Stocks closed mixed yesterday in a session with little economic news. The yield on 10-year Treasuries fell to 1.51%, the lowest yield since late February. This is despite the May CPI report, due out tomorrow morning, that is likely to report year-over-year inflation at or above 3%. The Fed has said that current inflation readings are a bit misleading, comparing current data to the abyss of the pandemic. Such surges are believed to be temporary, and apparently the market believes the same. Already futures for commodities like lumber and copper have fallen well below recent record highs.
Think of normal daily traffic. Barring accidents or construction delays, traffic normally moves along smoothly during the day. As volume picks up in mid-afternoon it slows. When rush hour begins, and more drivers are coming on the highway than leaving, it slows to a crawl. As rush hour passes, fewer enter while more get off, gridlock ends and traffic flows steadily again. The same pattern is happening post pandemic. Demand surges, coupled with low initial inventories, have more people buying than selling. Either prices spike as a result, or shelves run bare and out-of-stock signs are posted. Double ordering only increases demand and aggravates the problem. Eventually, production catches up as higher prices incentivize producers to work overtime to meet demand. As residual demand is filled, prices stop rising. If too much demand comes on line, prices ultimately recede. That is what is happening to lumber and copper futures at the moment. Commodity shortages don’t last long.
That doesn’t mean all shortages dissipate quickly. It will take some time for the semiconductor industry to fulfill demand for very sophisticated chips from the auto industry. Balance will be restored but not until sometime in 2022. With that said, dealer lots will be less bare in the Fall than they are today. The same is true for housing. To achieve balance, about 2 million or more existing homes have to come to market for sale. Higher prices will ultimately bring sellers into the market. As that happens, lines at Open Houses will shorten and the time between listing and sale will lengthen. Pre-pandemic norms may not return for years, and it might remain a sellers market for a long time. But the frenetic world today will slow to something approaching normal by the Fall.
That doesn’t mean inflation isn’t going to be with us in some fashion. There are 9 million posted job openings. Our economy is adding a bit over 500,000 jobs per month. The numbers say that at the current pace it would take 18 months to fill all 9 million jobs. Of course, not all the jobs will be filled, there is never a period with no job openings. Some of the job postings today will never be filled, while new postings are always added. But just like the housing market, there could come a time when employers trying to fill jobs will have to pay significantly more than they are paying today to get what they need. To be sure, there are skills mismatches. Some jobs will require training, others simply better offers. As long as our economy is growing faster than the rate of increase in the labor supply, the gap will narrow and wage inflation will rise. Once the pace of growth slows, and the number of workers seeking jobs rises at a faster rate than job openings, wage pressure will decrease. Right now that seems a long way off. The bigger risk would seem that too tight a labor market leads to higher-than-desired wage inflation.
At the same time, there are disinflationary forces at work. Automation is one. Robots replace humans. Order kiosks replace order taking workers. Self-checkout replaces cashiers. Parking lots today can be manned by one person. Fewer people go to banks. Online retailers increase penetration at the expense of storefronts.
Perhaps the biggest disinflationary force is the record amount of debt outstanding. Progressives often subscribe to an economic theory that says debt service is much more important than the amount of debt outstanding. As long as rates remain low, an economy can absorb much more debt. Therefore, governments and businesses should not fear deficit financing. They should embrace it and spend to fulfill current needs. That all works as long as rates stay low. Rates stay low as long as there are an increasing number of investors willing to buy and hold the swollen amount of debt.
Should the Fed “taper” and slow the pace of bond purchases in the future, who is going to step forward and replace the Fed as a buyer of $120 billion per month? Who is going to buy the $2 trillion of additional debt each of the next 5 years to finance the record deficits the Biden administration itself predicts? Without adequate buyers, demand falls, and supply rises. That means, in the bond world, lower prices and higher rates. Note that I did not use the word inflation in this explanation at all.
The conclusion is that if market forces are left to their own devices without central bank interference, interest rates should rise at least to a level where the investor can earn a positive real return, i.e. the coupon rate on the bond exceeds the rate of expected inflation. Since the Great Recession, Fed intervention has kept real rates negative. While that has promoted some investment spending, weak demand growth has served to channel the large part of the excess money created into investments, keeping rates low and allowing stock prices to reach record levels. It also served to keep inflation at bay.
Thus, the Government has two choices. It can reduce its market intervention and allow rates to rise. At some point, sooner rather than later because of the swelling amount of debt outstanding that has to be serviced, the rise in rates will slow the pace of economic growth, pushing us back toward the 2% growth, 2% inflation world we lived through in both the Obama and Trump years. Or it can continue to buy even more bonds as deficits swell, keep rates as close to zero as possible, and risk the unintended consequences associated with borrowers using free money for unintended and uneconomic purposes. There simply isn’t a good answer.
Short term, meaning now, everything looks rosy. The economy is rebounding quickly, profits are rising at a record pace, the Government is handing out checks to almost everyone, and there is enough slack in the economy to keep inflation low. Please note that the rise of cryptocurrency, ransomware, SPACs, NFTs, and other new tech contrivances are fed by the mismatch of too much money trying to find a new home. Cryptocurrency at the moment is a $2 trillion empire trying to find a legitimate purpose. Lordstown Motors is a company that came public via a SPAC merger in October to make electric trucks. Eight months later it has run out of cash, its value has dropped in half, and its first deliveries (should any ever happen) are still many months away. Good idea, bad management. Many other SPACs will follow its lead. There are over 300 publicly funded SPACs looking for something worthwhile to buy. Some will find success, most won’t. That’s what happens when too much money sloshes around.
The bond market, usually smarter than the stock market, is telling us that the economy won’t stay hot long enough to create significant inflation. It is also saying that it believes central banks will choose to or be forced to remain active net investors in order to ensure low rates persist for longer. That may prove good for stock prices. Whether it is ultimately good overall is an open question. We have never lived through a period of such massive spending and debt creation without an intervening financial crisis. How this all ends is still a crapshoot.
Today, Natalie Portman is 40. Johnny Depp is 58. Michael J. Fox turns 60.
James M. Meyer, CFA 610-260-2220