The Fed is pushing for higher inflation. Does that make any sense?
Anyone with a passing interest in the financial markets has observed the paradoxical position of the Fed wanting to encourage inflation. The Fed has two missions: price stability and full employment. How can the Fed push up inflation to 2% - or, more controversially, per the latest pronouncement - be very willing to let inflation run hotter than 2% for an extended period? This is said to make up for the punk price behavior over the last two years (closer to 10 years). The big fear is not inflation, which the Fed knows (presumes it knows?) how to control. Deflation is the real bogeyman; no one wants to end up like Japan, with zero growth for decades and a victim of frequent recessions. Efforts by the Japanese government to spend its way out of it has come to naught (that would be instructive to the current administration). Deflation retards standards of living improvement, and overall economic growth. Disinflation, which is basically no price growth, makes it difficult to create upward mobility for small businesses. So by juicing inflation a bit the Fed is actually fulfilling its mission of price stability. Ideally the Fed wants demand inflation propelled by economic growth.
Inflation, disinflation, and deflation
My thesis is that what I am calling "monetary" inflation is not happening now (this is my term, as the media doesn’t make this distinction and I am not a PhD economist, so forgive the neologism) and we are likely not going to see it any time soon - yet. More on my caveat at the end of this piece. The real issue is that the word "inflation" is being used in an imprecise way. It is said that the Inuit have innumerable names for different types and qualities of snow. I think we need to delineate what we use the word "inflation" for.
Very simply, inflation means a rise in prices. As we see above, a slight ongoing rise in inflation is a healthy thing for the economy and disinflation, the lack of any price growth, is a symptom of an ailing economy that with proper reform can be turned around. Deflation is bad and difficult to cure. That is why all the heroic financial and fiscal action has been taken. Now, back to inflation: A rise in prices does not mean “inflation inflation”, meaning the bad kind of inflation - and not what I am calling monetary inflation, which is caused by an ever-inflating money supply. Growing the money supply ahead of economic growth and the creation of wealth devalues the dollar rapidly, causing an inflationary spiral that is self sustaining. As the expectation of prices rises, consumers will accept higher prices and in return push for a raise in their income, and off to the races we go.
Contrary to that condition, any price rise right now is an indication that a huge part of our economy is coming back to life. Greater economic growth creates a demand for more credit, thus creating a rise in the 10-year from a tiny interest rate that hasn't been seen in hundreds of years (if ever). That is the core of my argument here. Right now we are in a demand pull and supply disruption. Economics 101 dictates a jump in demand will raise prices. Furthermore, even novice economists know that rising prices will bring more supply, ameliorating price rise so long as the currency that those rising prices represents retains its value. There is nothing to fear from this type of inflation.
Commodity traders have an old saw: The best cure for rising prices is rising prices
There are generally two types of price rise: demand and the growth of the money supply. Productivity is one way that lowers prices, while others are competition, productivity, and rising supply. The businesses that exhibit the best abilities with these efforts will reward their workers and stockholders with gains. Supply and demand do not have to be just about goods; they can also be about labor and capital.
For example, companies that have access to the capital markets and need funds can do a stock offering and then use that money to compete with an established firm that follows established norms and regulations, that shows a profit and pays taxes. A great example is the devastation that Uber (UBER) dealt to the global limousine, taxi and car services industry. Along with superior technology, it was the free money supplied initially by VCs and then the stock market that helped it to undercut the establishment. That, and using superior technology to defeat the establishment which chokes off competition. I believe that technology will continue to boost productivity tremendously and is one of the major factors keeping a hold on inflation, as it has done for perhaps two decades. Greater supply of capital and labor is a good thing, as well, so long as it’s not too much of a good thing.
In the example of Uber it was the leverage of “free” labor and the capital of their cars that gave the company the ultimate advantage in creating a killer people-mover app. I may seem to have gotten off the current topic, but a major countervailing force to the fear of the inflationary spiral is innovation. Innovation and entrepreneurial energy coming out of Silicon Valley and elsewhere will counteract the bad inflation in a big way - as long as big government, taxes, and stifling regulation doesn't get in the way.
I basically agree with Chairman Powell, even while all the “smart money” doubt him supremely
Sorry for the windup, but here is the finer point. Rising prices because of greater real demand are very good. That isn’t the inflation we should be afraid of. We should fear monetary inflation; that is the killer. That causes more dollars to be chasing too few goods and services.
We have had a historic shutting-in of the U.S. GDP. It is almost like the aftermath of a war. Instead of bombed-out buildings we have shuttered storefronts and empty hotels. The demand for these services will be off the charts, and prices will rise until enough storefronts and venues are filled with new restaurants, theaters, concerts, football games, bars, casinos, etc. The rise in demand will be met with more capacity and prices will level off. Just as Powell has modeled out.
Look, I respect Mohamed Al Arian (Chief Economist at Allianz (OTCPK:ALIZF)) and the great Rick Santelli on CNBC, both principal proponents of the notion that we are on the cusp of runaway inflation. I pick these two because they are not of the typical self-serving cohort that the media trots out. Mr. Al Arian has always been a cautious investor, and if I were lucky enough to have a retirement account big enough for him to advise me, on I would be thrilled. There is nothing wrong with careful money, slow money, protecting generational wealth. So his caution about inflation and economic growth is valid because, he is concerned with retirement and leaving wealth for the next generation. At some point - perhaps in the second half of this decade or two decades hence, or maybe even a few years from now if our economy is mismanaged - we will be confronted by real inflation. So being prepared for inflation long term, and being on the lookout for it is all well and fine.
And making note of the current political climate, as Santelli does, is perfectly valid. However, he is extrapolating even from the current profligacy out of DC that the Fed is therefore already over their skis. I would even give him that (not completely). Yet I still believe that, as it stands, we won't see monetary inflation until after 2025, if ever. There is plenty of time for a change in direction in Washington.
Since we are Seeking Alpha people, I am talking about looking out no further than 12 to 18 months, tops. With that window in mind I believe we will see leveling-off of prices. I just showed my hand about the big caveat I have at the end of this writing. In any case, the situation as I see it is not as immediately dire. And, again, I see the Fed has plenty of room to maneuver currently.
Rising money supply right now should not be feared; the jump in the current measure of money supply is irrelevant.
People are looking at the money supply being pumped up with government largess and point to it as the seed from which monetary inflation will sprout. What they don’t take into account are all the dollars that were basically put in a pyre and burned to a crisp during the pandemic. I am talking about the same empty storefronts. How many of those entrepreneurs lost everything and have consumed all their savings? How many of those newly employed people of color put to work for the first time during the Trump administration were promptly turned out due to the pandemic? Think about the millions of moms out there who gave up their careers and incomes to supervise and teach their kids. The list of destruction of dollars is endless. We all know someone that has lost everything now just scraping by.
So, no, we don’t yet have too many dollars being printed right now. In fact, without the showering of all those dollars on those who lost their livelihoods and savings, we would be in deflationary recession the likes of which we haven't seen in almost 100 years. Yes, we skirted the black plague of economics - Depression. So hurrah for us. Let’s cheer for the jump in the money supply, hopefully helping those that were hurt. Also, whatever money that was sent directly has already been spent, or it's in savings waiting to be spent when the world opens up again - and that is happening now.
Why did the market act so bearishly with the 10-year up only to 1.7%?
So why was the market so bearish when the 10-year bonds reached nearly 1.8%? Those are still negative real rates. Real interest rates are the current interest rate with inflation subtracted. So if inflation is at about 2.2%, we are still at negative rates. The answer is the nature of the stock market, which always views data trends out to six to nine months. So for the most part it was the speed with which it got there.
Because the market is forward-looking, it tends to take a trend and overshoot expectations - or, more to the point, it panics over where it may run to. I have said it before - and always trade and invest with this in mindset - the stock market hates uncertainty, or lack of visibility, as it is often termed.
There is also the reinforcing mechanism of a simplistic take on market indicators, and the 10-year now looms large among these. It used to be that, until recently, no one active in stocks paid much attention to the 10-year since it was always going down. Now its rise, and the alacrity in which it is doing so, must be a signal of some kind. The one most favored by the media and many self-serving market commentators-cum-participants is to point to it and tout runaway inflation. This is where the usual cast of characters that make up the "Prophets of Doom" are deployed by the media proclaiming inflation! Mostly to sell gold, Bitcoin or snake oil, and some very safe investment vehicles that they make bank on.
Nothing wrong with safety, but no one should be cowed into a vehicle because of general hysteria. Do it because you want to save for your kids' college and grad school, etc. The media wants to sell ads and needs your attention, and the most vocal doomsayers want to sell you financial products that give them a big commission. I don’t give a hoot about selling you anything, but please do your own research and weigh all the data yourself. I am betting on what seems to be the non-consensus, and that with the slowing of the rise in the 10-year, something unexpected is going to happen. I want to trade that.
The 10-year is consolidating its rise. Let's talk about what happens next.
I think we will continue to have spikes in interest rates and that we'll get to 2% later in the year. I would not be surprised to even see 2.5% by December. At the same time we are also overreacting to the interest rate. Rick Santelli has a brilliant technical insight: The interest rate has been sticky, meaning that every move up has been holding close to the high - meaning that it is likely to continue. As I said, we are in a consolidation phase right now, and we may even see more downside movement, but I think we are likely going to trade closer to 1.7% than to 1.2%.
Again, until this week all the volatility has been to the upside. That is what is causing the panic. It is also pushing momentum traders to take that trade even higher. I think this consolidation phase continues and that the momentum traders will seek alpha elsewhere. Unless the 10-year surprises everyone and breaks under 1.5%, it could happen in a consolidation phase when the "up" momentum traders leave.
Here is my caveat about inflation
Let me make this quick so I can get back to talking about what happens next. Nearly everyone in this country was in favor of helping out those who were upended by this pandemic through no fault of their own and by government fiat. To my mind, this was tantamount to what is known in the Constitution as a “taking” by the government. The Constitution makes room for when the government, for the good of the general public, will take private property for which it is obligated to recompense at a fair price. The shutdowns were by executive order, and many corners of the populace considered them unfair, unnecessary and ill advised - but I think everyone agrees on just compensation. Was money supplied 100% perfectly and wisely? Of course not. However, much trickled into the hands of those that deserved it, so it was money well spent.
We have now come to a time when soon vaccines will be available to nearly everyone. Even children will likely have access in a few weeks. Also in light of the high jump in employment in March, the true limitation on getting back to normal is the push to keep everything shut down. The principal cause of monetary inflation is government spending run amok, corruption, or a restrictive regulation scheme that tamps down competition, productivity and innovation. These are the conditions that lead to too many dollars chasing too few goods, and an entrenched expectation of rising prices. Pretty soon you have a situation similar to the Weimar republic where you need a wheelbarrow to buy a loaf of bread. As I said in the title of this piece we are not there yet. In order for a self-sustaining inflationary spiral to happen you need the consumer and worker to expect inflation, because the currency is perceived to be less valuable. This is something that the Fed needs to guard against.
If the profligacy does not moderate then by 2025 we may very well see the start of out-of-control monetary inflation. Again, that is further out than we need to worry about right now for our quest in seeking alpha today.
So what happens next?
The rise in the 10-year at first slammed the tech names because stocks are valued by the future stream of earnings and revenue. That means that fast growing stocks that have earnings in the future are supposedly worth less. Logically, however, the faster the physical world grows, the faster technology grows in use and value. More to the point on the overall market, the more hyperbolic the rise in the rates, the more the overall market will be affected. Even the banks will be temporarily affected if chatter of inflation becomes even more strident.
The typical commentator is basically repeating the consensus bear view, which is merely reacting to the current retrenchment of high P/E names. This is the typical talking-head move, taking what is happening right now and taking it to the extreme conclusion to get attention.
No one is taking into account that people are not going to stop using technology, and in fact technology is taking over more and more of the economy. Also the notion that interest rates will have any effect on the growth of tech. Most tech companies can, as I said earlier, skirt the bond market if they want to and just raise money in the secondary. If they have a great business then a successful secondary can cause the stock to rise even higher - though typically they have a hiccup when a secondary is announced. That is neither here nor there; I am merely pointing out that a fast-growing tech stock can theoretically raise funds and not worry about interest rates. Even with the current interest rate, it is still lower than in 2019 before the pandemic, and really still super low even as it approaches 2%. Worrying about high-PE tech stocks running out of money is nonsense.
My belief is, we chop around below 2% for most of the year. That means that tech stocks will come back to their old highs and perhaps make new highs. The general consensus is that while cyclical names are rising, tech stocks must continue to fall. I go by the rule that once something is the general consensus, it is likely not true anymore. I think we are going to have a broad-based rally. Sometimes tech will be out front and at other times other sectors will either be as strong or lagging a bit and then it will switch. Yes, I am still a bull despite the volatility of the first quarter, and the dive in many tech stocks took hurt me too.
In the short term I think the infrastructure stocks materials, metals, and capital equipment will give up some of their gains as there is a negative reaction to potential overspending by the government, and the taxes that target corporations. Also the rule that you buy on the news and sell on the fact. The fact is Biden introduced the infrastructure bill now reality will set in. The first question will be, will there even be an infrastructure bill passed?
A clue on why I think so is that the markets did not sell off on the announcement of corporate taxes. As I said earlier, stocks are valued on the future flow of earnings, cash flow and revenue growth. The value of that future is less if it is taxed more. Yet the indexes closed up on Thursday. So if industrials and materials take a rest what will work? I agree with the great Tom Lee, Chief of Research at Fundstrat, I am looking for what he calls the “Epicenter” stocks. I would get long restaurants, casinos, travel, theaters, and I would pair that with all the misbegotten tech stocks, especially the chips stocks, but also the IT high tech names that have gotten hit hard. I am not finished implementing this strategy, I am just sharing where I am so far.
Here are my trades: I sold all my financials, metals and materials names - too many to repeat here, but if you go back to my last writings I am sure I mentioned them. This is a medium speed type trade going out to about a month as far as selling this group. If you tend to hold positions for a few months, ignore this move and add to your positions if they have a short term sell-off, as I predict. On the other hand, I think traders will fall back in love with tech as the 10-year continues to find a bit of overhead resistance and chops around from +1.7% down to perhaps 1.5%. We may see a bit of an up move in rates on Monday after the very positive employment news on Friday. I consider this an opportunity to add to my new positions. Yes, I pretty much executed this strategy last week. I am not even finished yet. The newest part of this trade are the travel and entertainment sectors.
A new barbell strategy
I am taking a barbell approach for my travel and entertainment cohort to balance the forlorn tech sector. I am long Boeing (BA), Ruth’s hospitality (RUTH), Cheesecake Factory (CAKE), TJ Maxx (TJX), Shake Shack (SHAK), Las Vegas Sands (LVS) and Boyd Gaming (BYD), for tech I am long Facebook (FB), Pinterest (PINS), Snowflake (SNOW), Palantir (PLTR), Unity (U), Upstart (UPST), Draftkings (DKNG) and to cover chips I am long the semiconductor triple ETF (SOXL). (Please be careful with this. I do not make this a long-term investment as it is leveraged with options and futures. It is repriced intermittently so if I would just sit in it I will see the price move against me.) This is a trading vehicle only.
I have nothing against financials, materials or industrials, but I think they have run as far as they can go for now. I will look for some further weakness in them and will try getting long in them before they reassert leadership, very likely powered by the next leg up in the 10-year later on. Yes, the 10-year will be a driver for market moves for the foreseeable future.
Also, have you noticed the VIX? It broke under 20 and is falling into the teens. You don’t buy insurance when you need it; you buy it when it is cheap. Volatility has not been repealed. If you don’t know what I mean by the VIX and buying insurance, maybe you need to do more homework. If so, please don’t make any aggressive moves based on what you read here. Every discount broker has educational materials; please take advantage of that and watch the webinars.
I want to take a moment to remind you that I am not a certified financial advisor and whenever I talk about stocks it is about what I am doing, not what you should do. Before you buy a stock please do your own research as you are solely responsible for any trades you make after reading my content.