Fear Not Inflation - The Data Says

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by: David Cretcher

Summary

Inflation concerns are rising.

Understanding the drivers is critical to understanding inflation.

The data pints to reduced inflation.

Investors should position their portfolio for lower inflation.

There has been speculation in the news about a resurgence in inflation. The inflation rate has risen to 2.74 percent as of February 2017 (figure 1). This conclusion is based on news of decreasing unemployment, increasing wage growth, and a declining dollar. The data shows inflation concerns to be unwarranted.

Investors should avoid speculating and look at the inflation drivers in the economy. There are many false drivers in inflation analysis. For example, increasing interest rates will increase the cost of buying a home, but more expensive housing leaves less money for discretionary spending. So, a homeowner may reallocate money to the home purchase away from something else, like a new car or new furniture. There is no net gain in inflation from this reallocation.

Fig 1: US inflation rate.

(Courtesy of multipl.com)

General inflation occurs in a scenario where the consumer can both pay more for the house and also pay more for the discretionary spending. In short, it needs consumers with money in their pockets.

Increasing wages could do that, but not if they are offset by decreasing corporate profits. In this scenario an environment with both increasing wages and increasing profits is needed.

In short, inflation requires an environment with an increasing money supply or increasing money velocity inside an economy constrained by labor, raw materials, or capital. Without money growth/velocity or a constrained economy, we can't have high inflation.

When assessing inflation risk, investors should focus on six major inflation drivers - increasing government spending, federal taxes, bank credit growth, increased money velocity, raw material/commodity cost, and labor/goods exports. For brevity, we will ignore the last one.

Increasing Government Spending

When the government spends, it injects assets into the economy. This increases the money supply. If the government spends 10 billion on a new submarine, that's new money in the economy. It may decide to tax back five billion, but then there is still five billion remaining in the economy.

The government will issue bonds for the remainder, but those bonds are inside the economy on someone's balance sheet as an asset. So the level of assets in the economy rises.

Today, government expenditures are declining, and that is deflationary.

Fig 2. Government expenditures as a percent of GDP are declining.

Decreasing Federal Taxes

Reducing taxes is the opposite of government spending. When the government lowers taxes, there is more money left in the economy to spend on goods and services. Until last year, federal tax receipts have been increasing, which is deflationary. They have been decreasing in 2016.

Fig 3: Tax receipts have been growing until 2016. Taxes remove money from the economy and are deflationary.

The Budget Balance Tells All

The budget is the balance between the above two inputs. When politicians tell you they will balance the budget, it requires the government to tax more money out of the economy than the government spends into the economy.

When the government runs a deficit, it is spending more money into the economy than it is removing through taxes. Therefore, everything else equal, deficit reduction is deflationary, and government surpluses are inflationary.

For the last six years, we have been decreasing our deficit as a percent of GDP (figure 4). This is deflationary, not inflationary. It removes money from the economy.

Fig 4: After increasing from 2000 to 2009, the federal deficit as a percentage of GDP has declined from 10 percent to 4.5 percent.

Declining Bank Credit

The other major driver of money growth is bank credit. When banks loan money, they inject new money into the system (The mechanism behind this is beyond the scope of this article). In the last year, bank credit has been declining (Figure 5). This is deflationary.

Fig 5: Bank credit growth is slowing

Declining Money Growth

Declining government spending growth and declining bank credit growth lead to slow money supply growth and lower inflationary pressure in the economy.

Fig 6: M2 money supply growth is slowing after a jump in 2016

Turnover is as Important as Growth

Money stock times the velocity of spending is what makes the wheels of commerce turn. More money doesn't help if people don't spend it. Money velocity is at an all-time low. This is deflationary.

Fig 7: Money velocity is at a 60-year low.

Raw Materials are a Constraint

Raw material prices constrain the economy independent of money supply growth. Rising raw material cost limits the supply available at a given money supply level and bottleneck output. Higher commodity prices can drive inflation into the economy, e.g. the oil recessions of the 1970s. Lower prices are deflationary. Currently commodity prices are declining.

Fig 8: Commodity prices are declining.

Unconstrained Economies Grow Without Inflation

When the economy is below its Potential GDP, it means there is room for the economy to grow without generating labor, capital or raw materials shortages and the resulting inflation. Current GDP is improving, but still below Potential GDP. This means the economy can expand without creating inflationary pressures.

Fig 7: The economy is below capacity. The red bars represent the slack in the economy.

The Weight of The Evidence

The evidence points toward lower inflationary pressure and a future of lower or declining inflation. We may see a short-term uptick, but without a change in the drivers above significantly higher inflation will be difficult to generate.

Investment Implications

The obvious implication is that Treasury Inflation-Protected Securities (TIPS) will underperform. When inflation is low, TIPS behave in the short run like Treasury Notes with a reduced coupon.

Fig 8: Without inflation expectations, TIPS acts similar to Treasury Notes in the short run.

The bull market in stocks (NYSEARCA:SPY) may remain intact or at least be flattish until the next recession.

The next recession may be sooner than we anticipate. There is nothing economically stimulative in the 2017 budget or the 2018 proposed budget. It has nothing that would reverse the downturn in government expenditures or money velocity. If bank lending doesn't increase we will have slow money growth and lower inflation. Tax cuts will help if they are not offset with spending cuts, but that doesn't seem likely.

In this environment, the Fed will have an increasingly difficult time raising interest rates. We may see a few more small increases this year, but rates above two percent will be difficult.

The bond rally (NYSEARCA:AGG) may have more life left. If the Fed does raise rates, it will be short-lived, and it will move them back down during the next recession.

Cautious investors should look for assets that perform well in flat markets, like preferred stocks, dividend stocks, utilities and covered-call strategies (NYSEARCA:PBP). You want investments that are front-ended and pay you money now, and are less reliant on capital gains.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational and discussion purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. All investment and speculations have risk please consult your financial and tax advisers before investing.

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