLA calls a few years ago and moved to Puerto Rico…. I’m actally a physician by training, not an economist, so obviously due your own research. But all the talk of inflation seems to be missing something very obvious and I’m hoping to share.
I want to start by saying that inflation in my view isn’t as new or scary as some will make it seem. It’s simply more demand than supply which causes prices to go up. We’ve all seen this play out countless times–not enough PS5s or or Yeezys or concert tickets or raw materials as people want and the prices start skyrocketing. The difference between the inflation Jerome Powell (JPOW) talks about and some dude hawking Yeezys at a 500% premium to sticker price is really just how pervasive it’s become in so many parts of our lives–food, energy, shelter, ie the basics.
JPOW got a lot of flak for repeatedly insisting last year that inflation was “transitory.” In a philosophical sense maybe he was correct–everything in life is transient said the Buddha. And everything will eventually get sorted out–but it took years to get here. It could take years to get back.
In a more immediate sense he was speaking of supply-demand mismatches that are partly a result of “supply chain bottlenecks” like chip shortages that cause shortages of new cars that had spill over effect into used cars. This is definitely part of the story. But so too is the confluence of pandemic-era accommodative fiscal (stimulus) and monetary (QE, negative real rates) policies by Congress and the Fed, respectively. Just as one example, if a family was receiving thousands in stimulus payments and child tax credits (expiring) and also saw the value of their home and retirement accounts double because the Fed kept real rates near zero while buying trillions in bonds to essentially create money then they might have been quick to go out and buy an even bigger home or take a really nice vacation–but because millions of other families were in the same boat lumber prices and airfares started to soar. And in a sense this effect really is “transitory” although it will likely take years to mean revert.
By the end of 2019, the S&P 500 had (already buoyed by 4 previous rounds of QE since 2008) trended up to 3000 and the Nasdaq to 9000. Markets tend to overshoot and overcorrect so short or medium term it’s really anyones guess where things will bottom out but in the absence of QE and the return of higher interest rates I think we are likely to revert back to the pre-pandemic trajectory at some point. And there’s another 20-25% of correction left before we get there.
Futures are positive this morning and it will probably be a choppy road but the reason in my view markets haven’t corrected harder is the hope that the Fed can somehow engineer a “soft landing,” or in other words avoid having to engineer a recession to get asset prices back in line. This will be difficult for a number of reasons that are not a secret: The conflict in Ukraine has further accelerated the multiyear supercycle in commodity prices (if you look back in history, commodities invariably go through multiyear periods of extended boom followed by cyclical bust) that was already underway. Furthermore, extended Covid-related lockdowns in China will cause further supply disruptions and costs increases.
And now with all this in context I finally get to the crux of my post: While the markets are probably pricing in Ukraine and the China-lockdowns and the probably of two 50 basis point increase in interest rates, the Fed will likely be under even greater pressure to raise interest rates more and possibly faster than markets are already expecting while also drawing down their massive balance sheet for one rarely discussed reason:
We use the BLS Consumer Price Index (CPI) as the primary gauge of inflation. In the CPI, there are two components of housing costs: owners’ equivalent rent of residence (OER) and rent of primary residence, which combined are 40 percent of core CPI, which is the most widely watched because it excludes volatile energy and food prices.
However, these are not real-time metrics. Unlike milk which people buy often, people enter into longterm leases and as such the BLS (the government agency that publishes the monthly CPI) divides into 6 cohorts. For the May measure, which will be released in the second week of June, the will ask 1/6th of respondents how much they pay in rent despite the fact that most of respondents entered leases during the pandemic when before wages and home prices started to skyrocket and the measure will be artificially lower.
An even larger component of the 40% than actual rent is owners’ equivalent rent of residence (OER).**The methodology is beyond the scope but basically because BLS considers homes investments rather than consumption so uses an indirect metric rather than asking about actual expenses like maintenance or mortgage rates (which are rising and not captured) or taxes. I’m going to defer to a group of economists much smarter than me to explain. One is Larry Summers, former Treasury Secretary, Chief Economist for the World Bank, and President of Harvard. This research is supported by multiple others and I will post a longer lit review if enough interest but probably suffice to say this is solid research by world leading scholars with no obvious interest in manipulating markets or selling anything and much more helpful than whatever equity research department at Goldman says.
“[Last year] home prices have jumped by 19.9 percent according to Zillow. The Zillow Observed Rent Index has increased 14.9 percent, and the CoreLogic Single-Family Rent Index, likely to be a particularly good leading indicator for OER, had risen by 12 percent in December…
Dolmas & Zhou (2021) documents that historically the BLS measure of 12-month change in rental prices is more strongly correlated with the 12-month change in housing prices observed 16 months earlier than any more recent reading [see www.dallasfed.org/research/economics/2021/0824]…
Using a variety of techniques and datasets, we estimate housing’s contribution to 2022 inflation as almost incompatible with a swift return to trend inflation.”
I don’t think the 16 month delay is definitive but needless to say the CPI data we are looking at is VERY STALE and at least a year old. While we may say headlines about airplanes fares (only 0.5% of the CPI) we forget that 40% of core CPI measures direct and indirect rents over a year ago and won’t capture any decreases until 2023 at the earliest. For this reason, it is my view that the Fed will be under pressure well into next year to continue to raise rates and push markets further down to eventually mean revert to pre-pandemic levels.
So what to do?
C.R.E.A.M. (Cash Rules Everything Around Me aka Delever). Even if the scenario of a Fed being more Hawkish than currently priced somehow doesn’t pan out the risk-reward profile of markets at present is not favorable in my view. Keep a lot of cash on hand. Even if you’re still convinced GME is the greatest thing since sliced bread, keep some cash. Remember that high beta growth stocks are especially sensitive to changes in interest rates since their valuation depends in part on very far out csh flows that need to be discounted to present at a higher cost of capital.
Also consider hedging. Put options might be an obvious play but also consider (and I usually hate ETFs) like and ETF that is short ARKK or SOGU (which is short SPACS) or an ETF short emerging markets (which tend to get hit even worse than the US when rates rise quickly) or an ETF short the US housing market on a forward basis… not 16 months delayed like the CPI.
And diversify. Sounds like boring boomer advice and the energy trade has become crowded but the energy sector and underlying commodities remain attractively priced in my view. Yes you would have ignored me 6 months ago and that “would have been the time to buy” but with PEs of 10s and low price to book and sky high dividends and buybacks this sector remains attractive in the face of rising inflation for the next few years until everything gets sorted out. Remember that commodities tend to rise in supercycles that last years and it’s possible we’re just getting started.
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence or consult your financial professional before making any investment decision.