Point 1 – Staying at home.

Staying home renewed our demand for various physical stuff. If you can’t go to concerts anymore, maybe you buy better home electronics—or a bigger home, which means you (or your contractor) buy more construction material, tools, etc.

Now we see shipping rates and container traffic rising sharply. This isn’t coincidence. The global economy was optimized to deliver something else, and now has to suddenly satisfy new consumer preferences. That drives prices up. Throw in the fact that many transportation companies went bankrupt over the past few years, and the supply of transportation companies all along the supply chain was reduced and thus the prices paid to the survivors have increased.

Point 2 – The economic recovery begins.

With recovery now underway, employers need workers again and are often having to pay higher wages to get them. That means even more service inflation, on top of the prior 2.8%+ annual growth. Add in new goods inflation we don’t see how we avoid a new inflationary cycle. The question is how long will it last? It is not unreasonable to assume that the inflationary forces of rising wages caused by the pandemic and labor shortages will persist.

Point 3 – Demand driven.

The stimulus payments were huge. A lot of people have a lot of spending money we think it will push prices even higher. Some of this excess found its way into financial assets, helping stock prices, Bitcoin, etc. But a lot of it was spent on other goods and services. Much of this price inflation was due to production closures during the pandemic. Lumber has backed off recently as more supply comes online and high prices deter some buyers. This is why the Fed thinks inflation will be “transitory.” And to some extent, they are correct. But not completely and certainly not in the other elements of inflation.

One-third of everybody’s income is now mailed to them from the government. Everybody is stuffed full of money. They’re buying stuff like crazy. The supply chain cannot keep up. It is not a problem of COVID, semiconductors. Look, the head of Intel said that the semiconductor supply chain is going to be a problem for two years. There is a simple fix for the supply chain. Charge more money, that’s called inflation. What they’ve done now isn’t status, they’ve rationed the product, delivery times are at a 70-year high, but I think the next step is they’re going to charge more money and we’re going to get inflation.

The semiconductor shortages have a variety of downstream effects. Automotive production is slowing, with several companies temporarily closing assembly lines due to component shortages. At the same time, people and businesses need vehicles as the economy tries to resume growing. If you can’t find a new car or truck, the next best thing may be a used one—leading to the price spike shown in this used vehicle index.

Also, when investors pile into commodities as an investment vehicle to benefit from rising inflation, they create substantial upstream cost pressures. Beyond the cascading effect of upstream commodity price pressures, headline CPIs are also quickly impacted as food and energy prices rip higher.

 

 

Another factor is car rental companies, which liquidated much of their fleets when travel collapsed in 2020. They represent a large part of used vehicle supply which now isn’t there. This won’t last forever, but for now it’s another of many distortions to resolve before the economy can get back to normal.

Point 4 – Energy Prices.

Modern economies developed as we found more efficient energy sources, going from coal to oil to natural gas and nuclear. Now we want to transition from carbon to renewables like solar and wind. This may ultimately bring great benefits, but for now it has produced under-investment in fossil fuel production capacity.US shale production plunged last year and hasn’t yet recovered.

This may be a problem because inventories are low and fuel demand is rising as more people begin moving around again. We can import to make up lost domestic production, but that will add to the trade deficit and weaken the dollar (which is also inflationary). Meanwhile other countries will also be reopening, further increasing global oil demand. This will likely push energy prices significantly higher.

Point 5 – Wages

As housing becomes less affordable, wages will have to rise. Prior recessions always saw wage growth slow, if not reverse. We are trying to emerge from a recession in which wage growth never fell, which is historically unprecedented.

In a typical recession, even those who keep their jobs see wages cut or at least don’t get raises. Not so this time. If you weren’t a laid-off service worker, you saw little effect on your pay.

So, wages, generally speaking, haven’t dropped and are rising in some segments. You might expect employers to respond with more automation… but we also have a serious microchip shortage. It is reducing automotive production (which raises vehicle prices, further aggravating inflation). Replacing human workers with robots may not be a short-term solution.

Summary:

 

 

Interest Rates, Inflation and Deflation

 

Dr. Lacy Hunt of Hoisington Management has been consistently right about inflation (little or none), interest rates (flat or down), and Treasury bonds (bullish) for decades. He built that track record by simply standing his ground. To Lacy, it’s all just math: The equations have specific answers and thus do his investment choices. That may sound easy but it takes a lot of courage.

In Lacy’s view, today’s core problem is that excess debt suppresses economic growth, without which demand can’t rise enough to generate inflation or push up interest rates over the medium term. This is a structural problem, which at this point we really can’t fix.

 

 

Going back further, Lacy showed the US has experienced five major debt bubbles in the last two centuries, all of which led not to inflation, but to disinflation or deflation. If you could ask the world’s top central bankers what really terrifies them, I think the honest answer would usually be “deflation.” It is their greatest nightmare. They think a little inflation is good (thus the 2%+ target), and they’re confident they can subdue it if necessary. Deflation is a bigger problem.

Let’s note, however, that these aren’t either/or conditions. They have degrees of severity. Indeed, the last four decades we’ve seen disinflation—a mild form of deflation—in many segments of the economy. Compared to that, even relatively mild inflation looks quite concerning.

 

 

Lacy also pointed out that inflation is actually a lagging indicator. It doesn’t usually turn higher until well into a recovery phase.

 

 

This runs counter to today’s popular narrative (discussed last week), which says to expect strong recovery and rising inflation at the same time. Lacy explained why that doesn’t happen.

The typical lag between the start of a recession and the low point of inflation is almost 15 quarters and even when the lags are shorter, only six to seven quarters, in those particular two cases, the inflation rate was still near its low, two and three and four years later. And there’s a good reason why inflation’s a lagging indicator. If you go into a recovery or attempt to recover, and the inflation rate takes off, that will truncate the recovery. You’ll have a wider trade deficit, inflation will push up interest rates and that will work against the recovery. And since prices rise faster than wages, you reduce real income. In other words, to have a major acceleration in inflation means that the expansion will not hold.

Lacy also explained why he isn’t worried about the increased money supply. It gets back to his point on debt. The amount of money is less important than the speed with which it circulates, or “velocity,” which is at the lowest level ever.

 

 

We have to take into account what’s happening to the speed at which money turns over and the velocity of money hitting an all-time low. And what is causing velocity to decline is that we’re taking on too much debt, it’s triggering diminishing returns and non-linear relationship and this pulls the marginal revenue product of debt down and it also takes the banks out of the process and that pulls velocity lower.

Another problem, Lacy believes, is that debt reduces savings. If you do not have saving out of income, you cannot get sustained growth in investment. Without sustained growth in investment, the standard of living does not rise.

Bottom line – There’s only two situations that are worse and that was during the 1930s and also during the late 2000s. We simply do not have the resources to fund ourselves and to obtain a higher standard of living, which means that the economy will falter as we go forward, inflation will move lower. Lacy agrees we could see some transitory inflation this year. He doesn’t see it lasting long, and Fed policy doesn’t especially matter. We are beyond that point.

If the Fed wants to raise interest rates, they can slow economic activity down. However, when economies become extremely over-indebted and debt levels are rising very dramatically, the velocity of money falls. And that keeps shifting the aggregate demand curve inward. The fact of the matter is there is no mechanism other than for a very limited period of time by which the inflation rate can go higher.

On the idea that rising commodity prices will drive inflation. Commodities actually have no correlation with inflation. We have many examples of one rising without the other. Nor do we expect to see much wage pressure, given the large number of workers still on the sidelines. Aside from the many officially unemployed, millions more are working part-time and would expand their hours if possible. Another 6–7 million left the labor force but say they want a job. The number of available workers should grow considerably in the next few months as vaccinations make jobs safer, schools reopen, and enhanced unemployment benefits expire (which is already happening in many states).

That should, at the very least, cap aggregate wage pressure without even counting the many ways businesses have become more efficient and automated. Certain industries like restaurants and hotels are indeed seeing wage pressure, but we think it isn’t enough to affect the broader picture.

Finally, the CPI pressure we see right now is almost exclusively a US phenomenon. The rest of the world just isn’t feeling it.

 

 

Cathie Wood of ARKK fame weighed in.  “Goods are only one-third of consumption in the GDP accounts. Services are two-thirds. What I think is going to happen now is businesses are scrambling like crazy to keep up with demand. They can’t. They got way behind. They’re… double and triple and quadruple ordering. That’s the first thing. The consumer, yes, has been spending aggressively on goods, but probably is about to shift the mix back towards services, maybe disproportionately. I think we’re going to end up with a massive inventory problem towards the end of this year or into next year.“

 

Carbon Credits

 

Carbon credits will turn out to be the commodity of the 21st Century. Since 2018, the asset class has doubled Bitcoin and more than five times the 100% return in the Nasdaq.

 

 

Not a single research firm is factoring in the carbon offset costs that will impact corporations over the next five years.

  • This will be a new item on financial balance sheets.
  • ESG investing wave brings this forward.

Coming is the ability for the purchaser of a good to determine if they want to buy a product from a green manufacturer or from a heavy carbon emitting producer.

The world is moving to a 2050 carbon-neutral footprint. Europe has the most aggressive carbon-neutral goal. Currently, the world produces about 32 billion tons of CO2 per year. Think smokestacks at manufacturing plants, cars, trucks, air conditioning, etc. Anything that produces anything omits CO2 into the air.

If we do nothing, the dotted red line is where we are estimated to be in 2050. The black line is the Kyoto Protocol that they’re trying to get to. Carbon credits are a $16 trillion opportunity. The market is legitimate today, with verifications from firms such as PWC (PricewaterhouseCoopers, LLP) and all the big five accounting firms involved.

In America, there are 189 companies on the listed stock exchanges that said they have a target carbon reduction goal. In European listed markets, there are 268 companies with committed target reduction goals. Combined, this is a small number representing about 8% of all listed companies. Companies are just beginning to think about how to go carbon neutral. Herein lies the opportunity.

There are 2,410 companies in something called a Scope 1 category that have to report their target emissions. Only 8% have announced targets to reduce CO2 emissions but haven’t even begun to start to reduce.

There are 5,230 total companies in the US and Europe on the exchanges, with a market cap of more than $1 billion. Here is what we believe:

  • Over the next decade, accounting standards globally will incorporate CO2emissions on the balance sheets as liabilities in some form.
  • This will be used by ESG funds and green bond market (which will be the largest growing sector of the bond market) to track and rate coupons and flows of capital.
  • Nobody is talking about this now—but they will in three to five years.

Here’s the bottom line: The cost of capital, driven by CO2 mandates and incented by markets will drive the value of the carbon credit market higher. ESG and sovereign wealth funds bring this forward faster.

 

US Economy

 

  • The Richmond Fed Manufacturing index is off the highs but remains quite strong.
  • Supply chain constraints continue to worsen.
  • They are struggling with shortages of skilled workers. It’s amusing to hear politicians and the media talk about “bringing back” manufacturing jobs. The jobs are already here. The workers are not.
  • Manufacturers are boosting investments to make their existing workers more productive.
  • By the way, with the labor force growth increasingly constrained, productivity gains will drive economic expansion in the years to come. That’s why watching CapEx trends is critical.
  • The Conference Board’s consumer confidence index was weaker than expected in May.
  • But the labor differential (“jobs plentiful” – “jobs hard to get”) has fully rebounded, pointing to strengthening demand for labor.
  • The Conference Board’s index measuring households’ vacation plans remains depressed.
  • New home sales in April were weaker than market expectations.
  • The “home buying plans” index from the Conference Board declined sharply this month.
  • Builders increasingly see hesitancy from buyers.
  • Home price appreciation accelerated further in March.
  • 50% of homes have been sold above list price.
  • Home price gains continue to outpace wages.
  • The US dollar continues to weaken.
  • The decline in US real rates suggests further weakness for the dollar.
  • Population growth by state:

 

 

  • Utah vs Hawaii GDP

 

 

Thought of the Week

 

“Stay close to people who feel like sunshine.”

– Unknown

 

Picture of the Week

 

 

 

 

All content is the opinion of Brian J. Decker