Stocks rose once again amid optimism that Congress would come through with another Covid-19 aid package before it adjourns for Christmas. Government funding runs out at 12:01am Saturday and the hope is that a pandemic relief bill can be attached to an extension of government funding before adjournment. Congress always seems to wait until the proverbial last moment, or maybe a few hours past. Yesterday’s reaction in financial markets was a vote favoring a positive outcome.
While negotiations continue, the Federal Reserve is going to conclude its two-day FOMC meeting this afternoon. The quandary the Fed finds itself in at the moment is obvious. It cannot assume another relief bill by this weekend. It can only deal with what it sees. What it sees is an economy still dominated by the negative impact of Covid-19, particularly the small business parts of the economy that seem overlooked by Wall Street. In those parts of the country where restaurants have been closed due to the pandemic, without further aid, many will have to close. Without a new bill, unemployment for many will run out at the end of this month. Even with another aid package, closures dictated by the virus will have a short term economic impact. Given that the FOMC meets again at the end of January, there is little reason for it to be less dovish this afternoon, even if Congress announces a deal. Hey, Christmas is just over a week away. The wrong time to say Bah Humbug!
Between Fed actions and the Treasury, money supply is growing at a 25% annual rate. In normal times, that would be considered insane and inflationary. Simply pouring more money into a financial system already awash with cash doesn’t seem to make a whole lot of sense. In the 1970s, when the Fed and Treasury worked to grow money supply at an accelerated pace, we witnessed the century’s greatest wave of inflation, reaching mid-teen levels. So why isn’t the same thing happening again?
There are several reasons. First, Covid-19 has restricted our ability to spend. We don’t fly. We don’t take exotic vacations. We drive less. No concerts or sporting events. We rarely eat out. Some brave the cold although I suspect most won’t tonight. There is no reason to buy a new suit or evening gown. Malls are empty. Thus, collectively, we are accumulating money but can’t spend it.
Of course, there is part of the economy we don’t see much on Wall Street. The parts waiting in lines to get food. With no end in sight, even with a vaccine coming, they conserve whatever cash they have just to meet rent and keep the lights on. In the back of so many minds is the Great Recession with its massive numbers of foreclosures. Without Federal relief, many who are benefitting from rent forbearance need to husband every penny. Rent forbearance isn’t rent forgiveness. That money will have to be paid soon or else eviction follows.
If we don’t spend, then we save. But banks and money market funds pay nothing. So, we buy bonds, stocks or whatever we think will go up in value. Inflation isn’t in consumer prices, it’s in asset values. Zero interest rates only accelerates the upward move in stock prices.
Zero interest rates also incentivizes new investments. Not all these investments are good. Right now, there is a lot of empty office space. Rents are declining as millennials leave their apartments for new houses. Walk along Main Street or inside shopping malls and you will see lots of empty store fronts.
Yet at the same time, key commodity prices are soaring. Everything from oil to copper to lumber. Indeed, what we have is both an economy of excesses and an economy of shortages. We are awash in gasoline given no one is driving but we cannot find a bottle of Lysol. Rents are falling while house prices are soaring. Clothing prices are weak for high end clothes, but leisure-wear demand soars.
What is happening is that the excesses are slowly getting absorbed. Oil is a good example. At the height of fear last spring, NYMEX oil futures actually traded briefly below zero. $10-20 oil in March is now $45-50 today. What happened is as follows. In the wake of a sharp drop in demand, so steep it forced prices toward zero in March, producers stopped drilling and shut down production. But the damage had already been done. However, as economic activity gradually rose, demand began to eat into excess supply. Prices started to rebound. They still aren’t at levels that support additional drilling activity. Most oil producers have been losing money since the pandemic started and are in no mood to suddenly drill for more oil. Obviously, if prices get high enough that will change, but where that tipping point is remains only a guess. Thus, oil has gone from a deflationary influence on the economy to one that is now increasing inflationary pressure.
As noted, we live in a world of shortages and oversupply at the same time. That is because economic changes have happened so fast that the world can’t adjust as quickly. Retail has moved online at an accelerated pace. Companies that ship those boxes not only have seen a huge increase in demand, but because so many airplanes sit idle in the desert, capacity to move those boxes has shrunk. Thus, it has been a field day for FedEx# and UPS while stores are empty everywhere.
Rents are down and housing prices are up. Part results from the millennial desire to move out of the city and move to their own suburban home. Part, however, also results from a spate of new apartment buildings that arrived on the market at exactly the wrong time.
About 40% of the consumer price index is tied to the cost of shelter. That means rents or imputed rents. The cost of a house is considered an asset, not an expense. To try and equate the monthly cost of ownership to a monthly rental payment (an expense), the index gods use something called imputed rent based on mortgage rates and equivalent rents per square foot. What that means in English is that as long as rents and interest rates are low, the cost of occupancy imbedded in the Consumer Price Index (CPI) will suggest ultralow inflation, even as the cost of buying and maintaining a house rises at a faster pace. It isn’t just the cost of the house itself. Ancillary expenses from landscaping, home repairs, and, alas, snow removal, are also rising. With the unemployment rate back below 7% and falling, labor markets are tightening again. Not all sectors, but demand for skilled labor, from computer coders to plumbers, is rising.
From a stock market viewpoint, the question is when does this inflation show? When will it get above the 2% benchmark and start to get the Fed’s attention? While the Fed has said it is willing to let inflation run hot for a while before raising rates, long-term rates will rise on their own. If you buy a 10-year bond, not only do you want to cover the cost of inflation, but you want a real return on top of that. Such a rate doesn’t exist today because the Fed is buying $120 billion of bonds per month to artificially keep rates down. But that can’t go on forever. Indeed, today, as the economy continues to improve and commodity prices keep rising, investors will look to post-FOMC meeting comments for hints as to how the Fed’s dovish behavior might change.
Markets right now are super optimistic. They see economic growth accelerating. They are confident of more Federal aid, if not now, soon. They are confident that vaccines will arrest the pandemic in 2021 and life a year from now will be close to normal. And they are convinced that the Fed will keep rates near zero through 2021 and perhaps even into 2023. While the odds of each of those dreams are high, the odds that everything works perfectly is low. The odds of rain on any given day are fairly low. But a rain free month is unheard of in the Northeast. But as long as the bumps along the road aren’t too damaging, markets can still work higher. The greatest fear, in my mind, is that inflation and higher long-term rates appear sooner than expected. Rates and inflation will rise. The only question is when. Most say it will be 2022 or later. But forecasters aren’t always right.
Today, Leslie Stahl is 79. Actress Liv Ullmann turns 82.
James M. Meyer, CFA 610-260-2220