Stocks continued to move higher last week. Although President Biden stepped back from the bipartisan infrastructure bill by demanding it be tied to a broader progressive agenda to spend billions more on social programs, over the weekend he seemed to walk that back a bit, no longer insisting a veto would accompany a stand-alone bill. Nonetheless, the odds of any bill passing remain higher than they were at Thursday’s press conference announcing the infrastructure agreement.
Of all the President’s spending proposals, infrastructure probably has the greatest popularity among the electorate, with some polls showing 70%+ of Americans supporting the effort. Other progressive agenda proposals, both on the spending and tax sides, are far less popular. Trying to tie everything together is a political gamble the President may or may not want to take. To win he would require the votes of every Democrat. With the infrastructure plan agreement announced last week, there could be enough Republican support, such that every Senate Democrat wouldn’t need to vote yes. But could isn’t would. Minority Leader McConnell hasn’t spoken yet. He is laser focused on the 2022 mid-term elections. His support depends completely on whether that would help the Republican cause in 2022 or not. There are simply too many alternatives today to judge the success of anything. I suspect Wall Street will not try and decipher the tea leaves until the August recess is over and more clarity is potentially forthcoming.
Politics aside, we sit today at the peak of the economic mountain. GDP growth right now is near 10% annualized, as high as it is going to get. Numbers this quarter will be compared to the slowest quarter of 2020. Sequentially, we continue to climb out of hibernation, gaining traction. Inflation is also at a peak. The recent spike in some commodities, like lumber and copper, are already waning. Others will follow. Soaring home prices are starting to elicit more sellers. They also are pricing out potential buyers. Simply said, 24% annualized increases in prices are unsustainable. Used car prices are up 10%+ simply because new cars are unavailable thanks to chip shortages. In some cases, late model prices are nearly equivalent to new car prices. Once the chip shortage disappears, that gap will widen again. Beef, chicken, and pork are on separate cycles. Buyers will gravitate to what is the cheapest source of protein as they always do.
Peak earnings growth rates are not the same as peak earnings. With no recession in sight, earnings will continue to rise for several years, in our view. Likewise, while commodity prices will settle down, rents and wages are likely to continue to climb. Inflation won’t disappear, it will simply moderate.
That brings me to the $64,000 questions. What will be the growth rate a year from now? What will be the inflation rate a year from now? And how will the Fed respond?
Let’s take them in order. I don’t know the growth rate a year from now, but I do know that the underlying forces of growth are demographics and productivity. Long-term productivity growth in this country has rarely exceeded 2.0-2.5% on an annual basis for decades. Population growth is well under 1%. Without any sudden acceleration in immigration or productivity, it is therefore impossible to sustain growth of more than 3% for any sustained period without a permanent and steady infusion of money from the government, like the stimulus checks handed out over the past year. That is unlikely. Thus, growth will slow from the current pace of close to 10% to a normalized rate of 2-3%. The only question is how long will it take? At the recent FOMC meeting Committee members forecasted 3.5% growth next year. I will assume that to mean growth near 4% at the start of the year and closer to 3% and the end of 2022. I can’t be any more accurate than that. Such a trend suggests reversion to the mean no later than early 2024, ignoring all other extraneous factors.
As for inflation, the goal is 2%. History over the past decade says 2% is a tough goal. But tight labor markets and a tight housing supply suggest wage rates and rents may rise at a faster pace looking ahead. Nonetheless, powerful deflationary forces related to technology and the Internet remain in place. While I won’t make a precise inflation prediction, I would assume a year from now it won’t be as high as 3%, and a case can be made that it might not even be 2%.
Thus, given an economy a year from now moving back to trendline, what will the Fed do? Ideally, it would be nice to see market forces take over and the artificial influence of massive monetary easing to wind down. The question is whether the Fed can allow that to happen. The Fed currently is buying $120 billion of bonds (net) per month, about two-thirds being Treasuries of various maturities. Depending on one’s prediction of future Federal deficits, the Treasury will have to issue $100-$200 billion of additional debt each month. For a decade, the largest buyer of Treasury debt has been the Federal Reserve. Since the Great Recession, a little over a dozen years ago, the Fed has increased the size of its balance sheet by over $7 trillion, effectively monetizing our deficit. The government overspends beyond its means, and the Fed sops up the difference. The aftermath is trillions of additional dollars sloshing around, eventually evidencing itself via higher asset prices.
The key question, therefore, is can the Fed afford to taper its bond purchases to zero? If it does, who replaces it as the buyer of Treasuries? The answer is easy if you simply allow the price of Treasuries to fall to more attractive levels. But that means higher rates. Deficit spending only works effectively if rates stay low. The Fed and the U.S. government don’t want to see 3% 10-year Treasuries, much less anything higher. Note that I haven’t tied bond yields directly to inflation. I am only suggesting that if the Fed backs away, what is likely to happen is that real rates, negative for most of the past decade while the Fed was adding to its balance sheet, will become positive again, meaning owners of government bonds will earn a real return as a reward for lending the government money.
One might ask, what is so wrong with a policy that monetizes all deficits and inflates asset prices? There are several answers. First, savers, notably retirees, lose. Americans who don’t own assets, like homes and stocks, lose and get left behind. Finally, if the impact of stimulus eventually clashes with a full employment economy, inflationary pressures get ignited. It won’t be just asset prices that rise, it will be products and services we consume every day as well.
The bottom line is, can the Fed actually afford to taper its bond buying program all the way to zero? Can it increase rates at all a year or more from now with an economy slowing below a 3% rate? It’s an open question. But anyone suggesting a return to pre-Financial Crisis norms may want to reconsider what happens in a world where deficits average 4-7% of GDP and the Fed opts to allow market forces to price money efficiently. That is the backside to the grand experiment that has been going on for a decade plus, and could even be accelerated if President Biden’s aggressive agenda becomes law. So far, we have monetized the debt and created a boom in asset prices. How that might change awaits us.
Today, Elon Musk is 50. Mel Brooks turns 95.
James M. Meyer, CFA 610-260-2220