Happy St. Patrick’s Day in a Covid-19 world. No parade, but hopefully we will be seeing some green in the stock market. Actually, yesterday was a rather quiet session, and today, if futures are any indication, should be relatively calm as well. We are in that part of the quarter where there are few earnings reports and not much in the way of economic news. The big event today is the conclusion of the FOMC meeting. Clearly, there will be no change in interest rates and there is not likely to be any change in guidance.
With that said, markets are predicting rate hikes starting sometime next year, while Fed officials suggest it may be longer before a rate hike is initiated. Fed watchers will look at the dot plots of FOMC members to gauge individual predictions, but the track records of individual members have been abysmal historically. They have no more idea of what the economic backdrop will look like 18 months out than a weather forecaster has telling you what November 2022 will bring.
The real question is when will inflation pick up and how fast will it rise. The increase in interest rates over the first two months of this year, combined with a rise in commodity prices and the passage of another huge stimulus bill, has increased fears that a surge in inflation is inevitable. Clearly, there is logic behind that fear. More stimulus should mean more demand. If demand rises faster than supply, then inflation is inevitable. Fed officials and Treasury Secretary Janet Yellin seem to agree that we will return to full employment, with an unemployment rate close to 3% by the end of 2022. We are already witnessing difficulties filling some skilled positions. There is little doubt that much of the pending $1400 stimulus checks will be spent, adding to demand. With the pandemic winding down (hopefully), more people are flying and driving. No wonder gasoline prices are closing in on $3.00 per gallon.
But surging inflation isn’t inevitable. While the 10-year Treasury yield is now up to 1.6%, that hardly signals rapid inflation. It doesn’t even suggest we are getting back to the Fed’s stated 2% goal.
Indeed, the Fed itself may be its own villain. The idea of low interest rates is to make holding cash so unappealing that one will spend more money. If the money the Fed was pumping into the financial system was finding its way to those most likely to spend, perhaps that would be the outcome. But that isn’t where the money has been going. It ends up in the hands of investors, not spenders. Instead of buying clothes and cars, investors buy stocks or even Bitcoin. They might invest in bricks and mortar, but at least until recently there hasn’t been any need to build more factories or structures. We face a surplus of commercial real estate space today, partly due to the pandemic.
But low interest rates, negative in real terms, pushes people to make dumb decisions. When the cost of capital is real, meaning the interest rate to be paid is higher than the rate of inflation by a meaningful amount, investors must factor in the cost of borrowing. But when money is “free”, i.e., there is no real cost to borrow, investors ask themselves, “why not?”. Thus, we have Hudson Yards in New York, a glamorous new real estate development that was supposed to transform the entire city. Today, it looks more like a real estate graveyard. It could take a decade or longer to absorb all the empty space. Between 1900 and 1920, through one financial crisis and a World War, there were over 3,000 companies formed to manufacture automobiles in the United States. Yesterday, there was an article in the Wall Street Journal outlining the amount of time some new electric vehicle startups are telling investors it will take to reach $10 billion in sales each. Many suggest it will be done in 3-5 years, or less than half the time it took Google, Facebook# or Amazon# to reach those heights. Even Tesla took significantly longer and it is likely that none of these startups will replace Tesla as the electric leader. This is what happens when too much cheap money is sloshing around.
But I am not trying to discuss investment stupidity this morning. I have done that enough. I am talking about inflation. What cheap money does is force the development of excess supply. The Fed’s monetary policy cannot create more people, but it can facilitate the construction of excess capacity. We have seen this happen often in the past. When the Internet bubble burst, the biggest competition to Cisco for routers and switches was bankrupt companies selling hardly used Cisco routers and switches. Fiber cable under the Atlantic went unused for over a decade. After the oil bust in 2008, rigs were mothballed until, ultimately, they went to the salvage yard. The oil industry still hasn’t recovered. Offshore drilling today is a tiny fraction of what it was in 2008.
The reality is that most of today’s electric vehicle startups won’t succeed. Most will never make a profit. To be sure, some will, and a few will become tomorrow’s giants. But 3-5 years from now, some smart auto manufacturer will buy a zombie auto plant for dimes on the dollar. All these companies chasing the same pot of gold insure just one thing, the cost of an electric vehicle to the consumer is destined to go in one direction…down.
Right now, oil prices are spiking. But when mothballed production gets back on line and artificial supply constraints are lifted, prices will stop rising. As housing demand climbs, more sawmills will be built. That will temper the rise in lumber prices. There never was a shortage of trees.
And all this ignores the ongoing deflationary forces of technology and globalization. If Chinese labor costs get too high, there is always Vietnam and Bangladesh.
Sure, inflationary forces are intensifying and there will be some inflation. But the message of the stock market so far is that surging inflation is unlikely. The Fed is going to tell you today that it will keep pumping for as far is it can see. Indeed, as some suggest, the Fed may be trapped into maintaining current policy for a very long time. American investors can support a 3-5% deficit (as a percentage of GDP) through additional bond purchases. Beyond that, foreign buyers are needed. As long as the dollar remains the world’s reserve currency, that gap will be filled. But the dollar hasn’t been the reserve currency forever, and it won’t remain the reserve currency if we abuse the privilege by effectively devaluing it against other world currencies.
While some fear that may be happening now, the dollar isn’t losing ground against other currencies. The currency market serves to balance relative values. If our economy is much stronger than every other nation and the attractiveness of investing here is too strong, the value of the dollar will rise, making entry into our markets more expensive. Similarly, countries with ongoing economic disadvantages have the weakest currency. Look at Argentina or Venezuela, for instance. In reality, on the world stage today, there are only three notable currencies large enough to compete for the reserve currency crown: the dollar, the euro and the Chinese yuan. Until the yuan can float freely and the Chinese government allows free market forces to take hold, it will not be the reserve currency. As for the euro, the EU is more a confederation than a union. So, the dollar remains on top.
The bottom line is that for years we have heard talk of pending inflation that never arrived. This time may be different, given the amount of monetary and fiscal stimulus. But going from virtually no inflation to rapid inflation is simply a stretch. In an environment where the temptation to build extra and often inefficient capacity is persistent, even reaching and maintaining 2.5% inflation may be a stretch.
When one tries to alter the rules of natural order, pure success is rare. For a short time, GDP growth will accelerate. But just as climate change creates the extinction of species, too much external meddling in financial markets will, undoubtedly, bring unwanted consequences. We don’t know what they all will be right now. Today, what we do know is that the economy is gathering strength and earnings are rising. That is a big tailwind for stocks. Rising inflation fears are an offset. How those fears transform to reality will dictate the future course of markets. Perhaps the only guarantee is more volatility.
Today, Rob Lowe is 57.
James M. Meyer, CFA 610-260-2220